On 10th April the First-tier FTT (FTT) published its decision in Centrica Energy Storage Ltd v HMRC UK 566 (TC) in relation to the ring fence treatment of intra-group operating/service income.
- Summary
The FTT has dismissed Centrica Energy Storage Ltd’s appeal.
The case concerned whether service-fee income received by Centrica Energy Storage Ltd, “CESL”, for operating the Rough gas production field under a service agreement with an associated company was subject to the UK oil and gas ring fence regime.
The FTT held that as a matter of fact CESL was carrying out “oil extraction activities” within CTA 2010 s 272(3), even though the relevant production licence was held by an associated company rather than by CESL itself.
The effect was that all of CESL’s relevant service-fee income arising under the service agreement was ring fence income and was therefore within the charge to ring fence corporation tax and supplementary charge (NB: The facts in this case preceded the introduction of the Energy Profits Levy).
The decision is significant for oil and gas groups using separate licence holding and operating entities. It establishes that an intra-group operator service provider may fall within the ring fence even where it is remunerated on a cost-plus basis and does not itself hold the production licence.
It is unclear as to how wide this principle will be applied and in particular, can a service provider that is not an operator be dragged into the ring fence.
- High-level facts
CESL was part of the Centrica group and had historically been involved with the Rough facility, which had been used as a gas storage facility until 2017.
In June 2017, CESL sold the Rough complex to Centrica Offshore UK Ltd, “COUK”, for £148 million, with effect from 1 December 2017.
COUK held the relevant production licence, while CESL held storage-related licences and was appointed to provide services in relation to production operations at Rough.
CESL and COUK were associated companies for the purposes of CTA 2010 s 271.
Under the services agreement, CESL was to carry out all the services and works required in respect of “Production Operations”, broadly meaning taking “all necessary” steps to produce all recoverable gas from the Rough field.
CESL was remunerated on a cost-plus-15% basis for those services.
CESL treated the resulting service-fee income as non-ring-fence income.
HMRC took the view that the income was ring fence income because it arose from oil extraction activities.
HMRC issued closure notices resulting in additional tax of approximately £5 million for 2017 and 2018.
- Tax
The key statutory provision was CTA 2010 s 272(3), which defines “oil extraction activities” to include activities of a company in extracting, or causing to be extracted for it, oil under rights that authorise extraction and are held either by that company or by an associated company.
For these purposes, “oil” includes natural gas under CTA 2010 s 278.
Ring fence income includes income arising from oil extraction activities or oil rights under CTA 2010 s 275.
The question for the FTT was whether CESL’s services provided to COUK under the service agreement amounted to oil extraction activities, and if so whether all or only part of the relevant service-fee income fell within the ring fence.
(a) CESL’s arguments
CESL’s first argument was that “extracting” in CTA 2010 s 272(3) meant only lawful extraction by the licence-holder.
On that basis, CESL argued that only COUK, as the production licence-holder, could be regarded as carrying out extraction for the purposes of the ring fence rules.
CESL’s alternative argument was that the provision should be read purposively and in context as applying only to licence-holders, or to companies with an economic interest in the oil or gas being extracted. In this case the service provided received only a cost plus return.
CESL therefore sought to characterise itself as a service provider or contractor rather than as a company carrying on oil extraction activities.
CESL also argued that, if some of its activities did amount to oil extraction activities, HMRC’s approach was too broad because not all of the services provided under the agreement were sufficiently connected with extraction.
CESL relied on evidence suggesting that only around 28% of the production operations team’s time was directly attributable to extraction activities.
(b) HMRC’s arguments
HMRC argued that the wording of CTA 2010 s 272(3) was clear and did not require CESL to hold the production licence itself.
HMRC relied on the fact that the statutory wording expressly includes rights held by an associated company.
HMRC therefore argued that CESL’s activities fell within the legislation because CESL was as a matter of fact carrying out extraction-related activities under rights held by COUK, which was an associated company.
HMRC also argued that all of the services were required for the production of gas and that the service fees therefore arose from oil extraction activities as a whole.
- FTT Decision
The FTT rejected CESL’s arguments and dismissed the appeal.
The FTT held that the wording of CTA 2010 s 272(3) was clear and was not confined to the company that held the production licence.
The FTT found that the statutory reference to rights held by an associated company was directly relevant and meant that CESL could be carrying out oil extraction activities even though COUK held the production licence.
The FTT also rejected the argument that CESL needed to have a direct economic interest in the gas being extracted.
CESL had argued, amongst other things, that when Parliament first broadened the ring‑fence rules to include associated companies, this was to cater for specific commercial arrangements (such as illustrative agreements) in place at that time and not to cover every group company that happened to provide services somewhere in the chain. The FTT held that there was nothing in the broader history to suggest that Parliament meant to confine the application of the ring‑fence to only those specific arrangements and to exclude other associated‑company structures where a group contractor was carrying out the core extraction operations.
On the apportionment issue, the FTT held that all services under the service agreement were sufficiently connected with the production operations.
The FTT considered that the relevant services were operationally integral to the extraction, initial treatment and transport of gas.
The FTT therefore held that all of the relevant service fee income was ring fence income.
- Implications
The FTT decision confirms that a company does not need to hold a production licence itself in order to be carrying out oil extraction activities for ring fence purposes.
Where an associated company holds the relevant extraction rights, an intra-group operational service provider/operator may still be within CTA 2010 s 272(3).
The FTT’s approach suggests that one should look at the commercial and operational substance of the services, rather than simply asking whether each individual activity is directly physical extraction work.
Support functions such as maintenance, safety, administration, procurement and operational management may be treated as part of the extraction activity where they are integral to the production operation.
The decision may make it harder for groups to argue that only a narrow slice of operating-company income should be ring fence income where the underlying services agreement is directed to production operations as a whole.
- Comments:
The FTT’s decision is a disappointing result for the taxpayer and is likely to create uncertainty for those within the sector who have similar service provision arrangements in place.
As raised by CESL during the hearing, this decision effectively means that there is a more favourable tax outcome for a licence/asset owner to contract with an unconnected external service provider versus using internal, intra-group resources on the basis that the former’s income from the arrangement will be outside of the ring fence whilst the latter’s with be taxed within the ring fence.
When HMRC started to look at this issue a number of years ago they did suggest to industry that their main area of concern was in relation to cases where the whole of the activities of an operator were carried out by an affiliate. The Centrica case looked at just such a situation, where the service company acted as the operator. When all of the activities carried on by the service company on behalf of the licensee were looked at together it was found that as a matter of fact it was carrying out oil extraction activities. The FTT rejected the argument that this phrase has any special meaning.
We do not know whether CESL will appeal the FTT decision given that the question of whether CESL was carrying out oil extraction activities is essentially a question of fact. The grounds for appeal would need to be that this term has a special legal meaning for the purposes of the ring fence code. Pending an appeal, groups should review their service company arrangements to establish whether they are susceptible to challenge and if necessary what steps can be taken to minimise the risks.
Should you have any queries, please contact Tommy McKnight or your normal CWE contact.