ATO ID 2004/796: Income tax: deductibility of repeat hydraulic fracture stimulation - no access to further formations or increased gas flow
Date of decision: 27 August 2004
Year of income: Year ended 30 June 2003
Business line: Private Groups and High Wealth Individuals

Issue
Is the taxpayer entitled to a deduction, under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997), for expenses incurred in performing a repeat hydraulic fracture stimulation, at the same production zone within a hydrocarbon production well where a hydraulic fracture stimulation has previously been undertaken, where the procedure simply returns the rate of gas flow back to the rate achieved after the first fracture stimulation without accessing further hydrocarbon bearing formations?

Decision
Yes. The taxpayer is entitled to a deduction, under section 25-10 of the ITAA 1997, for expenses incurred in performing a repeat hydraulic fracture stimulation, at the same production zone within a hydrocarbon production well where a hydraulic fracture stimulation has previously been undertaken, where the procedure simply returns the rate of gas flow back to the rate achieved after the first fracture stimulation without accessing further hydrocarbon bearing formations.

Facts
The taxpayer conducts a business of oil and gas exploration and production. The taxpayer has previously performed hydraulic fracture stimulation at a certain production zone within a hydrocarbon production well. Since that hydraulic fracture stimulation was performed the fractures in the hydrocarbon bearing formation have become blocked and the rate of flow of gas from that formation into the well has dropped. The taxpayer engages a contractor to perform a repeat hydraulic fracture stimulation in the same production zone as the previous hydraulic fracture stimulation. The repeat hydraulic fracture stimulation results in the rate of flow of gas (from the hydrocarbon bearing formation into the well) returning to the levels achieved after the initial hydraulic fracture stimulation. The repeat hydraulic fracture stimulation does not increase the rate of flow of gas beyond what was achieved with the first hydraulic fracture stimulation, or allow access to any hydrocarbon bearing formations, or other gas reserves, that were not previously accessible. The process simply restores the rate of gas flow to the previous level.

Reasons for decision
Summary: Section 25-10 of the ITAA 1997 allows a deduction for expenditure incurred in making repairs to an asset, unless the expense is capital in nature. Whether a particular expense qualifies as a repair is considered by Taxation Ruling TR 97/23. That ruling states at paragraph 15: Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its character and may include restoration to its former appearance, form, state or condition. In the High Court decision in W Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58 Windeyer J commented at 72 that: Repair involves a restoration of a thing to a condition it formerly had without changing its character. A repeat hydraulic fracture stimulation will be considered to be a repair of the hydrocarbon production well when it is performed in the same production zone within the well where a hydraulic fracture stimulation has previously been undertaken and the repeat fracture stimulation simply returns the rate of gas flow back to the rate achieved after the first fracture stimulation without accessing further hydrocarbon bearing formations or other gas reserves. In this situation the asset (the hydrocarbon production well) has had its efficiency of function restored to its former state by the process of hydraulic fracture stimulation. The expense is considered a repair because the well has been restored to its former condition without changing its character. The expense of hydraulic fracture stimulation in this situation is not considered to be capital in nature as there is no enduring benefit obtained from the performance of the repeat fracture stimulation. This is because the procedure simply returns the well to its former state rather than enhancing the production capacity of the well, or increasing the level of gas reserves accessed by the well. As the expenditure on the repeat hydraulic fracture stimulation is not capital in nature the expense will be deductible under section 25-10 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 25-10
Case references: W Thomas & Co Pty Ltd v. Commissioner of Taxation (1965) 115 CLR 58
Related public rulings and determinations: Taxation Ruling TR 95/36 | Taxation Ruling TR 97/23
Related ATO interpretative decisions: ATO ID 2004/795 | ATO ID 2004/797
Subject references: Exploration or prospecting Minerals, petroleum or mining operations Mining & petroleum Mining operations