Income Tax: deductibility of hydraulic fracture stimulation

Is the taxpayer entitled to a deduction, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), for the expenses incurred in performing a hydraulic fracture stimulation in a hydrocarbon production well, where it is the first fracture stimulation undertaken at that production zone within the well, for the purpose of initiating or increasing the flow of gas from a hydrocarbon bearing formation?

No. The taxpayer is not entitled to a deduction, under section 8-1 of the ITAA 1997, for the expenses incurred in performing a hydraulic fracture stimulation in a hydrocarbon production well, where it is the first fracture stimulation undertaken at that production zone within the well, for the purpose of initiating or increasing the flow of gas from a hydrocarbon bearing formation. Such expenses are capital in nature.

The taxpayer conducts a business of oil and gas exploration and production.

The taxpayer has engaged a contractor to perform hydraulic fracture stimulation in hydrocarbon production wells owned by the taxpayer on a number of occasions.

The hydraulic fracture stimulations performed resulted in either an increase in the rate of flow of gas from the hydrocarbon bearing formation in the production zone where the hydraulic fracture stimulation occurred, or resulted in the taxpayer gaining access to a hydrocarbon bearing formation that was previously inaccessible from that hydrocarbon production well.

A deduction is allowed under section 8-1 of the ITAA 1997 for losses or outgoings to the extent that the loss or outgoing is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowed under the section where the loss or outgoing is of a capital, private or domestic nature, or is incurred in producing exempt income, or where another provision prevents a deduction.

The expenses incurred in undertaking hydraulic fracture stimulation on a hydrocarbon production well are clearly incurred in the gaining or producing of assessable income from the hydrocarbon mining business. The only relevant question then in determining whether a deduction is allowed under section 8-1 of the ITAA 1997 is whether the costs of undertaking hydraulic fracture stimulation are of a capital nature.

The decision of the High Court in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers Case) is a leading authority on the distinction between revenue and capital expenditure. The general rule is found in the frequently quoted statement of Dixon J at 359 where he said: 'The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay,...'

Dixon J further commented at 360: 'In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.'

In the Sun Newspapers Case Dixon J stated at 363 that there are three matters to consider when deciding whether an expense is revenue or capital in nature. These are: • the character of the advantage sought by the outgoing • the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer; and • the means adopted to obtain the advantage, such as by recurring payments.

In a more recent decision the High Court in G P International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 added emphasis to the first point above. The court stated at 137: ...for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.

In relation to the character of the advantage sought by the outgoing it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205, by Viscount Cave at 213-214: But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

In the case of hydraulic fracture stimulation performed for the first time at any given production zone in a hydrocarbon production well there is an enduring benefit obtained from the performance of the hydraulic fracture stimulation. The enduring benefit obtained is the increase in efficiency that results from the fracturing process or the ability to access new hydrocarbon bearing formations that cannot be accessed without hydraulic fracture stimulation. The performance of hydraulic fracture stimulation improves the profit making structure of the operation as a whole by either increasing the flow of gas from formations currently accessed, and thereby increasing the efficiency and profitability of these formations, or by accessing new gas bearing formations.

This is consistent with the statement of Lockhart J in Commissioner of Taxation v. Ampol Exploration Limited (1986) 13 FCR 545; 86 ATC 4859; (1986) 18 ATR 102 ( Ampol Exploration Case ) where he stated at FCR 562; ATC 4872; ATR 119: Where expenses are incurred in establishing, developing, extending or rejuvenating a mine, they will generally be of a capital nature since they are incurred for the purpose of bringing a capital asset into existence or enhancing it.

The operation of hydraulic fracture stimulation falls within the categories spoken of by Lockhart J as the purpose of the operation is to extend or otherwise enhance the mine. This is also the case where multiple hydraulic fracture stimulations are performed at the start of a well's production life. This is because the character of the advantage sought does not change simply because multiple hydraulic fracture stimulations are necessary to achieve what may take only a single hydraulic fracture stimulation in another well. As the costs of performing hydraulic fracture stimulation are of a capital nature they will not be deductible under section 8-1 of the ITAA 1997.