Farm-out Arrangements

What is a farm-out agreement?
A farm-out arrangement typically involves an entity (the farmor) agreeing to provide a working interest in a mining property to a third party (the farmee), provided that the farmee makes a cash payment to the farmor and/or incurs certain expenditures on the property to earn that interest.

Why would a company consider entering into a farm-out arrangements?
A company may decide to enter into a farm-out agreement with a third party if it wants to maintain its working interest while reducing risk, or doesn't have the money to undertake the operations that are desirable for that working interest.

Farm-out agreements also give farmees a potential profit opportunity that they would not otherwise have access to.

What is the accounting treatment of farm-out arrangements?
The most common accounting treatment of farm-out agreements is:

• the farmor uses the carrying amount of the interest before the farm-out as the carrying amount for the portion of the interest retained
• the farmor credits any cash consideration received against the carrying amount, with any excess included as a gain in profit or loss 
• the farmor does not record exploration expenditures on the property made by the farmee

What the tax considerations are associated with farm–out agreements?
Immediate transfer farm-out agreement
Under an immediate transfer farm-out agreement, the farmor transfers a percentage of its interest in a tenement to the farmee, in return for the farmee undertaking exploration commitments and/or making cash payments. Such arrangements are treated as a sale of a percentage interest in a tenement by the farmor for income tax and GST purposes.

Generally, for income tax purposes the taxable market value of the component of the interest transferred to the farmee will be offset by the deduction allowed to the farmor in respect of the exploration benefits, resulting in a net nil tax position.

However, where the farmor also receives cash payments from the farmee, these amounts will generally be taxable to the farmor. Consequently, in many cases the farmor will only be taxed where they receive cash payments.

GST will be levied on the farmee on the aggregate value of the exploration benefits provided by the farmee and on the farmor for the value of the supply made by the farmee to the farmor. However, the farmor should also be able to claim an input tax credit with respect to the acquisition of the exploration benefit supply made by the farmee to the farmor. As a result the net effect will be that GST should only be payable on any cash component of the arrangement. It should be noted that in some instances the GST-free going concern exemption may be available.

Deferred transfer farm-out arrangement
Under a deferred transfer farm-out arrangement, the transfer of the interest in the tenement only occurs after the farmee has met all of the exploration commitments and any payment requirements to earn that interest (referred to as the “earn-in requirements”). The farmee’s exercise of the right to acquire an interest in the tenement is subject to it satisfying the earn-in requirements within the earn-in period.

In general terms, the ATO takes a similar approach to that for immediate transfer farm-out arrangements, in that income tax should generally only be payable by the farmor where it receives cash from the farmee.

Similar to an immediate farm-out arrangement, GST will be levied on the aggregate amount of both cash and non-cash considerations received by the farmor under a deferred farm-out arrangement.

Warning: extreme care should be exercised when undertaking farm-out arrangements to ensure the optimum tax and accounting outcomes are achieved.