On Monday 9th July the Government published its long awaited consultative paper (the “Condoc”) on the proposed implementation of a contractual arrangement between oil and gas companies operating in the UK and UKCS and their affiliates, and the Government, to provide a level of certainty as to the tax relief that will be available on decommissioning expenditure.
There have been discussions between Government and Industry on how to deal with the uncertainties over tax relief for decommissioning for many years. This uncertainty has had three main effects on Industry over the years.
- First, it has acted as a barrier to changes in licence interests, as typically a seller has requested security against default in respect of decommissioning liabilities to be provided on a gross of tax basis, which has the impact of tying up the purchaser’s borrowing base
- Second, the uncertainty acts as a disincentive to new investors buying in to fields, particularly where tax relief on projected abandonment costs are a material element of any valuation
- Third, existing owners are dis-incentivised from investing to prolong the life of existing fields because of the risk that existing decommissioning relief would be lost as a result of possible law changes.
The increase in the supplementary charge (SCT) and the introduction of a cap on the rate of SCT relief for certain decommissioning costs has led to an intensification of these discussions. This culminated with an announcement in Budget 2012 that the Government would introduce “a contractual approach to offer long term certainty on decommissioning relief”. This will take the form of the issue of Decommissioning Relief Deeds (the “Deed”) to all past and future licensees and their affiliates.
The wording in the Condoc is naturally not as precise as will be contained any actual Deeds, if and when they are introduced, so the commentary below is necessarily based on our interpretation as to what the current intent behind the proposals in the Condoc is.
Industry had asked that this contractual approach guarantee tax relief at the current restricted rate of 50% for ring fence CT and SCT, without the need to have reference to the particular taxpayer’s tax capacity, whilst accepting that any mechanism for PRT would need to take into account the field history.
The proposals in the Condoc are less generous than requested.
The proposed regime has two separate methodologies for providing assurance depending on whether the company is meeting its own decommissioning costs, or is picking up another party’s costs in the case of a default.
In the case of default the Government proposes to “switch off” the subsidy rules but only in the case where security has been provided on a post-tax basis. It is not however clear how receipts in other circumstances are to be treated.
The proposals do not commit Government to the current tax regime for CT or SCT, or indeed the current rates of tax for CT, SCT or PRT, except in the case of relief in respect of expenditure incurred by a company in connection with another company’s default, where relief is to be fixed at current rates of 30% for CT and 20% for SCT.
For PRT, in a default situation, assurance is to be provided with reference to the defaulting party’s PRT field profile. There is also some protection in the case of PRT abolition. If the PRT rate is reduced however the guarantee would appear to work with reference to the prevailing rate in both the default and no default cases.
As currently drafted the proposals are likely to enable companies to provide security on a post CT and SCT basis. The position with regard to PRT is more difficult as this will turn on the profile of the field and the history of the ownership of the interest.
The proposals do not, however, put new entrants on a level playing field with existing field owners as guarantees will, except in the case of default, work with reference to a company’s tax profile. A new owner may not have sufficient tax capacity to utilise relief in which case the guarantee will not apply to make up the shortfall.
Further, while it appears that a company without a ring fence trade which picks up decommissioning liabilities of a defaulting affiliate can benefit from the Deed; this will not be the case if the relief under the Deed would be better than could be obtained if the defaulting affiliate had been adequately funded.
The Condoc is open for discussion for 12 weeks, meaning that responses should be made by 1st October 2012. Given the revolutionary nature of these proposals it is to be hoped that as many companies and industry bodies as possible respond to its proposals. As part of the consultation process the Government is setting up four work groups to discuss the details of the proposals, and invites interested parties to apply to join these. The working groups cover the commercial aspects, legal design, reference amounts and technical and anti-avoidance issues.
The Condoc states that the Deed should be a mechanism of last resort; thus the Government is not expecting many claims to be made where relief is otherwise available through the prevailing tax system.
In all situations there are to be anti-avoidance provisions which disapply the provisions of the Deed if the decommissioning work is undertaken by an affiliate of the Deed holder, or if relief under the Deed has been engineered to give a better result than would otherwise be available.
The affiliate restriction would seem to mean it is very unlikely that any contractor groups will be able to obtain protection under a Deed which may mean that these groups could be at a competitive disadvantage.
Details of the proposals:
The guarantee works by comparing tax relief available to the company in respect of specified categories of decommissioning expenditure to a “reference amount”. Should there be a shortfall then the Government will make a payment under the Deed to the taxpayer.
1. Where there is a default:
Where a company pays for a defaulter’s share of decommissioning costs the reference amount is fixed at 30% in the case of CT, and is capped at 20% in the case of SCT. The Deed holder can claim the shortfall between the actual amount repaid and this reference amount under the Deed from the Government. In this case the capacity of the company to actually obtain effective relief for these costs (i.e. its past CT and SCT paying history and profits) is not relevant in determining the reference amount.
A slightly different approach is to be adopted in the case of PRT. Here the Deed will only provide relief on the decommissioning costs being borne as a result of default if the Deed holder has insufficient PRT history for the field to achieve the same level of PRT relief that the defaulting party would have achieved had they borne the decommissioning expenditure. In this case, and subject to certain other conditions, the reference amount is the amount of relief that the defaulter would have achieved under the tax code in place as at the time the expenditures are incurred, such that the Deed holder can claim the difference between the actual PRT repayment it has received and that provided under the Deed.
Importantly, if PRT is abolished the reference amount will be the level of relief that the defaulting part would have achieved as of the last period of account where PRT was in place.
