Capital allowances: depreciating asset - decline in value calculation - use of a mining, quarrying or prospecting right - operations in the course of working a mining property

In determining whether subsection 40-80(1) of the Income Tax Assessment Act 1997 (ITAA 1997) applies in respect of determining the decline in value of a mining, quarrying or prospecting right a taxpayer holds, does the taxpayer's 'first use' of the right in drilling to ascertain the quality and distribution of the mineral so as to determine the location of mine pits and mine infrastructure trigger the exclusion contained in paragraph 40-80(1)(b) of the ITAA 1997?

Yes. The taxpayer is excluded from determining the decline in value of the mining, quarrying or prospecting right under subsection 40-80(1) of the ITAA 1997 because the taxpayer first used the mining, quarrying or prospecting right for operations in the course of working a mining property under subparagraph 40-80(1)(b)(ii) of the ITAA 1997.

All legislative references are to the ITAA 1997 unless otherwise stated.

The taxpayer purchased a mining exploration project from a vendor pursuant to a sale agreement. The vendor had completed exploration sufficient that they had proved mineral reserves in accordance with the Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves (JORC Code).

The assets acquired by the taxpayer pursuant to the sale agreement included a lease issued by the relevant State Government Minister which conferred on the registered owner of the lease the right to explore the subject land in search of mineral deposits suitable for mining (the exploration right). The exploration right allowed exploration and some other mining-related purposes. The exploration right is a mining, quarrying or prospecting right that is a depreciating asset within the meaning of subsection 40-30(2). The taxpayer holds the exploration right under item 5 of the table in section 40-40.

The mineral deposits to which the exploration right relates are 'minerals' and are obtainable by 'mining operations' as defined by section 40-730.

The taxpayer made a decision to mine the subject land.

Subsequent to the decision to mine, the taxpayer first used the exploration right to conduct drilling. The drilling ascertained the quality and distribution of the minerals within an area known to contain the minerals. The drilling falls within the definition of 'exploration or prospecting' in subsection 40-730(4) and in particular subparagraph 40-730(4)(a)(i) of that definition.

The drilling was directed toward defining the limits of suitable mineral resources in order to determine the positioning of the mine pit wall and the construction of other mining infrastructure.

The taxpayer had a mining property.

Subsection 40-80(1) provides that the decline in value of a depreciating asset you hold is the asset's cost if the conditions in paragraphs (a), (b) and (c) of that subsection are met.

Paragraph 40-80(1)(a) requires that 'you first use the asset for exploration or prospecting for minerals, or quarry materials, obtainable by mining operations'.

In this case, the drilling conducted by the taxpayer satisfies paragraph 40-80(1)(a).

However, it is necessary to consider whether paragraph 40-80(1)(b) operates to exclude the taxpayer from determining the decline in value of its mining, quarrying or prospecting right under subsection 40-80(1).

Paragraph 40-80(1)(b) specifies that when you first use the [depreciating] asset, you do not use it for: (i) development drilling for *petroleum; or (ii) operations in the course of working a mining property, quarrying property or petroleum field.

Apart from the word 'petroleum' none of the expressions contained in these subparagraphs are defined for the purposes of the ITAA 1997. For the purpose of considering the meaning of these expressions, it is relevant to consider whether there are any explicit statements in the legislation or in the associated extrinsic material which might provide assistance in establishing their meaning.

