In our news brief issued in June last year on the emergency Budget we commented that the oil and gas industry seemed to have been exempted from the increased tax burden levied elsewhere. Unfortunately the Industry has not fared so lightly this time with the announcement of a significant rise in the rate of tax for UK upstream oil and gas profits.
There is a hint of development on structural change to the North Sea regime in the area of abandonment, but the only firm measure announced today is an unhelpful one: a restriction in the tax relief that will be available for abandonment costs.
This note sets out details of the main measures relevant to our corporate clients operating in the Energy sector in today’s Budget announcements, and our initial comments thereon. We expect a Finance Bill to be published towards the end of next week and we will comment further as additional details emerge.
1. Supplementary Charge (SC)
The rate of SC will be increased for accounting periods beginning on or after 24th March 2011 from 20% to 32%, with straddling period rules for accounting periods which overlap this date.
If the price of oil falls below a certain level, currently expected to be $75 per barrel, for a sustained period of time, the Government states that it will reduce the SC rate back towards 20% on a “staged and affordable basis” while prices remain low. The Government will seek the views of the oil industry and motoring groups to determine whether $75 is an appropriate level.
The effect of this is to increase the marginal tax rate for non PRT fields to 62% and to 81% for PRT fields for profits accruing from 24th March 2011.Unlike the previous increase in the rate of SC in 2006 no compensating measures have been offered to soften the blow of the increase, except perhaps a possible extension on the scope of Field Allowance.
This measure will clearly adversely affect those companies that have invested in North Sea fields and have received relief at 50% but have yet to achieve the additional production resulting from that investment, which will now be taxed at 62%.
Depending on the pattern of profits for 2011 companies will need to consider how best to present their results to minimise the impact of this increase. There may also be other limited measures which companies might wish to consider to mitigate the effect of this change.
The offer of a reduction of the SC rate if prices fall below $75 on a sustained basis “back towards” 20% seems a half-hearted response and appears to offer little comfort of a significant reduction in the SC rate, especially at current price expectations.
2. Restriction in Decommissioning Relief
Legislation is to be introduced in Finance Bill 2012 to restrict tax relief for decommissioning expenditures to the 20% supplementary charge rate. This measure is stated as having effect from Budget Day 2012.
The government have given an undertaking that there will be no further restrictions on decommissioning relief in this Parliament. They have however stated that they intend to work with industry to develop measures to introduce long-term certainty on decommissioning at the time of the 2012 Budget.
Comment: Although we will have to wait for further details of the measure we assume that the restriction will apply to ”general decommissioning expenditure” (i.e. expenditure incurred on decommissioning offshore installations and pipelines) incurred after Budget Day 2012, and would apply where allowances are set against current year profits of the company, group relieved, carried forward, or more probably carried back. If this is how the restriction works there are likely to be very limited opportunities to advance expenditure in order to mitigate the effect of the measure. We fear that this is the first of a number of measures which will seek to restrict the Treasury’s exposure to repayment of taxes on abandonment. We suspect that “certainty” will come at a heavy price for iindustry.
3. Other Oil and Gas Measures
3.1 Field Allowance
Somewhat surprisingly the Red Book states that the Government recognise the continuing importance of investment in the North Sea and there is a suggestion that a further category of field allowance may be introduced to deal with what are called “marginal gas fields”.
It is understood that Government do not believe that the increase in SCT will have any significant adverse impact on investment but if this can be shown not to be the case, they are prepared to consider some new form of field allowance.
3.2 Intangible Assets
Changes are to be made to the intangible asset rules to prevent oil and gas companies from claiming relief for goodwill created on acquisitions.
Changes are to be made with effect for accounting periods beginning after Budget Day.
Although licence interests were excluded from the categories of assets which could qualify for relief within the intangible asset rules this exclusion does not apply to goodwill arising on an acquisition. In the past it has not be usual for goodwill to be recognised on a licence acquisition, however as a result of IFRS and in particular the fact that an increasing number of North Sea acquisitions are accounted for as a business combination, accounting practice can generate goodwill. HMRC have stated that it was never intended that relief would be available in these cases and the legislation is to be amended to ensure that relief will no longer be available.
Previously announced measures
It has been confirmed that many of the previously announced changes are to be included in the Finance Bill. These items are either going to be included without any change to the previously published draft, or in a number of cases are to be included but with changes to reflect representations that have been made by taxpayers, or concerns that HMRC have with regard to potential tax avoidance.
The issues of main relevance to the oil and gas sector are as follows:
- the extension of reinvestment relief to exploration and appraisal relief,
- the amendment of the swaps rules
- the definition of fields qualifying for field allowance
- the branch profits exemption
- the change to the de-grouping charge
- the changes to the value shifting anti-avoidance rule.
