25 Aug 2020

Scope of the ring fence: Royal Bank of Canada case

A recent tax case has considered whether an oil and gas royalty interest held by a non-UK resident gave rise to ring-fence income and whether the relevant treaty allowed HMRC to tax the income.

Whilst the case concerned the treatment of royalty receipts, the findings potentially have wider application.

The Case

Royal Bank of Canada (the Bank) had lent money to a Canadian oil company operating in the North Sea.  The Canadian company transferred its interest in the Buchan oil field to BP and in part consideration for the transfer received a royalty interest.  Payments under the royalty interest became due only if the oil price was above $20 a barrel and were based on the actual production from the Buchan interest transferred to BP.  The Canadian oil company suffered financial difficulty and entered receivership.  As part of the receivership process, the royalty interest was assigned to the Bank.

The case addressed two key issues:

  1. whether the income received under the royalty was ring-fence income under UK domestic law and;
  2. whether the UK/Canada double tax agreement afforded taxing rights to the UK.

The Bank lost on both issues.

Issue 1 – Ring fence income under UK domestic law

Domestic law charges non-residents to tax on “profits..(a) from exploration or exploitation activities, or (b) from exploration or exploitation rights”.  Exploration or exploitation rights are defined as being “rights to assets to be produced by exploration or exploitation activities or to interests in or to the benefit of such assets”.

The Tribunal rejected any proposition that the Bank was carrying on exploration or exploitation activities, finding no evidence that the Bank undertook such activities.

It also rejected the contention that the payments derived from an “interest” in the oil to be won from the Buchan field. HMRC had argued that a commercial interest was sufficient but the judge stated that a more legalistic approach was necessary and “a right to an interest” in the oil must refer to some underlying legal interest in the oil itself.

However, the Tribunal found that the royalty did represent a right to the benefit of the oil, stating that identifying who held the ‘benefit’ of oil to be extracted meant taking a broader and less legalistic approach than was needed in identifying the parties who held an interest.

Therefore, the Tribunal found that UK domestic law imposes taxation on the profits derived from the royalty interest and further as the income was found to be from an “oil right” it fell to be regarded as ring-fence income.

Issue 2 – Application of the double tax agreement

The UK/Canada Treaty shares the standard OECD model wording in respect of income from immovable property and allows taxation in the State in which the property is situated, inter alia, where the property represents “..rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources..”.

The Tribunal concluded that the character of the payments was set when the Canadian company transferred its interest in the Buchan field. The judge stated, “It is quite clear that on any realistic analysis, the royalty payment rights were originally created as part of the contractual arrangements under which the right to work the Buchan field (including the ownership of all oil won from it) was [transferred], and as part of the consideration for that right”. Once the character had been established the subsequent novation of the right did not alter this.

Therefore, the Tribunal found that the UK had been afforded taxing rights under the Treaty in respect of the royalty income.

 

CW Energy analysis

We are not surprised that the court found in favour of HMRC in this case.  The common view, and indeed that set out in HMRC’s published manuals, has been that royalties granted in consideration for the acquisition of an oil licence would give rise to ring-fence income in the hands of the recipient of the royalty income under UK domestic law, although there has perhaps been some uncertainty as to the precise technical basis for this view.

While the case does not set a legal precedent, it has raised the profile of the matter.

The key finding was that payments amounted to rights to “the benefit of” the oil won from the Buchan field, with a wide meaning ascribed to the term ‘benefit’.

We do not, however, believe that the case supports the proposition that any wider interpretation should be given to the ring-fence under domestic law. Nevertheless, it remains to be seen if HMRC will seek to apply the decision to non-royalty type situations.

This is a difficult area and in the light of this decision, it is worth looking again at any such arrangements to identify whether any risk arises.

With regards to the treaty protection, the position is also complex. There are few remaining UK treaties where the territorial waters of the UK are not included in the definition of ‘UK’ and based on this decision it seems clear that a treaty will preserve the UK taxing rights where there is a standard immovable property article.

Many treaties also include an offshore activities article which will need to be considered. Often income is only brought within the scope of this article if there are activities carried on offshore, but not always, and some treaties do allow income from “exploration or exploitation rights” to be taxed even where there are no such activities. Exploration or exploitation rights would tend to be defined in the same way as oil rights under domestic law.  It is also customary for this article to permit gains from the alienation of such rights to be taxed.

Although the decision does not throw any light on the equally difficult technical issue as to whether payments under a royalty by the holder of a licence interest are deductible in computing the ring fence profits of the relevant trade, the implication seems to be that the payer was obtaining such a deduction.

Finally, in considering the extent to which the Bank’s activities could comprise a ring-fence trade, the court was clear that the Bank did not undertake “extraction activities” which constituted a ring fence trade. This may be of interest to companies that have ongoing correspondence with HMRC in respect of service companies, where HMRC are asserting that their activities do amount to a ring-fence trade.

CW Energy would be pleased to assist companies reviewing their arrangements in light of the findings in the Royal Bank of Canada case.

CW Energy LLP
August 2020


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