House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon. Josh Frydenberg MP)

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Tax arrangements for transitioned petroleum activities

This Bill amends the ITAA 1997 to give effect to the tax arrangements required to support the 2018 Treaty. In particular, this Bill fulfils Australia's obligation under the 2018 Treaty to provide 'conditions equivalent' to participants in transitioned petroleum activities affected by the 2018 Treaty in respect of their taxation affairs.

Date of effect: The tax arrangements apply from the day the 2018 Treaty enters into force.

Proposal announced: This Bill partially implements the legislation required to support the Treaty between Australia and the Democratic Republic of Timor-Leste Establishing their Maritime Boundaries in the Timor Sea signed at New York on 6 March 2018.

Financial impact: This Bill has an unquantifiable cost to revenue.

Human rights implications: This Bill does not raise any human rights issue. See Statement of Compatibility with Human Rights - Chapter 2, paragraphs 2.1 to 2.4.

Compliance cost impact: Minimal.

Chapter 1 - Tax arrangements for transitioned petroleum activities

Outline of chapter

1.1 This Bill amends the ITAA 1997 to give effect to the tax arrangements required to support the 2018 Treaty. In particular, this Bill fulfils Australia's obligation under the 2018 Treaty to provide 'conditions equivalent' to participants in transitioned petroleum activities affected by the 2018 Treaty in respect of their taxation affairs.

Context of amendments

The 2018 Treaty

1.2 The 2018 Treaty establishes permanent maritime boundaries between Australia and Timor-Leste and a regulatory framework for petroleum development in the Timor Sea. When it enters into force, the 2018 Treaty will supersede and replace the provisional arrangements agreed in the 2002 Treaty and the Agreement between the Government of Australia and the Government of the Democratic Republic of Timor-Leste relating to the Unitisation of the Sunrise and Troubadour Fields (Dili, 6 March 2003) [2007] ATS 11.

1.3 This Bill forms the second and final tranche of legislation required to implement the 2018 Treaty. The first tranche of legislation consisted of the Timor Sea Maritime Boundaries Treaty Consequential Amendments Bill 2018 and the Passenger Movement Charge Amendment (Timor Sea Maritime Boundaries Treaty) Bill 2018. All legislation required to implement the 2018 Treaty must be in place before the Treaty can enter into force.

Effect of the 2018 Treaty on tax arrangements

1.4 The 2018 Treaty has an effect on two classes of petroleum activities:

•

projects in the Joint Petroleum Development Area, which are currently subject to Australian income tax on 10 per cent of the taxable income and to Timorese income tax on 90 per cent of an equivalent Timorese amount. Under the 2018 Treaty, these projects will transfer to being entirely within Timorese jurisdiction; and

•

the portion of Australian exploration permit WA-523-P, including the Buffalo Oil Field, which is currently within Australia's jurisdiction that will transition to become within the jurisdiction of Timor-Leste.

1.5 In relation to the portion of Australian exploration permit WA-523-P permit area not referred to above, the holders of exploration permit WA-523-P are taken to continue to hold their interest in the Australian portion of WA-523-P and at no point in time does the Australian portion of WA-523-P cease to exist.

1.6 The taxation arrangements for the Joint Petroleum Development Area are outlined in the 2002 Treaty and incorporated into Australia's domestic law under Part 3 of the Petroleum (Timor Sea Treaty) Act 2003.

1.7 The primary effect of the jurisdictional transition on the tax affairs of the relevant project participants is that the projects will cease to generate Australian assessable income and will instead generate Timorese income or additional Timorese income. This has the potential to disadvantage taxpayers who have invested in depreciating assets used in transitioned petroleum activities. Under the current law, the decline in value of these assets will cease to be deductible to taxpayers if they are no longer held for a taxable purpose of producing Australian assessable income. Equivalent deductions will not be recognised for these assets under the Timorese income tax system.

1.8 Further, taxpayers will be disadvantaged if they have insufficient Australian assessable income against which any deductions or carried-forward tax losses can be applied.

1.9 The 2018 Treaty provides that on transition to the new jurisdiction the rights of commercial operators will continue on 'conditions or terms equivalent' (Article 1(1) and 4(2) of Annex D to the 2018 Treaty). This includes conditions in respect to taxation arrangements.

Summary of new law

1.10 This Bill amends the ITAA 1997 to give effect to the tax arrangements required to support the 2018 Treaty. In particular, this Bill fulfils Australia's obligation under the 2018 Treaty to provide 'conditions equivalent' to participants in transitioned petroleum activities affected by the 2018 Treaty in respect of their taxation affairs.