All of these have been covered by previous CWE newsbriefs but we set out below a brief summary and details of any changes that have been proposed.
1. Minor changes to oil and gas regime
1.2 Extension of scope of reinvestment expenditure
The scope of reinvestment relief will be expanded to include “exploration or development expenditure”. The new rules will apply for disposals taking place on or after 24th March 2010, although the reinvestment can take place before that date, subject to the usual 12 month time limit.
To ensure that these costs can qualify for reinvestment relief, there are a series of deeming provisions in the draft legislation to ensure that the costs qualify for rollover relief, which is one of the preconditions for reinvestment relief. In particular the costs are deemed to be within the classes of qualifying assets for rollover relief (thereby avoiding the need to decide whether they are land or fixed plant and machinery).
When the reinvestment rules were initially under discussion relief for drilling costs was promised but when the legislation was published these costs were excluded. It is welcome that HMRC have listened to industry and agreed to include such costs within the scope of costs eligible for reinvestment.
The original draft legislation referred to “exploration or development expenditure” as being qualifying expenditure for the purposes of the reinvestment relief but following representations it will be madet clear that appraisal costs are also included. The scope of the rules would therefore seem to be wider than drilling and could include for example engineering studies, feasibility studies, seismic and geological studies etc.
The original draft included a requirement that qualifying costs exclude consideration for the purchase of an asset. Following representations this has also been removed as it was agreed it was unnecessary.
1.3 Swap rules
Provisions were introduced in FA 2009 to limit the taxable consideration for CGT purposes on swaps of licence interests, where at least one licence related to a developed field. The limit was to the non-licence consideration, if any, payable in respect of any difference in value. The rules only applied to transactions where non-licence consideration was given by only one party. As drafted it was likely that the requirements to fall within the provision could not be met for many typical North Sea disposals, as one needed to look at the position at completion, when it is common for non-licence consideration to be payable by both parties. Government has acknowledged that this was not the intent of the provision and has revised the requirements such that the tests have to be applied at the commercial “effective date” of the deal. All “interim period” adjustments to the consideration, apart from any time value of money adjustment on the initial cash amount, are effectively ignored for CGT purposes, such that any CGT (before reinvestment relief) is limited to the amount by which the cash differential, plus any time value of money adjustment to that number, exceeds the basis the company had in the licence they have disposed of.
There is no specific reference to this provision in the Budget Press Releases but we understand that the changes will be included in the Finance Bill to be published next week. While more development licence swaps may now fall within the provision the rules would appear to have little practical significance as the reinvestment rules which, as noted above are being extended to include exploration and development costs, are likely to mean that no capital gain will in any event arise if the transaction does not fall within these swap rules. Indeed in many cases companies might well prefer to fall exclusively in the reinvestment relief rules rather than in these swap rules, although the swap rules, if they apply, take priority.
1.4 Extension of Definition of New Field
The definition of a “new field” for the purposes of field allowances against SCT, is now to include certain previously decommissioned fields.
A new field is now to be defined as an oil field whose development is first “authorised” on or after April 22, 2009, i.e. essentially a field which received its first development consent after this date. For a field which has previously been developed the draft legislation states that any earlier development consent is to be ignored in identifying whether the development of a field can be treated as first authorised after April 22, 2009 provided any assets which have been used for the purposes of winning oil from the field under that previous development consent have been “decommissioned”. The definition of decommissioned follows that introduced in Finance Act 2009 in connection with the cessation of oil fields due to licence expiry.
The extended definition is to be backdated to April 22, 2009, the date of introduction of the first field allowance rules.
Again there is no specific reference to this proposed change in the Budget announcements but we understand it is nevertheless to be included. Arguably the existing legislation could be interpreted to include fields which had previously received development consent but the new legislation will in most cases remove the uncertainty, which is welcome. In order to fall within the redrafted legislation it will be necessary to establish that any asset which has been used for the purposes of winning oil from the relevant field has been decommissioned. If a field has previously been produced across another field and that field has not been fully decommissioned this could prevent any redevelopment qualifying for the field allowance.
2. Branch Profits Exemption
An elective exemption, which will apply to all large and medium sized companies and to small companies with branches in jurisdictions with a “full” UK treaty, will apply on a company by company basis. A number of apparently significant changes to the original draft clauses published last year have been made but the new clauses are not yet available. Some of these changes are apparently beneficial but there are also suggestions that the final rules will include stronger anti avoidance measures. The following comments are made with reference to the clauses that were published last year. We will update readers as soon as the revised draft clauses become available.
