Edited version of your written advice

Authorisation Number: 1051448719929

Date of advice: 30 October 2018

Ruling

Subject: Acquisition of mining assets – tax treatments

Question 1

Does the tax cost of the mine assets acquired by the Acquiring Company include the consideration paid to the Vendor Companies and the market value of the right to receive the royalty payments granted to the Vendor Companies?

Answer

Yes.

Question 2

Will the portion of the financial adjustment amount (FAA) payments received by the Acquiring Company in compensation for the assumption of the rehabilitation obligations accompanying the purchase of the mine be a recoupment under section 20-25 of the Income Tax Assessment Act (1997) (“ITAA97”)?

Answer

Yes.

Question 3

Will the receipt of the remaining portion of the FAA payments by the Acquiring Company cause CGT event C2 to occur?

Answer

Yes.

Question 4

Is there a capital gain on the grant of a right to future royalties?

Answer

Yes.

Question 5

Are the production based vendor royalty payments to the Vendor Companies deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods

Particular income years

Relevant facts and circumstances

The Acquiring Company entered into an agreement with Vendor Company A to acquire a XX% interest in mining assets held by a joint venture for $X, plus the assumption of the following liabilities:

● Rehabilitation Obligation;

● Port Allocation & DBCT;

● Rail Haulage Contract;

● Electricity Contract;

● Water Contract; and

● Accommodation Contract.

The Acquiring Company entered into a reciprocal arrangement with Vendor Company B to acquire the remaining XX% interest on similar terms.

The Acquiring Company is not a related party with Vendor Company A and Vendor Company B.

The assets acquired by the Acquiring Company through the staged acquisition of the mine include handling and preparation plant equipment, train loading facility, pumps and generators, light and heavy vehicle wash down bays, power lines, evaporation fans, and site improvements, buildings, mining rights and licences.

The agreement contains a clause in respect of the payment of a financial adjustment amount (“FAA”) from the Vendor Company to the Acquiring Company. The agreement with Vendor Company A allows for a deferred payment over XX months, while the agreement with Vendor Company B requires that Vendor Company B pay the Acquiring Company XZ% of the FAA (amongst other things) immediately at the time the contract is completed.

The rounded fair value of the total compensation payments is $XYm.

The FAA paid by the Vendor Companies as part of the acquisition of the mine is to compensate the Acquiring Company for certain portions of the onerous contracts up to the period of production.

Rehabilitation commenced in the first income year of the acquisition, and deductions were claimed under section 40-735 of the ITAA 1997 in that same income year.

Both the agreements contain a deed of royalty (“Royalty Deed”). These Royalty Deeds share the same characteristics between the two agreements. The Royalty Deeds provide that the Acquiring Company will pay the Vendor Companies royalty payments, calculated in accordance with the agreement, once the price of the mineral has reached a prescribed average spot price.

Both Royalty Deeds state the payment of royalties will be a continuing obligation for the full term of the tenement. However, the obligation to pay royalties will expire when a payment equal to the Royalty Cap is received. The Royalty Cap is composed of the top compensation amount (plus CPI) and the FAA (plus CPI). The royalty payable is dependent on the amount of mineral transferred.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 15-10

Income Tax Assessment Act 1997 subdivision 20-A

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 subsection 20-25(4)

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 section 20-40

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 subsection 40-185(1)

Income Tax Assessment Act 1997 section 40-735

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All legislative references made refer to the Income Tax Assessment Act 1997 (ITAA 1997) or the Income Tax Assessment Act 1936 (ITAA 1936).

Question 1

Does the tax cost of the mine assets acquired by the Acquiring Company include the consideration paid to the Vendor Companies and the market value of the right to receive the royalty payments granted to the Vendor Companies?

Answer

Yes, the consideration paid to the Vendor Companies and the market value of the right to receive the royalty payments granted to the Vendor Companies are included in the tax cost of the mine assets acquired by the Acquiring Company.

Detailed reasoning

Application of Uniform Capital Allowance (“UCA”) or Capital Gains Tax (“CGT”) Regime

It is first necessary to consider whether the underlying assets of the mine acquired through the transaction are depreciable assets in accordance with the Division 40 UCA system, or alternatively are treated as assets to which the CGT regime applies.