Comparison of key features of new law and current law

Detailed explanation of new law

Transitioned petroleum activities

1.11 This Bill amends the income tax law to fulfil Australia's obligation to provide conditions equivalent to taxpayers affected by the entry into force of the 2018 Treaty. The amendments in this Bill only apply to transitioned petroleum activities. [Schedule 1, item 1, sections 417-1 and 417-5 of the ITAA 1997]

1.12 Transitioned petroleum activities generally relate to petroleum fields transitioned from Australian jurisdiction or the Joint Petroleum Development Area to become exclusively within the jurisdiction of Timor-Leste.

1.13 Article 1 of Annex D to the 2018 Treaty lists the Joint Petroleum Development Area production sharing contracts that are subject to the conditions equivalent obligation. These include:

•

production sharing contracts JPDA 03-12 and JPDA 03-13 (the Bayu-Undan Gas Field);

•

production sharing contract JPDA 06-105 (the Kitan Oil Field); and

•

production sharing contract JPDA 11-106 (the 11-106 Oil Field).

[Schedule 1, item 1, section 417-10 of the ITAA 1997]

1.14 The amendments in this Bill do not apply to two production sharing contracts JPDA03-19 and JPDA03-20 or the two retention leases NT/RL2 and NT/RL4 listed in Article 1 of Annex D that are within the Greater Sunrise Fields. The 2018 Treaty creates a 'Special Regime Area' for these fields in Annex C to the Treaty.

1.15 The amendments in this Bill also apply to petroleum activities in the part of the Petroleum Exploration Permit WA-523-P permit area that, as a result of the 2018 Treaty entering into force, ceased to be within the continental shelf of Australia. [Schedule 1, item 1, section 417-10 of the ITAA 1997]

1.16 This part of the Petroleum Exploration Permit WA-523-P permit area includes the Buffalo Oil Field. Article 4 of Annex D to the 2018 Treaty provides an obligation to provide conditions equivalent to participants in the Buffalo project.

1.17 The term 'petroleum activities' is defined in paragraph 1(p) of the 2018 Treaty to mean 'all activities undertaken to produce petroleum, authorised or contemplated under a contract, permit or licence, and includes exploration, development, initial processing, production, transportation and marketing, as well as the planning and preparation for such activities'.

Capital allowances

1.18 This Bill amends the tax arrangements for depreciating assets used in transitioned petroleum activities prior to the entry into force of the 2018 Treaty. The amendments fulfil Australia's treaty obligation to provide conditions equivalent and ensure the 2018 Treaty does not disadvantage taxpayers.

1.19 Following the entry into force of the 2018 Treaty, depreciating assets used in transitioned petroleum activities may not produce Australian assessable income because the income will not be derived from sources in Australia.

1.20 Without amendments, the absence of a taxable purpose for the depreciating assets would mean the decline in value of the assets would not be deductible in Australia. Further, the decline in value of these assets would not be deductible in Timor-Leste.

1.21 The amendments to the uniform capital allowance regime provide that continuing to use a depreciating asset (or have a depreciating asset installed for use) for transitioned petroleum activities is a taxable purpose. As a result, the decline in value of the depreciating assets continues to be deductible in Australia. [Schedule 1, item 1, subsection 417-25(1) of the ITAA 1997]

1.22 If the relevant transitioned petroleum activity is carried on in the Joint Petroleum Development Area, the extent to which the asset is taken to be used for a taxable purpose for this reason is reduced to 10 per cent. This reflects the tax arrangements under Part 3 of the Petroleum (Timor Sea Treaty) Act 2003 whereby taxpayers are entitled to a reduction of 90 per cent of the business profits subject to tax in Australia. [Schedule 1, item 1, subsection 417-25(2) of the ITAA 1997]

Example 1.1 Taxable purpose and decline in value deductions

Solitaire Petroleum uses a floating, storage and offloading facility for transitioned petroleum activities in the Joint Petroleum Development Area. Under current tax arrangements, the facility is used exclusively for the taxable purpose of producing assessable income and Solitaire Petroleum can deduct the full decline in value of the facility each income year. Under the current arrangement, Solitaire is entitled to 10 per cent of the deduction for the decline in value of facility.

Following the entry into force of the 2018 Treaty, Solitaire Petroleum continues to use the facility to support production at the same project. Ten per cent of the facility's use is treated as being for the taxable purpose of undertaking transitioned petroleum activities. Ten per cent of the asset's decline in value during this period is deductible to Solitaire Petroleum (see subsection 40-25(2) of the ITAA 1997).