In the case of CT and SCT, where there is default, the guarantee of a fixed rate of relief without reference to the tax capacity of the company coupled with the switching off of the subsidy rules means that a company (whether they be an existing partner selling out of a field or a continuing joint venturer) should be comfortable in accepting a post CT and SCT guarantee. However there doesn’t appear to be any protection for relief for losses resulting from costs other than decommissioning if a company’s tax capacity is used up by meeting other parties’ liabilities.
In the case of PRT it is unlikely that linking the reference amount to the PRT profile of the defaulting party will be of any practical benefit where a field has changed hands late in life as in practice the defaulter may have been looking to use a previous owner’s tax profile to obtain relief for costs. There is nothing in the document that suggests that this profile can be factored into the reference amount.
The inclusion of a specific provision to cover the abolition of PRT is welcome. Further clarification on this aspect is required but on the face of it this would suggest that PRT will not be abolished at any time. This does not however represent a guarantee that relief will be available at the current 50% rate. Rather it would appear that absent abolition of PRT, protection will be based on the prevailing PRT rate at which the profits which are subsequently sheltered by losses generated by decommissioning spend were taxed.
2. No default:
The proposal is that for CT and SCT losses resulting from decommissioning set against current or previous years’ profits will attract relief at the rate those profits were taxed, subject in the case of SCT to the 20% cap. This calculation will take into account the tax capacity of the company. However if that capacity has been wholly or partly utilised as a result of the company having to pick up defaulters’ costs then the reference amount will be calculated as if that capacity had not been used.
Apart from in the case of the extension of the tax capacity to reflect default expenditure, this proposal appears to reflect the current situation, so that if the rate of tax falls the rate of decommissioning relief would also fall for that element of the cost which is set against profits taxed at the lower rate. The only protection being offered is against a change in the deductibility of decommissioning costs.
The stated rationale for not guaranteeing the rate is that Government believes that any company investing in a project will expect to make profits and hence have sufficient capacity to fully absorb decommissioning costs, and it wants to retain the flexibility to reduce tax rates if that is in the overall interest of the economy. Capacity would not be available if a company wanted to take on an asset where decommissioning costs were already predicted to be in excess of future net revenues (such that a reverse premium would be paid). This feature will therefore restrict when a company is able to dispose of a mature field interest.
Whilst the use of the prevailing rate may be reasonable, what is unhelpful is that there is no suggestion in the document that the Government are guaranteeing that the scheme for providing relief for decommissioning costs will not be restricted in the future. For example, under the current proposal, in the case of a non-default situation, it is not clear if the law were changed to restrict the periods for which a loss carry back could be made, whether this would restrict the reference amount and no claim could be made under the Deed for any shortfall in relief as result of such a restriction.
For PRT the relief available will reflect the PRT history of the Deed holder.
If PRT is abolished, as with the default situation, the relief will reflect the situation in the last chargeable period when PRT was in place.
Again where a company’s PRT tax capacity has been reduced as a result of it bearing defaulters’ costs, the reference amount in respect of the non-defaulter amount will be based on the relief available ignoring any defaulter cost amounts claimed.
The PRT solution is complicated by the fact that PRT losses are relieved against profits of all previous owners of the field interest, and it is not clear how assurance is to be provided in this case.
Whilst most companies now take care of the PRT loss carry back as part of the Sale and Purchase agreement for an asset, this is not the case in all situations and there will be cases where a company will not be able to obtain effective PRT relief because the relief will be given to a previous owner of the interest, which may not exist at the time of decommissioning.
However even if a Purchaser has adequately protected itself it is unclear whether the current proposals offer any assurance to a purchaser in respect of repayments which it expected to receive by means of loss carry back to a previous owner.
The Condoc proposes that all companies with interests in PRT fields will have their PRT history certified by HMRC. Presumably this will be a case of companies listing their PRT history and HMRC checking it, which may not be a simple process in practice, particularly where there have been claims for non-field relief.
There are still a number of unanswered questions, (and we suspect more will emerge as the provisions are considered further), such as when will payments under the Deed become due, if these are not made before the expenditure is incurred how will that expenditure be funded, how will receipts under the Deed in a non-default situation be dealt with in the tax regime, and what relief is available if the SCT rate were to be increased above 32%?
3. Taxation of decommissioning security trusts
The Condoc is also proposing to look again at the taxation of monies held in decommissioning security trusts, in particular the issue of the application of Inheritance Tax to such trusts. However it suggests there is little Government support for dealing with the other tax issues that have been identified in the past.
Companies and industry bodies have long lobbied that IHT is inappropriate for such trusts and it is to be hoped that this will now be removed. The application of other taxes to such trusts is also anomalous but it seems it is up to respondents to prove a case for change.
There is no mention in the Condoc of a number of other issues that have arisen in connection with the taxation of decommissioning trusts such as FX capital gains, and double counting if the funds in the trust were treated as a loan relationship.
4. Other Technical changes
Currently decommissioning losses would displace field allowances such that the level of effective relief for SCT purposes would be restricted. The Government is to look at possible changes to the operation of the field allowance rules where there are losses carried back.
The Condoc also highlights areas where it is believed that tax relief is uncertain, being:
- Decommissioning studies
- Setting cement plugs when wells are abandoned
- Removal of drill cuttings
- Onshore decommissioning
- Associate company obligations
It is intended that the tax relief for the above items will be discussed in the technical working group as part of the consultation process.
It was originally hoped that when changes were made to the scope of decommissioning relief in 1991 and other years that these would cover all the costs of decommissioning. This view was confirmed by HMRC at the time but latterly HMRC seem to have moved away from these assurances. A review of areas where there are doubts with a view to correcting this in legislation is therefore to be welcomed.
CW Energy LLP