A depreciating asset is defined broadly under section 40-30 as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except:

(a) Land; or

(b) An item of trading stock; or

(c) An intangible asset, unless it is one of the following:

● mining, quarrying or prospecting rights;

● mining, quarrying or prospecting information;

● items of intellectual property;

● in-house software;

● IRUs;

● spectrum licences;

● datacasting transmitter licences;

● telecommunications site access rights.

The assets acquired by the Acquiring Company through the staged acquisition of the mine include handling and preparation plant equipment, train loading facility, pumps and generators, light and heavy vehicle wash down bays, power lines, evaporation fans, and site improvements, buildings, mining rights and licences.

All the above assets including plant and equipment and the mining rights meet the definition of a depreciating asset in accordance with section 40-30. Where Division 40 applies to an asset, the CGT provisions do not apply. Accordingly the assets will be dealt with under the UCA regime.

What is the relevant tax cost of the assets acquired?

Under Division 40, the cost of an asset comprises two elements:

1. The amount you are taken to have paid to hold a depreciating asset; and

2. The amount you are taken to have paid to bring the asset to its present condition and location since you started to hold the asset.

The agreements include a number of components that may form part of the cost of the mining assets acquired. These are identified and analysed below having regard to Division 40.

Consideration Paid

Under the first element, subsection 40-185(1) Item 1 provides that amounts taken to have been paid include consideration actually paid.

The Acquiring Company has provided consideration of $X in each agreement to acquire the assets and liabilities of the mine. Accordingly, a total of $Y consideration is included in the cost of the depreciating assets.

Liabilities Assumed

Subsection 40-185(1) Item 2 provides that where a taxpayer incurs or increases a liability to pay an amount, this will also be included in the cost of assets acquired.

Therefore it is necessary to consider whether the first element of cost will include the following liabilities assumed by the Acquiring Company through the acquisition:

● Rehabilitation Obligation;

● Port Allocation & DBCT;

● Rail Haulage Contract;

● Electricity Contract;

● Water Contract; and

● Accommodation Contract.

We do not consider these liabilities should be included in the cost of the mining assets for the following reasons:

● The Explanatory Memorandum clarifies that the amount of a liability will be included in the cost where it is incurred in order to hold the depreciating asset. The abovementioned liabilities have not been assumed in connection with acquiring the mining assets but rather comprise part of the ongoing business costs that will be assumed as part of operating the acquired business.

● The liabilities have not been ‘incurred’ at the time of acquisition. In accordance with FC of T v James Flood Pty Ltd, ‘incurred’ is taken to mean the taxpayer is “definitely committed” or has “completely subjected” itself to the liability. This was further expressed in New Zealand Flax Instruments Ltd v FC or T whereby it was determined a liability must be “more than impending, threatened, or expected”. As the liabilities relate to provisions for expected future obligations rather than current liabilities that have been incurred they are excluded from the cost of the mining assets.

Royalty Deed

In accordance with the terms of the Royalty Deed, the Acquiring Company has undertaken to provide the vendors future royalties on any mineral transferred, to be calculated in accordance with the Royalty Deed.

In determining whether this has any bearing on the cost of the mine assets acquired, it is necessary to distinguish between the right to receive future royalties, and the royalty payments themselves.

A key case that is relevant to the royalty payments is the High Court decision of Cliffs International. In that case, the High Court drew a distinction between the right to receive the royalty payments and the royalty payments themselves;

“…the fact that the promise to make payments formed part of the consideration for the transfer of the shares does not mean that, when made, they were paid for the shares. Rather the payments were outgoings incurred in gaining the taxpayer’s assessable income consisting of royalties paid by the consortium.”

Cliffs International emphasises a number of points:

1. The right to receive a royalty and the royalty payment itself are separate and distinct from each other and must be treated as such for income tax purposes.

2. Right to receive a royalty is capital in nature and forms part of the consideration of an acquisition.

Actual royalty payments should be treated separately from the agreement to pay royalties. Accordingly, they do not amount to deferred consideration and are instead ordinarily deductible business expenditure. Although they are paid in connection with a promise made at the time of acquisition, the acquisition of the asset itself is not dependent upon the future payment. This endorses a “separate rights approach” in connection to the treatment of the right to receive a payment and the payment itself.