On 1 January 2023, Solitaire Petroleum moves the facility and the facility now supports a production facility in Australia (50 per cent) and transitioned petroleum activities (50 per cent). For the 2022-23 income year, 55 per cent of Solitaire Petroleum's use of the asset is treated as being for a taxable purpose.

That is:

•

the facility was used 50 per cent of the time for the taxable purpose of undertaking transitioned petroleum activities and this is reduced to 5 per cent because the activity is in the (former) Joint Petroleum Development Area; and

•

the facility was used 50 per cent of the time for the taxable purpose of producing assessable income in Australia.

Therefore, Solitaire Petroleum can deduct 55 per cent of the facility's decline in value.

1.23 The amendments creating a taxable purpose continue to apply to a subsequent purchaser of a depreciating asset, including where the purchaser acquires the asset after the entry into force of the 2018 Treaty, provided the seller had used the asset for transitioned petroleum activities before that time. In these cases, the depreciable cost of the asset in the hands of the purchaser is limited to the adjustable value of the asset in the hands of the seller (see paragraph 1.31). [Schedule 1, item 1, paragraph 417-25(1)(b) of the ITAA 1997]

1.24 The amendments do not apply to allow a deduction for depreciating assets not used and not installed ready for use in transitioned petroleum activities before the entry into force of the 2018 Treaty. The decline in value of these assets will not be deductible if they are not used for an existing taxable purpose.

1.25 The amendments also do not apply to the make second element costs - for example the cost of improving an asset - incurred after the entry into force of the 2018 Treaty deductible. [Schedule 1, item 1, subsection 417-25(3)

Balancing adjustments

1.26 When sold, depreciating assets may be subject to a balancing adjustment. If the termination value of the asset exceeds its adjustable value, the difference is included in the taxpayer's assessable income.

1.27 Following the entry into force of the 2018 Treaty, the proceeds on the sale of a depreciating asset used in a transitioned petroleum activity will be taxable in Timor-Leste. To provide conditions equivalent and prevent double taxation, the consequences of a balancing adjustment event are disregarded if the event occurs to a depreciating asset used in a transitioned petroleum activity before the entry into force of the 2018 Treaty.

1.28 Consequently:

•

for a balancing adjustment event where the termination value of the depreciating asset exceeded its adjusted value - no amount is included in the entity's assessable income; and

•

for a balancing adjustment event where the adjustable value of a depreciating asset exceeds its termination value - the entity is not entitled to a deduction.

[Schedule 1, item 1, subsection 417-30(2) of the ITAA 1997]

1.29 It does not matter if the depreciating asset was held for another purpose in addition to being held for the purpose of undertaking transitioned petroleum activities. [Schedule 1, item 1, subsection 417-30(3)) of the ITAA 1997]

1.30 Balancing adjustment events normally occur at the same time as CGT events in relation to the same asset. Generally, depreciating assets are not subject to CGT because any gain or loss from the CGT event is disregarded when the event is also a balancing adjustment event under the uniform capital allowance regime (section 118-24 of the ITAA 1997). By disregarding the consequences of a balancing adjustment event rather than the event itself, section 118-24 continues to apply to disregard associated CGT events as appropriate. [Schedule 1, item 1, note to subsection 417-30(2) of the ITAA 1997]

1.31 Where a depreciating asset that was used for undertaking transitioned petroleum activities is sold after the entry into force of the 2018 Treaty, the depreciable cost of the asset to the purchaser is taken to be equal to the adjustable value of the asset to the seller. This ensures that disregarding the consequences of the seller's balancing adjustment event does not create an inappropriate step-up in the depreciable value of the asset. [Schedule 1, item 1, subsection 417-30(4) of the ITAA 1997]

Depreciating assets pool

1.32 Taxpayers may choose to treat all of their depreciating assets used for the purpose of transitioned petroleum activities as a pool. Choosing this treatment is an alternative to applying the amendments that concern the taxable purpose of individual assets.

1.33 The choice applies to all assets used, or installed ready for use, in undertaking transitioned petroleum activities at the time the 2018 Treaty enters into force. The choice cannot differ between different assets. Choosing to create a pool requires all assets within the scope of the amendment to be included in the pool. [Schedule 1, item 1, subsection 417-35(1) of the ITAA 1997]

1.34 Taxpayers must make the choice in their income tax return for the income year the 2018 Treaty enters into force. The choice is irrevocable. [Schedule 1, item 1, subsection 417-35(2)and (3) of the ITAA 1997]

1.35 If the taxpayer chooses to create a pool, all depreciating assets eligible for inclusion in the pool are taken to be a single depreciating asset. The cost of the single depreciating asset is the sum of the adjustable values of all of the pooled assets at the time when the 2018 Treaty enters into force. [Schedule 1, item 1, paragraphs 417-35(4)(a) and (c) of the ITAA 1997]

