ATO ID 2004/797: Income tax: deductibility of repeat hydraulic fracture stimulation resulting in increased gas flow or access to other formations
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 either section 8-1 or 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 increases the rate of gas flow beyond what was achieved after the first hydraulic fracture stimulation or allows access to hydrocarbon bearing formations, or other gas reserves, that were not accessible after the first hydraulic fracture stimulation?

Decision
No. The taxpayer is not entitled to a deduction, under either section 8-1 or 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 increases the rate of gas flow beyond what was achieved after the first hydraulic fracture stimulation or allows access to hydrocarbon bearing formations, or other gas reserves, that were not accessible after the first hydraulic fracture stimulation. Such expenses are capital in nature.

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) increasing beyond the levels achieved after the initial hydraulic fracture stimulation. The repeat hydraulic fracture stimulation also results in access to gas reserves that were inaccessible following the initial hydraulic fracture stimulation.

Reasons for decision
Summary: 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: 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. There will be an enduring benefit obtained from a repeat hydraulic fracture stimulation that is performed at the same production zone within a hydrocarbon production well where a hydraulic fracture stimulation has previously been undertaken and the procedure increases the rate of gas flow beyond what was achieved after the first fracture stimulation or allows access to hydrocarbon bearing formations, or other gas reserves, that were not accessible after the first 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 were not accessed by the previous hydraulic fracture stimulation. The performance of a repeat hydraulic fracture stimulation in this situation 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 the repeat hydraulic fracture stimulation in this situation falls within the categories spoken of by Lockhart J as the result of the operation is the extension or otherwise enhancement of the mine. As the costs of performing a repeat hydraulic fracture stimulation in this situation are of a capital nature they will not be deductible under section 8-1 of the ITAA 1997. 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. FC of T (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. In the current situation the hydrocarbon production well has not been repaired for the purposes of section 25-10 of the ITAA 1997. This is because the procedure resulted in more than a mere restoration of the well's efficiency of function to its former condition, rather the well has been improved due to new gas bearing formations becoming accessible and the rate of gas flow increasing beyond what was achieved following the initial hydraulic fracture stimulation. As outlined above, in relation to section 8-1 of the ITAA 1997, the expenses incurred in performing a repeat hydraulic fracture stimulation in the current situation are capital in nature. They are therefore excluded from deductibility under section 25-10 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 8-1 section 25-10
Case references: Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337
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 2004/796
Subject references: Exploration or prospecting Minerals, petroleum or mining operations Mining & petroleum Mining operations