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Tax Alert: Clarification on availability of depreciation on acquisition (i.e. farm in) of Participation Interest in the Production Sharing Agreement

21 August 2019

The Government of India (GoI) offers exploration and development rights through global bidding for specified oil and gas blocks under National Exploration and Licensing Policy (NELP), Hydrocarbon Exploration and Licensing Policy (HELP), Open Acreage Licensing Policy (OALP), etc. by signing Revenue Sharing Contract (RSC) or Production Sharing Agreement (PSC) with the Oil Exploration and Production (E&P) Companies. Oil E&P Companies are granted licenses to explore, develop and carry out production operations in oil and gas blocks. Generally, owing to the large investments required and the risks involved, more than one Oil E&P Company (hereinafter referred to as RSC or PSC participant) executes the PSC with GoI.

In the past, Central Government in exercise of its powers under section 293A of the Income Tax Act, 1961 (IT Act) vide notification[1] dated 08 March 1996, had laid down that each RSC/PSC participant shall be assessed in respect of its own share of income in the same status in which it enters into RSC/PSC and not as an association of persons (AOP) or body of individuals (BOI).

As the life-cycle of the Oil and Gas block is for longer duration, generally, RSC/PSC participants buy (i.e. farm in) and sell (i.e. farm out) their Participation Interest (PI) in the RSC/PSC. ‘Farm-in’ expenditure is incurred when an entity in oil and gas business acquires PI from another entity and becomes participant of RSC/PSC entered with GoI.

Since the tax treatment for farm in expenditure is not expressly dealt by any provision of the IT Act, representations were made by Oil E&P Companies to clarify whether ‘farm-in’ expenditure, being in the nature of rights, should be allowed to be treated as an intangible asset under section 32(1)(ii) of the IT Act.

Recently, the Central Board of Direct Taxes (CBDT) has issued a circular[2], clarifying two important aspects pertaining to ‘farm-in’ expenditure incurred by Oil E&P Companies:

  1. Amount paid for acquiring the PI shall not be treated either as cost for acquiring the share in partnership or investment for acquisition of a member's interest in an AOP or BOI, rather it would be treated as an amount paid to acquire the underlying assets; and
  2. The amount paid for acquiring the PI, after reducing component of cost attributable to tangible assets for purposes of section 32(1)(i), would be treated as an 'intangible asset' (being a business or commercial right akin to a licence), eligible for claim of depreciation for purposes of section 32(1)(ii) of the IT Act.

Further, it is also clarified that this circular being clarificatory in nature shall be applicable from the date of applicability of section 32(1)(ii) of the IT Act.

BDO Comments:

In the past, tax controversies had risen on treatment of farm-in expenditure and the Court had decided that depreciation should be allowed on the same. However, this circular will put to rest the controversy that was prevailing vis-à-vis its tax treatment. Recently, in February 2019, the Central Government had launched the third bidding round under its OALP in respect of 23 blocks spread across 12 sedimentary basins. The successful bidder under this round will stand to benefit from this circular.

[1] Notification No. GSR 117(E) dated 08 March 1996.

[2] Circular No. 20/2019 dated 19 August 2019.