1.36 In working out the extent to which the single depreciating asset is used for a taxable purpose, the asset is taken to be used for the same purpose or purposes as the underlying assets at the time the 2018 Treaty enters into force. This assessment will determine the extent (if any) to which deductions for the decline in value of the pool are reduced to 10 per cent because the underlying assets were used for undertaking transitioned petroleum activities in the Joint Petroleum Development Area. [Schedule 1, item 1, paragraph 417-35(4)(b) of the ITAA 1997]

1.37 The cost of the single depreciating asset is deductible on a straight-line depreciation basis where:

•

40 per cent of the cost is deductible in the initial income year in which the 2018 Treaty enters into force;

•

40 per cent of the cost is deductible in the second income year; and

•

the remaining 20 per cent of the cost is deductible in the third and final income year.

[Schedule 1, item 1, paragraph 417-35(4)(d) of the ITAA 1997]

1.38 This depreciation schedule is based on an effective life of depreciating assets ending on 31 December 2021 for taxpayers with a standard income year that aligns to the financial year.

1.39 The underlying pooled assets cease to be recognised for any income tax purpose. The decline in value of the underlying assets is not deductible (to the original holder or to any subsequent purchaser) and no balancing adjustment may arise can occur in relation to the assets. Similarly, as a notional asset, the single depreciating asset cannot be subject to a balancing adjustment or CGT event. [Schedule 1, item 1, paragraphs 417-35(3)(e), (f) and (g) of the ITAA 1997]

Example 1.2 Depreciation pools

Wilson Petroleum exclusively undertakes transitioned petroleum activities in the Joint Petroleum Development Area. The 2018 Treaty enters into force during the 2019-20 income year and, at that time, Wilson Petroleum has 25 depreciating assets. At the start of the 2019-20 income year, the sum of the adjustable values of Wilson Petroleum's depreciating assets was $200 million.

Wilson Petroleum chooses to allocate its assets to a depreciation pool and prepares its 2019-20 income tax return on this basis. The decline in value of the single depreciating asset in that income year is taken to be 40 per cent or $80 million.

Wilson Petroleum is taken to use 10 per cent of the single depreciating asset for the taxable purpose of undertaking transitioned petroleum activities (see paragraphs 1.22 and 1.36). Wilson Petroleum is entitled to a deduction for $8 million in the 2019-20 income year.

1.40 The single depreciating asset may continue to decline in value for tax purposes and be deductible to the entity that made the pooling choice despite that entity transferring some or all of the underlying assets to another entity. [Schedule 1, item 1, subsection 417-35(5) of the ITAA 1997]

Mining site rehabilitation

1.41 The cost of undertaking mining site rehabilitation is generally deductible under section 40-735 of the ITAA 1997. In the Joint Petroleum Development Area, deductions are effectively limited to 10 per cent of the cost incurred because of the operation of Part 3 of the Petroleum (Timor Sea Treaty) Act 2003.

1.42 Following the entry into force of the 2018 Treaty, there may be some situations where the cost of rehabilitating sites within the Joint Petroleum Development Area are not deductible in Timor-Leste or under the general provisions of Australia's domestic law.

1.43 A deduction may not be available where a taxpayer:

•

has not undertaken any exploration on the site; and

•

did not undertake any mining operations on the site before the entry into force of the 2018 Treaty when such mining operations were capable of producing assessable income.

1.44 To provide conditions equivalent, 10 per cent of the cost of rehabilitating sites within the Joint Petroleum Development Area will continue to be deductible. The existing exclusions from the scope of the section 40-735 deduction under section 40-745 continue to apply. [Schedule 1, item 1, section 417-40 of the ITAA 1997]

Capital expenditure

1.45 If an entity allocated capital expenditure to a project pool under section 40-830 of the ITAA 1997 prior to the entry into force of the 2018 Treaty and that capital expenditure is in relation to transitioned petroleum activities in the Joint Petroleum Development Area, for the purposes of calculating any reduction in an entity's deduction under section 40-835, 10 per cent of that project is taken to be for a taxable purpose. [Schedule 1, item 1, subsection 417-45(1) of the ITAA 1997]

1.46 Where the project amount was allocated to a project pool prior to the entry into force of the 2018 Treaty and was for the purposes of undertaking transitioned petroleum activities other than in relation to the Joint Petroleum Development Area, for the purposes of calculating any reduction in an entity's deduction under section 40-835, the project is taken to operate in the year for a taxable purpose. [Schedule 1, item 1, subsection 417-45(2) of the ITAA 1997]

1.47 The reference to project pools that existed prior to the entry into force of the 2018 Treaty is distinct from the pooling of depreciating assets used for transitioned petroleum activities.