If an election is made the aggregate profits and losses attributable to all the company’s non UK branches will be left out of account for the purposes of calculating the company’s UK tax liability. The attributable profits or losses, including capital gains and losses and investment income, of each branch have to be computed on treaty principles. An election is irrevocable following the filing date for the first returns applying the election, and applies to all future accounting periods of the company. If no election is made the company will continue to be taxed under the existing credit relief system.
It will be possible for groups to make the election in respect of some companies but not others such that the group’s non UK branches can be organised into appropriate companies, with some remaining within the UK tax net, and the others electing to be treated as exempt. There also doesn’t appear to be anything to stop a group moving non UK branch assets out of a company which has made an election into one that hasn’t, and vice versa, with the result that the branch profits and losses could come in and out of the scope of UK tax. If not amended through the consultation phase this may present planning opportunities, although there will, of course, be local jurisdiction consequences to take into account before moving assets between corporate entities.
There are however transitional rules dealing with losses. If, in aggregate, a company electing into the new regime has non UK branch accumulated losses (ignoring any capital gains and losses, and, if relevant, that any of those losses have been utilised for UK tax purposes, for example by offset against other income or by way of group relief), from the six years prior to the first year in which the election is made, or since 2005 if the losses are more than £50 million, any net profits from non UK branches will not be excluded until such time as the post election aggregate profits (ignoring any post election net losses, or post election capital gains or losses) exceed these accumulated losses. During this time credit will be available for any non UK tax paid on these profits.
This deferral of the effective date could mean that it may not be possible to protect capital gains on non UK branch assets if the company is trading but there is no income in the non UK branches. As with the comment above it would however appear to be possible to move assets from one UK company to another, subject to there not being any non UK tax cost, before making the election in the transferee, such that the transferee would have no past losses to absorb before the exemption applies.
There are a number of exclusions from the election. As noted above the exemption does not apply to any profits or losses of “small” companies (i.e. those with fewer than 50 employees, and with both turnover and a balance sheet total of less than €10 million) attributable to jurisdictions which do not have a “full” double tax treaty with the UK containing a non discrimination clause. The exemption is not available to investment companies, in respect of capital gains of close companies, nor in respect of profits which would be subject to a CFC apportionment if held in a non UK subsidiary. Further, the exclusion is not available if profits which have been diverted to a “low tax” jurisdiction exceed certain de-minimus levels, and the diversion had as one of its main purposes the reduction in UK tax.
We would expect that most oil and gas companies, even in the exploration phase, are unlikely to be “small”, but if they are, this exclusion could mean that, for example, capital gains made on licences in oil provinces where the UK does not have a treaty may still not be exempt, even if an election has been made.
As the reason for oil and gas companies conducting upstream operations outside the UK will be because that is where the licences are located, it is not thought that the diverted profits exclusion could apply. However groups with other activities outside the UK will need to review these rules to determine whether an election will be effective.
As noted above the potentially exempt profits attributable to a non UK branch are computed in accordance with treaty principles. The initial requirement is that the branch profits must be those which would have arisen if the branch had been an independent entity. This is then caveated that it should be assumed that the branch has the same credit rating as the company and that equity and loan capital is allocated on a just and reasonable basis.
It is not clear how this rule should work if, for example, a company had a producing interest in the UK which gave it capacity to take on third party bank debt, but had only exploration interests in the non UK branch, or vice versa.
The introduction of these rules should make tax compliance easier for UK resident companies with non UK activities. The flexibility of an elective regime ensures that all upstream oil and gas players should be pleased with the new regime which also, as drafted, appears to offer a significant amount of planning opportunities. Any clients wanting CWE to carry out a review of their position, and the potential opportunities open to them, should speak to their usual CWE contact.
3. De-grouping changes
At present, if a company leaves a group owning an asset which it has acquired from another member of the group within the previous 6 years under a transfer which was tax free at the time, there is a deemed capital gains disposal event in the company, whereby the company is deemed to have disposed and reacquired the asset at its market value as at the date it acquired it. This is so even though the disposal of the shares themselves may be exempt as a result of the application of the substantial shareholding exemption (SSE).
Although there are provisions to allow any such gain to be transferred intra group, or rolled over in the company or any other seller group company, it is often difficult to avoid a tax charge arising and careful planning is required to avoid this situation.
The proposed changes will significantly reduce the impact of such a degrouping charge. The effect of the proposed legislation will be that if the company elects, the gain arising on the deemed disposal as a result of leaving the group will be treated as additional consideration for the disposal of the relevant shares; thus, if the disposal of the shares qualifies for the SSE, the whole of the gain, both actual, on the sale of the shares, and deemed, arising as a result of the degrouping charge, will be exempt.
