Farm-in transactions are unique to the exploration and production (E&P) sector since mineral oils embedded in a particular territory in their natural habitat are the property of the State/Central Government in whose territory/jurisdiction they rest.

As such, no person other than such State/Central Government can carry out the exploration and extraction of mineral oil unless a right to explore and extract mineral oils from the specified areas is granted by the State/Central Government.

Such exploration rights typically rest with the company(ies) which enters into a Production Sharing Contract (PSC) with the Government and can be wholly or partly assigned and transferred to other companies subject to approval from the Government.

Transfer of rights

It is very common in the E&P sector for the existing parties of the PSC to transfer such exploration rights through farm-out transactions. The acquisition of exploration rights may either be in the form of equity buyout or asset purchase. In case of an equity buyout, the purchase cost of shares of the entity is not amortisable, and thus, the cost of acquisition is locked until the shares are sold.

In case of an asset purchase, the tax treatment of the acquisition/farm-in cost has not been provided either in the Income-Tax Act, 1961 or in the Model PSC.

Despite several attempts by the industry to seek clarification on the tax treatment of farm-in costs, there is not much guidance available to date, resulting in a dispute between the industry and the tax department. Even the proposed Direct Taxes Code Bill, 2009 does not categorically provide for the treatment of farm-in costs leaving open the possibility of dispute with the tax authorities on this account.

In the absence of specific provision relating to the taxability of farm-in costs, under the current tax regime and depending upon the facts of the case, E&P companies have been resorting to three possible alternatives for claiming the farm-in costs: as revenue expenditure incurred for the purpose of business under Section 37 of the I-T Act; or as exploration expenditure in accordance with Section 42 of the I-T Act read with the PSC; or as depreciation on intangible assets being licence or business or commercial rights of similar nature to that enumerated under Section 32 of the I-T Act.

The Revenues stand

However, the revenue authorities do not allow the claim of the farm-in costs either as revenue expenditure or as depreciation. The revenue authorities reject the claim of farm-in costs as revenue expenditure under Section 37 on the ground that the specific section, that is, Section 42 of the I-T Act, is applicable to E&P companies to claim the deduction of expenditure. Hence, a deduction for such expenses under any other section is not allowable.

At the same time, the revenue authorities do not accept the claim under Section 42 by contenting that the exploration expenses are actually incurred by the farmer-out and the essence of the farm-in transactions essentially is to transfer the participating interest from one party to another.

Even cases where the farmer-in has merely reimbursed the exploration costs have not found favour with the tax authorities. While disallowing the claim of depreciation, the revenue authorities do not take into account that the exploration rights granted by the Government are in the nature of licence.

It may be noted that such exploration rights entail exclusivity to the holder of such rights over the exploration and production operations from a particular block and the assignment/transfer of such a licence gives a right to the farmer-in, which should be recognised as a licence eligible for depreciation.

It is important to note that the licence is specifically covered as an intangible asset eligible for depreciation under Section 32(1)(ii) of the I-T Act. In any case, if not a licence, it should at least be recognised as a business or commercial right in the nature of licence, which again is eligible for depreciation. The position of the revenue authorities however has been that since the scope of the intangible assets eligible for depreciation is restricted to the assets which represent intellectual property rights, farm-in costs are not eligible for depreciation.

The contention of the revenue authorities appears to be incorrect as intangible assets eligible for depreciation also include trademarks and franchises, which may or may not include intellectual property rights.

The fact that the expenditure for acquisition of exploration rights has been incurred exclusively for the purpose of the business cannot be disputed. Thus, this expenditure deserves to be allowed within the start and finish line of business cycle. The position of the revenue authorities, however, has led to an anomaly, leading to permanent disallowance of the farm-in costs and resulting into unnecessary litigation. This anomaly since has put a question mark over the tax treatment of the farm-in costs, cause considerable financial hardship to the farmer-in.

The high tax costs result in farm-in transactions becoming uneconomical. The interpretation by the revenue authorities makes acquisitions less competitive in E&P sector, which is not in the countrys interest. India needs to encourage exploration of its vastly unexplored basins to increase its domestic oil and gas production to achieve better energy security, which is critical to its growth and economic development. Thus, a clarification in this regard is extremely critical.

Delhi ITAT

The question of whether the farm-in costs is amortisable has been answered for the first time by the Delhi Income-Tax Appellate Tribunal (ITAT) in its very recent ruling which is worth noting by all the upstream oil and gas companies. The Delhi ITAT, in the case of a key player engaged in oil and gas E&P activities, held that the commercial rights of exploration of mineral oils as acquired by the assessee falls under the expression of any other business or commercial right of the nature similar to licence as stipulated in Section 32(1)(ii).

The right has been granted to the assessee by way of licence and the assessee became owner of such right, that is, licence to have an access and to carry on the business of exploration and development of mineral oils. The ITAT has accordingly allowed the claim of the assessee of depreciation on the farm-in cost, based on the facts of the case.

Though the Delhi ITAT decision has provided some assurance to the E&P companies to reduce the financial hardship, it is still not conclusive and subject to challenge by the revenue authorities in the higher courts. It is highly desirable that the revenue authorities accept the decision and put a rest to the controversy. If the revenue authorities choose to challenge the decision, the matter would remain uncertain.

The Central Board of Direct Taxes or the Finance Ministry should issue appropriate clarification regarding the timing of the claim of such costs. Until then, the E&P companies should watch out and undertake adequate planning before giving effect to the farm-in costs in their tax returns.