The High Court’s separate rights approach was affirmed in Ivanac v Deputy Commissioner of Taxation (“Ivanac”). In Ivanac it was held that the royalty payable by the taxpayer had no proximal relationship to the sale of the mining tenements and could not be said to be derived from that sale. Consequently, they did not have the character of capital and did therefore not form part of the purchase price of the sale.

Similarly, in the present case, the transaction contains an agreement under which the Acquiring Company has undertaken to pay future royalties to the vendors based on the amount mined. The amount to be paid is separate and distinct from the consideration provided for the acquisition of the mine, and the acquisition is not dependent on the payment of any future royalties.

We therefore consider any payments made under the Royalty Deed should be treated as outgoings incurred in gaining assessable income. They do not amount to deferred consideration and therefore will not form part of the consideration paid.

Right to receive royalties

As established by the High Court in Cliffs International, the right to receive the royalties is considered separate to the royalty payments.

The royalty right forms part of the consideration for the mine purchase under subsection 40-185(1) Item 5 as a “non-cash benefit”. Under this subsection, where a taxpayer incurs or increases a liability to provide a non-cash benefit, this will be included in the cost of assets acquired.

A non-cash benefit is broadly defined under section 995-1 as property or services in any form, except money. A right to future income (being the right to receive royalty payments) is a generally assignable equitable interest and may therefore be classified as property.

The Royalty Deed has been agreed upon as part of the acquisition transaction between the Acquiring Company and the Vendor Companies. As partial consideration for the mine, the Acquiring Company undertook to provide a non-cash benefit to the Vendor Companies, being the right to receive royalty payments. Subsection 40-185(1) Item 5 provides that the relevant amount to include in the cost is the market value of the non-cash benefit or the increase at the time the liability is incurred or increased.

Based upon the factors considered above, the tax cost should include the $Y monetary consideration paid and the market value of the royalty right. None of the assumed liabilities will form part of the cost of the assets acquired as they are no more than impending or expected and not incurred.

Question 2

Will the portion of the FAA payments received by the Acquiring Company in compensation for the assumption of the rehabilitation obligations accompanying the purchase of the mine be a recoupment under section 20-25 of the ITAA97?

Answer

Yes, the FAA Payments relating to Environmental Obligations is a recoupment under section 20-25 of the ITAA 1997.

Detailed reasoning

Under the agreements, the Acquiring Company is entitled to compensation payments for certain portions of the onerous contracts assumed by the Acquiring Company through the acquisition. The FAA payments are intended to compensate the Acquiring Company for certain portions of the onerous contracts acquired as part of the acquisition.

The first issue to confirm in determining the income tax treatment of the FAA Payments is whether the payments are assessable income under either of the following sections:

● Section 6-5;

● Section 6-10;

● Section 15-10; or

● Deferred under Subdivision 20-A.

Ordinary income – section 6-5

Section 6-5 provides that your assessable income includes income according to ordinary concepts. In assessing whether the nature of a receipt is of an income or capital nature, consideration is had to a variety of factors. As stated in GP International Pipecoaters Pty Ltd v FCT, it is necessary to consider the character of the receipt in the recipient’s hands, in particular its periodicity, regularity, or reoccurrence, the scope of the transaction, venture or business to which the receipt relates, and the recipient’s purpose for engaging in the transaction, venture or business.

As the FAA payments are received in compensation for agreeing to acquire the onerous contracts and as the FAA payments form an essential part of the assets acquired under the purchase agreement it is considered that the payments are a capital receipt and are therefore not ordinary income of the Acquiring Company.

Statutory income – section 6-10

Section 6-10 applies to deem amounts not meeting the definition of ordinary income as being otherwise assessable as statutory income. This includes bounties or subsidies under section 15-10, as well as certain recoupment receipts for deductible losses or outgoings contained in Subdivision 20-A.

Bounty or Subsidy – Section 15-10

Section 15-10 will apply to assess bounties and subsidies whether they are capital or revenue in nature. Therefore where a payment is difficult to classify as either capital or revenue it may still be assessable under section 15-10. Section 15-10 provides:

Your assessable income includes a bounty or subsidy that:

(a) you receive in relation to carrying on a business; and

(b) is not assessable as ordinary income under section 6-5.