Paragraph 7.10 of the Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001, which introduced section 40-80, provides that: The meaning of exploration or prospecting is not defined exhaustively and so takes its ordinary meaning ... It does not, however, include expenditure on developing or operating a mining or quarrying field or site. The point at which a decision to proceed to actual mining operations has been made, is the dividing line between exploration and prospecting on the one hand, and development and operation on the other . (Emphasis added)

Paragraph 1.70 of the same Explanatory Memorandum provides that: The decline for a depreciating asset you hold will be the asset's cost, if the asset is for exploration and prospecting. This means you must first use the asset for exploration and prospecting for things you can get by mining operations. But you must not use the asset for petroleum development drilling, or for operations in the course of working a mining or quarrying operation ... These restrictions mirror the current law ; see the former section 330-15 and subsection 330-20(2 ). (Emphasis added)

As these restrictions were clearly intended to retain the policy intent of prior provisions, it is also relevant to have regard to the context in which the expressions employed in paragraph 40-80(1)(b) arose in prior statutory provisions dealing with the same subject matter. This is because the courts may have regard to the history of the legislative scheme in order to enable them to work out what the legislation is intended to achieve.

Division 40 is a legislative scheme mainly based on deductions for decline in value of depreciating assets. The provisions relating to the general mining, quarrying and petroleum resources sector which existed before it were expenditure based. The expressions under consideration here were contained in the definition of 'exploration or prospecting' in former section 330-20. In Division 40, the expressions have instead been placed into the operative provision of subsection 40-80(1). Irrespective of that change, the expressions still retain the same meaning under Division 40 as they did under former Division 330. The Explanatory Memorandum to the Income Tax Assessment Bill 1996 which introduced Division 330 is silent on the meaning of these expressions, therefore it is necessary to consider that Division's predecessor provisions in the Income Tax Assessment Act 1936 (ITAA 1936).

The predecessor to the mining and quarrying provisions in Division 330 was the mining and quarrying provisions in Division 10 of Part III of the ITAA 1936.

Former subsection 122J(6) of Division 10, Subdivision A of the ITAA 1936 contained the definition of 'exploration or prospecting' in the context of general mining. The definition specifically excluded 'operations in the course of working a mining property'.

The Explanatory Memorandum to Income Tax Assessment Bill (No. 2) 1968, which introduced the definition of 'exploration or prospecting' in former subsection 122J(6) of the ITAA 1936, provided that: The definition does not extend to normal mining operations which are directed towards the extraction of minerals as opposed to the discovery of mineral deposits. (Emphasis added)

Former subsection 122JF(12) of Division 10, Subdivision B of the ITAA 1936 contained the definition of 'exploration or prospecting' in the context of quarrying. Also excluded from that definition was 'operations in the course of working a quarrying property'.

The Explanatory Memorandum to Taxation Laws Amendment Bill (No.2) 1990, which introduced the definition of 'exploration or prospecting' in former subsection 122JF(12) of the ITAA 1936, provided that: The definition does not extend to normal quarrying operations which are directed towards the extraction of quarry materials as opposed to the discovery of deposits of quarry materials. (Emphasis added)

Former subsection 124AH(7) of Division 10AA (Prospecting and Mining for Petroleum) of the ITAA 1936 contained the definition of 'exploration or prospecting' in the context of petroleum. Excluded from that definition was 'development drilling or operations in the course of working a petroleum field'.

The Explanatory Memorandum to Income Tax Bill (No.2) 1974, which introduced the definition of 'exploration or prospecting' in former subsection 124AH(7) of the ITAA 1936, provided that the definition: ... does not include development drilling or operations in the course of working a petroleum field. Capital expenditure incurred on the items specifically excluded from the definition will qualify as allowable capital expenditure and be deductible over the estimated life of the field or, in the case of plant, as depreciation if the taxpayer so elects.

The statements explaining the meaning of the expressions - 'development drilling for petroleum' and 'operations in the course of working a mining property, quarrying property or petroleum field' - in the abovementioned Explanatory Memoranda make it clear that the expressions cover the items of expenditure which, under the predecessor provisions to Division 40, qualified for deduction as allowable capital expenditure. This included, but was not limited to, mining operations which were directed towards the extraction of minerals, quarry materials or petroleum.