Transfer of entitlement to pool deductions

1.48 A transferring entity must make the choice by the time the entity lodges their income tax return for the income year in which the choice is made. The choice must be made in the approved form and is irrevocable. [Schedule 1, item 1, section 417-50 of the ITAA 1997]

1.49 A franking credit arises in the franking account of the entity that receives the deduction entitlement. The amount of the franking credit is the amount of the deduction transferred multiplied by the standard corporate tax rate. [Schedule 1, item 1, section 417-50(6) of the ITAA 1997]

Example 1.3 - Transfer of entitlement to deductions

In the 2019-20 income year, Matteo Pty Ltd has pooled assets under section 417-35 and is entitled to deduct 40 per cent of the decline in value of those pooled assets.

Matteo Pty Ltd chooses to retain 50 per cent of that deduction and transfer 50 per cent of the entitlement to that deduction to another corporate tax entity, Gilmore Pty Ltd.

The result is that in the 2019-20 income year both Matteo Pty Ltd and Gilmore Pty Ltd can claim 20 per cent of the decline in value of the pooled assets. Gilmore Pty Ltd cannot transfer any part of that entitlement to another entity.

Subsequently, in the 2020-21 income year, Matteo Pty Ltd can deduct 40 per cent decline in value or make a similar or different choice to transfer all or part of that entitlement to the deduction.

In any income year Matteo Pty Ltd could also make a choice to transfer all or part of its future entitlement to deductions and does not have to do it on a year by year basis.

1.50 If the entity transferring the pool deduction entitlement receives any consideration from the receiving company for the transfer, the consideration is neither assessable income nor exempt income of the transferring company. Similarly, a capital gain does not arise for the transferring company. [Schedule 1, item 1, subsection 417-70(1) of the ITAA 1997]

1.51 A loss or outgoing a receiving company incurs for the receipt of the pool deduction entitlement is not deductible to the company and cannot contribute to a CGT loss to the company. [Schedule 1, item 1, subsection 417-70(2) of the ITAA 1997]

Replacement petroleum rights

1.52 Taxpayers undertaking transitioned petroleum activities are required to hold rights authorising their activities. These rights may take the form of exploration permits, production licences, production sharing contracts and other similar rights.

1.53 When the 2018 Treaty enters into force, rights under Australian law and production sharing contracts issued under joint Australian-Timorese jurisdiction will cease. Taxpayers will need to obtain replacement rights under Timorese law to continue their transitioned petroleum activities.

1.54 When an entity ceases to hold a depreciating asset because it ceases to exist, a balancing adjustment event and a notional CGT event occur.

1.55 To provide conditions equivalent, no depreciating balancing adjustment event and no CGT event applies when an existing right is replaced with a new Timorese right that reflects the arrangements under the 2018 Treaty. [Schedule 1, item 1, subsection 417-30(1) and section 417-65 of the ITAA 1997]

1.56 Consequently, a CGT rollover under Subdivision 124-L of the ITAA 1997 does not apply to the replacement of a right to undertake transitioned petroleum activities.

Tax treatment of transferred entitlement

1.57 If the entity transferring an entitlement to a deduction or a tax loss and receives any consideration from the receiving company for the transfer, the consideration is neither assessable income nor exempt income of the transferring company. Similarly, a capital gain does not arise for the transferring company. [Schedule 1, item 1, subsection 417-70(1) of the ITAA 1997]

1.58 A loss or outgoing a receiving company incurs for the receipt of the transfer is not deductible to the company and cannot contribute to a CGT loss to the company. [Schedule 1, item 1, subsection 417-70(2) of the ITAA 1997]

Membership interests affected by transfer of entitlement

1.59 If an entity holds a membership interest in an entity that chooses to make a transfer, the capital loss is disregarded unless the entity can demonstrate that the loss is attributable to a matter that is not related to the transfer of the loss. This prevents the deduction that has been transferred from being duplicated. The section will not apply to the extent that the entity can demonstrate that the capital loss is attributable to any other CGT event. [Schedule 1, item 1, section 417-75 of the ITAA 1997]

Transferring or applying tax losses

Transfer of existing losses to associates

1.60 An entity can choose to transfer any loss that is attributable to transitioned petroleum activities undertaken prior to the entry into force of the 2018 Treaty to an associate of the transferor who is a corporate tax entity and either an Australian resident or has a permanent establishment in Australia. [Schedule 1, item 1, subsection 417-90(1) of the ITAA 1997]