The primary elements of the section that need to be considered include:

● Whether the amount received is a bounty or subsidy;

● Is a business being carried on; and

● Is the amount otherwise assessable because it is ordinary income?

In the First Provincial case it was stated that the word, subsidy, means financial assistance given by the Crown. This definition was quoted with approval in the following statement by Windeyer J in Placer Development Ltd v Commonwealth of Australia:

The word is no longer used in its early legal sense of a grant to the Crown. It ordinarily means today not aid given to the Crown but aid provided by the Crown to foster or further some undertaking or industry. A subsidy was defined in America fifty years ago as a 'legislative grant of money in aid of a private enterprise deemed to promote the public welfare': Shumaker and Longsdorf, Cyclopedic Law Dictionary. This I take to be, broadly speaking, the sense in which the word is currently used in Australia...

The term ‘bounty’ is also not defined in the Act; however, the Macquarie Dictionary defines bounty as a premium or reward, esp. one offered by a government. In Squatting Investments, Webb J referred to the term “bounty or subsidy” as a compound expression, this view was referred to in Reckitt & Colman Pty Ltd by Mahoney J where his Honour said:

Whatever the terms signify, they include in my opinion a financial grant made by the State for the purpose of encouraging a particular activity in the field of trade or commerce.

As such, the payments made would not be considered a subsidy by definition as it has not been received from the Crown. The payments would also not be considered a bounty as it is not a reward or premium that has been received; it is a payment to compensate the Acquiring Company for the future expenses involved in complying with the obligations that arise under The Environmental Protection Act 1994.

Assessable Recoupment – Subdivision 20-A

In applying Subdivision 20-A, regard must be had firstly to whether the FAA Payments meet the definition of an “assessable recoupment” and secondly, if assessable, when they are to be assessed for income tax purposes.

Are the FAA Payments an assessable recoupment?

Recoupment of a loss or outgoing is broadly defined in section 20-25 to include:

● Any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery however described granted in respect of a loss or outgoing.

A portion of the FAA payments by the Vendor Companies to the Acquiring Company are intended to compensate the Acquiring Company for future outgoings that will be incurred in mine site rehabilitation. Subsection 20-35(3) provides for the situation where a recoupment has been received before the outgoing to which it relates is incurred, therefore the fact that the FAA payments are received prior to the rehabilitation expenditure being incurred does not prevent that part of the FAA payment from being a recoupment of those amounts. Accordingly, it is considered that the payment is a kind of recoupment captured by section 20-25 as the purpose of the payment is to compensate the Acquiring Company for that inevitable expenditure.

In accordance with section 20-20, an assessable recoupment will include the following where a taxpayer can deduct an amount for the loss or outgoing for the current year:

● An amount received by way of insurance or indemnity as recoupment of a loss or outgoing deducted under any provision; or

● An amount received as recoupment (except by way of insurance or indemnity) of a loss or outgoing deducted under specific provisions outlined in section 20-30.

Section 20-30 specifically includes at Item 1.18 “rehabilitation expenditure relating to mining or quarrying”. Pursuant to section 40-735, such rehabilitation expenditure will be deductible in the income year of expenditure to the extent it is incurred on the mining site rehabilitation of:

(a) a site on which you:

(i) carried on mining and quarrying operations; or

(ii) conducted exploration or prospecting; or

(iii) conducted ancillary mining activities; or

(b) a mining building site.

“Mining site rehabilitation” is defined in subsection 40-735(4) as an “act of restoring or partly restoring or rehabilitating a site or part of the site to a reasonable approximation of its condition before general mining, quarrying, exploration, prospecting or ancillary mining activities commenced”.

The rehabilitation liability assumed by the Acquiring Company in the acquisition relates to rehabilitation of the land affected by the mine site, as well as a commitment to removing the infrastructure.

Accordingly, where the Acquiring Company incurs expenditure on rehabilitation activities within the meaning of section 40-735, a deduction is allowed for the expense in the year in which the expenditure is incurred, and the corresponding amount of recoupment relating to that expenditure will be assessable under Subdivision 20-A.

Question 3

Will the receipt of the remaining portion of the FAA payments by the Acquiring Company cause CGT event C2 to occur?

Answer

Yes, the receipt of the remaining portion of the FAA payments by the Acquiring Company will cause CGT event C2 to occur.