If such an election is made the deemed market value tax basis of the asset is reduced by the amount by which the consideration for the disposal is increased. Thus in most cases the basis for the asset will continue to be the group historic cost.
If a number of companies leave the group at the same time as the result of the sale of a company which itself holds shares in other group companies and there is a degrouping charge in one or more of them, if the election is made for all the companies, these gains will be added to the proceeds for sale of the shares in the company sold.
The existing provisions which allow companies the ability to roll over the degrouping gain or to reallocate the gain within the group will be repealed and in their place changes will be made to section 171A to allow for a degrouping gain to be reallocated under those provisions.
However if a company leaves a group otherwise that as a result of a sale of shares e.g. by means of a new issue of shares, the degrouping charge will remain within the company.
The Budget papers state that some minor helpful changes have been made to the draft clauses originally published.
Industry have lobbied for some time for this charging provision to be abolished and the FB 2011 provisions effectively mean that in most cases there will no longer be a chargeable gain arising in the company being sold. Care would need to be taken however with structures that involve issuing new shares to third parties who could cause the issuing company or any affiliate to leave the group.
There are also provisions amending the SSE rules to allow SSE to be available for the sale of the shares in a newly incorporated company if a trade is transferred into it from another group company; previously it was necessary for the seller’s group to have owned the shares in the target company for at least 12 months and for the company to have been a trading company for at least this period of time. The new provisions achieve this by deeming the period of ownership of the transferee company to extend to the time the transferred assets have been used for a trade within the group. In these circumstances the transferee company will also be treated as having carried on the trade for this same period.
Assuming these provisions become law as drafted, they will be effective for share disposals from the date that FB 2011 receives Royal Assent i.e. sometime around late July 2011, regardless of when the intra group asset transfers occurred.
The effect of these rules is that a newly incorporated company can be used to sell trading assets providing those assets have been used as trading assets within the group for at least 12 months.
Therefore, when assets are to be sold there is now a clear choice as to how this can be done. The assets can either be sold by way of an asset sale (if for example it was expected that reinvestment relief can be claimed to exempt a ring fence gain) or they can be transferred to a fellow subsidiary and the shares in that company sold, without generating any capital gains charge, providing the conditions for the election are satisfied.
Once enacted, this will mean that there will be no need to keep assets in separate companies, and all of a group’s interests can be amalgamated in fewer appropriate companies.
This greatly simplifies group structuring for assets and will also mean, for example, that there is no need to retain dormant companies from which assets have been transferred in order to avoid the de-grouping charge. Once these provisions become law these companies can be liquidated if required, but the value shifting rule changes mentioned below would need to be borne in mind..
4. Capital Gains Tax Value Shifting
The value shifting rules are to be amended as part of a number of simplification measures for Capital Gains Tax.
The existing regime, which provides for a general measure with specific exclusions for certain types of transactions, is to be replaced by a new targeted anti avoidance rule.
The new rule will apply where there is a disposal of shares or securities by a company, arrangements have been entered whereby the value of those share or securities is materially reduced, and the main purpose or one of the main purposes of those arrangements is to obtain a tax advantage. In these circumstances any gain or loss on disposal of the shares or securities will be computed as if the consideration for the sale was increased by such an amount as is “just and reasonable” having regard to the value shift.
Where the disposal of shares qualifies for the substantial shareholdings exemption the value shifting rules will have no effect. However, there are a number of circumstances where disposals might not fall within the substantial shareholding exemption and care will be needed to ensure that the new rules do not create an unexpected tax charge.
The depreciatory transaction rules, which limit the amount of an allowable capital loss on a disposal where value has been stripped out of a company, are also being amended such that any depreciatory transactions that occur more than 6 years before the disposal can be ignored.
The rewritten provisions are to apply for disposals of shares and securities after Royal Assent of Finance Act 2011 (probably July 2011).
Although the new rules are billed as a simplification, the reality is that they are likely to be of much wider application, and the introduction of a sole or main benefit test will lead to more uncertainty.
One potential area for difficulty is where transactions have already been entered into to reduce the value of a company prior to disposal where the SSE might no longer apply, for example a disposal as part of the liquidation of a company. Although there is a specific exemption in the case of a value shift attributable to an exempt distribution, exempt distribution for these purposes is extremely narrowly drawn, such that, for example, a dividend of profits created via a capital reduction is unlikely to fall within the exemption.
Clients who are in the process of reorganising groups need to review any potential liquidation disposals in the light of the new rules and where necessary aim to ensure that any disposals occur before the new rules become effective.