1.61 The effect of a loss transfer is that the loss is taken to be incurred by the transferee in the income year in which the choice is made. However, if the loss year is the same as the transfer year, the transferee is taken to have incurred the tax loss in the income year before the loss year. This means the transferee can deduct the amount of the transferred loss in the year of transfer. The transferor can no longer utilise the loss. [Schedule 1, item 1, section 417-100 of the ITAA 1997]

1.62 A franking credit arises in the franking account of the entity that receives the tax loss. The amount of the franking credit is the amount of the tax loss transferred multiplied by the standard corporate tax rate. [Schedule 1, item 1, section 417-100(3) of the ITAA 1997]

1.63 If the receiving company does not have enough assessable income to offset the transferred loss in the year of the transfer, the receiving entity can carry-forward the loss to future income years.

1.64 A transferring entity must make the choice by the time the entity lodges their income tax return for the income year in which the choice is made. The choice must be made in the approved form and is irrevocable. [Schedule 1, item 1, section 417-95 of the ITAA 1997]

Transfer of future losses

1.65 An entity can choose to transfer any future transitioned petroleum activity loss to an entity that is a corporate tax entity and either an Australian resident or has a permanent establishment in Australia. This ability to transfer a loss is subject to the limit on the utilisation of future losses. [Schedule 1, item 1, subsection 417-90(2) and subsection 417-90(3) of the ITAA 1997]

1.66 The mechanism for the transfer of future transitioned petroleum activity losses mirrors that which applies for the transfer of existing tax losses to an associate.

Loss carry-back

1.67 An entity may choose to apply a future transitioned petroleum activity loss and claim a deduction in any of the four income years that preceded the current income year. This ability to carry-back a loss to a prior year is subject to the limit on the utilisation of future losses. [Schedule 1, item 1, subsection 417-90(1) and paragraph 417-90(2)(d) of the ITAA 1997]

1.68 The effect of choosing to apply a loss to an earlier income year is that the loss can be applied as a deduction in that earlier income year but can no longer be utilised in the current income year. [Schedule 1, item 1, section 417-105 of the ITAA 1997]

1.69 A transferring entity must make the choice by the time the entity lodges their income tax return for the income year in which the choice is made. The choice must be made in the approved form and is irrevocable. [Schedule 1, item 1, section 417-95 of the ITAA 1997]

Example 1.4 Utilisation of future losses

In the 2020-21 income year, Mathilde Pty Ltd undertakes transitioned petroleum activities. The project is in its production phase and the activities result in Mathilde Pty Ltd being liable for income tax on income of $10 million in Timor-Leste. In relation to these same transitioned petroleum activities and in the same year, Mathilde Pty Ltd realised a tax loss of $1 million in Australia.

For the 2020-21 income year, Mathilde Pty Ltd can choose to:

•

transfer the entire $1 million loss to any Australian resident corporate tax entity; or

•

carry-back the loss to one or more of the four preceding income years.

Subsequently, in the 2022-23 income year, the project has moved from the production to the decommissioning phase. For the 2022-23 income year, Mathilde Pty Ltd is liable for income tax on $5 million of income in Timor-Leste. In relation to these same transitioned petroleum activities and in the same year, Mathilde Pty Ltd again realised a tax loss of $1 million in Australia.

For the 2022-23 income year, Mathilde Pty Ltd can choose to:

•

transfer $500,000 of that the tax loss to an Australian resident corporate tax entity; or

•

carry-back $500,000 of that tax loss to one or more of the four preceding income years.

The remaining $500,000 loss for the 2022-23 income year is retained by Mathilde Pty Ltd and may be carried forward to future income years.

Limitations on utilising future losses

Timor-Leste tax liability limitation

1.70 A limit restricts part of the amount of future transitioned petroleum activity losses that can be utilised under the special arrangements in this Bill. The intention of the limit is to restrict relief to the extent required to provide conditions equivalent. The ability to utilise future losses without applying them to future assessable income is limited to a level approximating a taxpayer's natural rate of loss utilisation under current arrangements.

1.71 The limit applies to the loss carry-back mechanism and the transfer of future losses to corporate tax entities. The limit does not apply to the transfer of losses that are attributable to transitioned petroleum activities prior to the 2018 Treaty entering into force which are transferred to associates.