The concept of 'allowable capital expenditure' existed under the former Divisions 10 and 10AA of the ITAA 1936 and former Division 330. The various deductions provided under those former Divisions depended on whether the expenditure incurred by the taxpayer fell within one of the classes of expenditure specified for deduction. To determine the class of expenditure specified for deduction, it was first necessary to have regard to the meaning of 'exploration or prospecting expenditure' and 'allowable capital expenditure' under those former Divisions.

Assistance in determining whether expenditure incurred by a taxpayer was deductible as exploration or prospecting expenditure or allowable capital expenditure is provided by Taxation Ruling TR 98/23 'Income tax: mining exploration and prospecting expenditure'. In particular, paragraph 55 of TR 98/23 which states that: It is understood that once an ore body, quarry materials or a petroleum field has been discovered and delineated, generally two types of expenditure are incurred. The first relates to project evaluation expenditure such as feasibility studies, pilot plant and environmental impact studies. The second relates to the establishment of access facilities and other infrastructure to carry out properly the mining or quarrying project. Often, the latter type of infrastructure put in place during this stage is of such a scale it is far in excess of that required to complete the project evaluation and essentially has an enduring benefit to the mine.

Further, paragraph 56 of TR 98/23 provides that: In these circumstances, it is important first to determine the predominant purpose of establishing infrastructure. In doing so, regard could also be had to the scale of the operations undertaken. If the establishment of infrastructure is to such a degree as to be commensurate with preparing the site for eligible mining or quarrying operations, or the work is more concerned with establishing the permanent extractive facilities for ore or quarry materials rather than with whether to mine or quarry, then the expenditure incurred would more properly be classified as allowable capital expenditure rather than exploration or prospecting expenditure.

Whilst Division 40 retains the concept of 'allowable capital expenditure', the items of expenditure which previously fell within that concept now fall within the definition of the new term 'mining capital expenditure' in section 40-860.

Notwithstanding these changes, it is the Commissioner's view that for the purposes of paragraph 40-80(1)(b), the meaning of the expressions - 'development drilling for petroleum' and 'operations in the course of working a mining property, quarrying property or petroleum field' - has not changed since the introduction of the definitions of 'exploration or prosecting' in the former provisions of Division 10 and Division 10AA of the ITAA 1936.

Given the history of the legislative scheme, the Commissioner considers that these expressions have been inserted into paragraph 40-80(1)(b) to ensure that a taxpayer will not be entitled to an immediate deduction for the cost of a depreciating asset where their first use of the asset is in an activity, expenditure on which could give rise to the incurrence of capital expenditure that is 'mining capital expenditure' as defined in section 40-860.

It is the Commissioner's view that the exclusion in paragraph 40-80(1)(b) is not limited to actual extraction activities and includes the developmental work such as preparing a site for mining operations and providing water, light and power for use on the site for future mining operations as specified in section 40-860. The only difference in relation to the operation of the exclusion in paragraph 40-80(1)(b) is that the exclusion is applied where the taxpayer first uses the particular depreciating asset for any one of those developmental or mining operations purposes.

Application to the taxpayer's circumstances

In this case, the exploration right pertains to minerals obtainable by mining operations. Accordingly, as provided in subparagraph 40-80(1)(b)(ii), when the taxpayer first used the exploration right, if they used it for operations in the course of working a mining property the taxpayer is excluded from determining the decline in value of the exploration right under subsection 40-80(1).

It is the Commissioner's view that the drilling was undertaken by the taxpayer to prepare the site for mining operations. This is because, based on an objective determination, the drilling undertaken by the taxpayer was directed toward defining the limits of suitable mineral resources in order to determine the positioning of the mine pit wall and the construction of other mining infrastructure. Further evidence in support of this view is the fact that prior to the commencement of the drilling the taxpayer had already made a decision to mine.

It follows that the taxpayer's drilling was a first use of the exploration rights for operations in the course of working a mining property. In these circumstances, the exclusion in subparagraph 40-80(1)(b)(ii) applies to exclude the taxpayer from determining the decline in value of the mining, quarrying or prospecting rights under subsection 40-80(1).