Detailed reasoning

● Above rail haulage contracts

● Port capacity at DBCT

● Ergon Electricity supply contract

● Accommodation contract

In respect of the remaining onerous contracts listed above, these will fall outside the scope of Subdivision 20-A, as expenditure in relation to meeting the liabilities is not covered by an Item provided for in section 20-30.

It is therefore necessary to consider their classification as capital receipts under the CGT regime.

This may occur under the following CGT events:

● CGT Event H2

● CGT Event C2

CGT Event H2

CGT Event H2 may arise in the case where a taxpayer has not actively sought compensation but nevertheless receives a compensation payment in respect of an asset. For CGT Event H2 to apply, an act needs to happen in relation to a CGT asset that the taxpayer owns. Given no act has occurred in relation to a CGT asset that the Acquiring Company holds, CGT Event H2 should not be triggered.

CGT Event C2

CGT Event C2 occurs where a taxpayer’s ownership of an intangible asset ends by the asset:

● Being redeemed or cancelled;

● Being released, discharged or satisfied;

● Expiring;

● Being abandoned, surrendered or forfeited;

● If the asset is an option – being exercised; or

● If the asset is a convertible interest – being converted.

The right granted under the contract to the Acquiring Company to receive the FAA payments can be classified as a right to receive an amount. This is an asset for the purposes of CGT.

When the FAA payment is received, the payment acts to discharge the Acquiring Company’s right to receive payment thereby giving rise to CGT Event C2. The consideration received by the Acquiring Company is therefore assessable as a capital gain at the time of receipt

Therefore, the remaining portion of the FAA, as it relates to onerous liabilities and obligations, will be subject to CGT under CGT event C2 and be recognised in the year in which the contract was entered into.

Question 4

Is there a capital gain on the grant of a right to future royalties?

Answer

The grant of the right to royalties by the Acquiring Company to the Vendor Companies is a capital gain under CGT Event D3. This results in a capital gain equal to the market value of the right.

Detailed reasoning

CGT Event D3 applies where a taxpayer owns a prospecting or mining entitlement and grants another entity the right to receive ordinary or statutory income from operations carried on by the entitlement. Where CGT Event D3 is triggered, the taxpayer will make a capital gain where the capital proceeds from the grant are less than the expenditure to grant it and a capital loss is made where the capital proceeds are less than the expenditure. The time of the event is when the contract is entered into or when the right is granted in absence of a contract.

Mining entitlement is defined to include an authority, licence, permit or entitlement under Australian law to mine for minerals in an area. The Acquiring Company has acquired the licence to mine as part of the acquisition of the underlying assets in the mine and accordingly is a taxpayer to which this section applies.

The Acquiring Company has also provided the Vendor Companies the right to receive ordinary income in the form of royalties generated from mining operations carried on under their mining entitlement.

Accordingly, CGT Event D3 applies to the grant of a right to royalty payments. The capital proceeds will comprise the value of the royalty right, being the market value. As the Acquiring Company has not incurred any expenditure in granting the right, the Acquiring Company will be assessed upfront on the capital gain equal to the market value of the right at the time the contract to provide the right is entered into.

Conclusion

Under CGT Event D3, the grant of the right to royalties is assessed as a capital gain at the time the contract is entered into.

As no capital proceeds were received in the grant of the right, the market value substitution rule applies to deem capital proceeds to have a value equal the market value of the CGT asset at the time of the event.

Question 5

Are the production based vendor royalty payments to the Vendor Companies deductible under section 8-1 of the ITAA 1997?

Answer

Yes, the royalty payments, will be deductible under section 8-1 in the income year in which they are incurred.

Detailed reasoning

As discussed above, based on Cliffs International and Ivanac, future royalty payments do not amount to deferred consideration. Rather, they are separate and distinct from the purchase price of an asset and should be treated as deductible outgoings ordinarily incurred in carrying on a business.

Accordingly, any future royalty payments made by the Acquiring Company to the Vendor Companies will be deductible under section 8-1. This is on the basis that the royalty payments are necessarily incurred in carrying on the business of mining in order to produce assessable income.

Conclusion

The royalty payments are treated as separate and distinct to the acquisition of the mine. We consider they are deductible under section 8-1 as expenditure ordinarily incurred in carrying on a business to gain or produce assessable income.