1.72 The limit is 10 per cent of the amount on which Timor-Leste imposes income tax prior to any deductions for tax paid in Timor-Leste in relation to an entity's transitioned petroleum activities. The limit is broadly equivalent to the taxable income (excluding transitioned petroleum activity losses and deductions) an entity would have derived in Australia but for the entry into force of the 2018 Treaty. [Schedule 1, item 1, paragraph 417-90(3)(a) and subsection 417-90(5) of the ITAA 1997]

1.73 The limit does not apply to the extent that the transferred losses are attributable to deductions from pooled assets under this Division. [Schedule 1, item 1, subsection 417-90(4) of the ITAA 1997] Franking balance limitation

1.74 The loss for an income year that an entity may choose to carry-back and claim as a deduction for an earlier income year is limited to the grossed-up surplus of the entity's franking account balance at the end of the income year. [Schedule 1, item 1, paragraphs 417-90(3)(b) and (c)]

1.75 This limitation does not apply where the entity choosing to carry-back the loss does not have a franking account balance because it is a foreign resident entity (other than a NZ franking company) for more than half of the income year and is not required to have a franking account. [Schedule 1, item 1, subsection 417-90(6)]

1.76 Limiting the loss carry-back to the grossed-up surplus of a company's franking account at the end of the loss year prevents shareholders receiving franking credits in respect of refunded income tax. This also avoids companies having a negative franking account balance and a liability to franking deficits tax.

1.77 If a loss carry-back deduction generates a refund of income tax for the loss year, a franking debit equal to the amount of the refund will arise in the entity's franking account at the time the refund is received. (table item 2 in subsection 205-30(1) of the ITAA 1997).

Employee foreign income tax offset

1.78 Employees working in the Joint Petroleum Development Area are currently entitled to a foreign income tax offset for income tax paid in Timor-Leste. The tax offset and its calculation is based on Article 13.2 of Annex G of the 2002 Treaty rather than the more general foreign income tax offset in Division 770 of the ITAA 1997. Further information about the current arrangements is available in Australian Taxation Office class rulings, for example Class Ruling 2010/51.

1.79 Following the entry into force of the 2018 Treaty, Australian resident employees would still be entitled to a foreign income tax offset but differences between the 2002 and 2018 treaties may cause the amount of the offset to be calculated differently. That is, the calculation of the offset would be governed by Subdivision 770-B of the ITAA 1997.

1.80 To provide conditions equivalent, the provisions of the 2002 Treaty will continue to apply to the calculation of the offset. [Schedule 1, item 1, section 417-125 of the ITAA 1997]

1.81 Consistent with current arrangements, the 2002 Treaty will only continue to apply to employees and its operation does not extend to independent contractors.

Transfer pricing

1.82 A transfer pricing benefit is taken not arise under Australia's transfer pricing regime in Division 815 of the ITAA 1997 after the entry into force of the 2018 Treaty because of a mismatch in the arm's-length prices used for determining an entities liability to taxation in both Timor-Leste and Australia in relation to existing arrangements for petroleum or goods and services.

1.83 If an entity acquires petroleum that was produced in the Bayu-Undan Gas Field, for the purposes of Australia's transfer pricing provisions, a price used by or agreed with the Tax Authority of Timor-Leste is taken not give rise to a transfer pricing benefit for the entity. [Schedule 1, item 1, subsection 417-140(1) of the ITAA 1997]

1.84 Where arrangements to provide goods or services were in place when the 2018 Treaty was made (6 March 2018) and those goods or services continue to be provided in relation transitioned petroleum activities on substantially similar terms, a transfer pricing benefit is not taken arise if those prices are used by or agreed with the Tax Authority of Timor-Leste. [Schedule 1, item 1, subsection 417-140(2) of the ITAA 1997]

1.85 These amendments provide a safe harbour to ensure that, if an entity would otherwise be taken to get a transfer pricing benefit under Australia's transfer pricing regime, that transfer pricing benefit will not arise for the entity where the price is used by or agreed with the Tax Authority of Timor-Leste. The term used by or agreed could include:

•

an explicit pricing agreement that is in place with the Tax Authority of Timor-Leste;

•

the price used is consistent with the Timor-Leste equivalent to Australia's transfer pricing regime; or

•

it is reasonable to assume the pricing arrangement would not be challenged by the Tax Authority of Timor-Leste. For example where the entity was using the same pricing arrangement for a number of years before the 2018 Treaty comes into force and the entity continues to use the same pricing after the 2018 enters into force.

Consequential amendments

1.86 The definition of 'Australia' in the ITAA 1997 is amended to exclude the Joint Petroleum Development Area. A further consequential amendment is made to the 'indirect tax zone' in the A New Tax System Goods and Services Tax) Act 1999 because this definition relies on the ITAA 1997 definition of 'Australia' and no longer needs to exclude the Joint Petroleum Development Area. A further reference to the Joint Petroleum Development Area used in the definition of 'transport capital expenditure' is also removed. [Schedule 2, items 1, 2, 16 and 11, section 195-1 (definition of 'indirect tax zone') of the A New Tax System Goods and Services Tax) Act 1999, and subsection 960-505(2) and paragraph 40-865(1)(b) of the ITAA 1997]

1.87 The definitions of 'Joint Petroleum Development Area', 'Petroleum Exploration Permit WA-523-P permit area' 'production sharing contract', 'Timor Sea Maritime Boundaries Treaty' and 'transitioned petroleum activities' are included in the ITAA 1997 dictionary. [Schedule 2, items 18 and 20, subsection 995-1(1) of the ITAA 1997]

1.88 Part 3 of the Petroleum (Timor Sea Treaty) Act 2003 is repealed. Further consequential amendments are made to remove redundant references to this Act and the 2002 Treaty from the taxation law. [Schedule 2, items 3, 4, 5, 6, 7, 8 and 21, subsection 67(12) of the Fringe Benefits Tax Assessment Act 1986, subsection 6(1) (definition of 'Timor Sea Treaty'), subsection 23AG(7) (definition of 'double tax agreement'), and paragraphs 23AG(2)(b), 177B(1)(b) and 177(1)(c), of the ITAA 1936, and Part 3 of the Petroleum (Timor Sea Treaty) Act 2003]

1.89 The list of non-assessable non-exempt income provisions in section 11-55 of the ITAA 1997 is amended to include 'consideration received for transfer of tax losses relating to transitioned petroleum activities' and 'consideration received for transfer of entitlements to deductions relating to transitioned petroleum activities'. [Schedule 2, items 9 and 10, section 11-55 of the ITAA 1997]

1.90 Subsection 205-15(1) provides that an amount of franking credit arises in the franking account of an entity and at the time provided in Division 417 of the ITAA 1997. [Schedule 2, item 12, subsection 205-15(1) of the ITAA 1997]

1.91 The definition of 'retained cost based asset' is amended to include a depreciating asset that the joint entity holds as a result of a balancing adjustment event mentioned in paragraph 417-30(2)(b) of the ITAA 1997. Subsection 705-25(4B) is amended to reference this new definition so that, if a retained cost based asset is covered by that definition, its tax cost setting amount is equal to the joining entity's termination value for the asset. [Schedule 2, items 14, 15 and 13, paragraph 705-25(5)(d) and subsection 705-25(4B) of the ITAA 1997]

1.92 A note is added to the definition of a 'balancing adjustment event' to reference the fact some balancing adjustment events are disregarded under the amendments in this Bill. [Schedule 2, item 17, the note to subsection 995-1(1) (definition of 'balancing adjustment event') of the ITAA 1997]

1.93 A note is added to the definition of a 'taxable purpose' to reference the fact transitioned petroleum activities are taken to be a taxable purpose for some depreciating assets under the amendments in this Bill. [Schedule 2, item 19, the note to subsection 995-1(1) (definition of 'taxable purpose') of the ITAA 1997]

1.94 Subsection (1) of the Taxation (Interest on Overpayments and Early Payments) Act 1983 does not apply to overpayments to the extent the overpayment results from paragraph 417-105(a) of the ITAA 1997. [Schedule 2, item 22, after subsection 9(1B) of the Taxation (Interest on Overpayments and Early Payments) Act 1983]

Application provisions

1.95 This Bill commences the day the 2018 Treaty enters into force for Australia.

1.96 Article 13 of the 2018 Treaty provides that the Treaty will enter into force on the day on which Australia and Timor-Leste have notified each other in writing through diplomatic channels that their respective requirements for entry into force of the Treaty have been fulfilled. For Australia, this requires the passage of this Bill, the Timor Sea Maritime Boundaries Treaty Consequential Amendments Bill 2018 and the Passenger Movement Charge Amendment (Timor Sea Maritime Boundaries Treaty) Bill 2018.

Chapter 2 - Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Treasury Laws Amendment (Timor Sea Maritime Boundaries Treaty) Bill 2019

2.1 This Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

2.2 This Bill amends the ITAA 1997 to give effect to the tax arrangements required to support the 2018 Treaty. In particular, this Bill fulfils Australia's obligation under the 2018 Treaty to provide 'conditions equivalent' to participants in transitioned petroleum activities affected by the 2018 Treaty in respect of their taxation affairs.

Human rights implications

2.3 This Bill does not engage any of the applicable rights or freedoms.

Conclusion

2.4 This Bill is compatible with human rights as it does not raise any human rights issues.