UK North Sea fiscal regime

On 17 March 2016, in Budget  2016, the Chancellor announced a number of headline-grabbing measures designed to support the UK oil and gas industry and to encourage investment in exploration, infrastructure and late-life assets. The most prominent announcements concerned “effectively abolishing” Petroleum Revenue Tax (PRT) and halving the rate of Supplementary Charge (SC) from 20 per cent to ten per cent. The effect is the reduction of the effective marginal rate of tax payable in respect of all fields on the UK Continental Shelf (UKCS) to 40 per cent.

This article is designed to provide: (i) an update as to where we are now in the context of the fiscal regime which applies to activities on the UKCS; and (ii) analysis of the extent to which the announcements made in Budget 2016 are likely to be beneficial for companies operating on the UKCS, particularly in the context of the current environment of around US$45 per barrel of oil (at the time of writing).

Background to the UKCS regime

Oil and gas-related activities on the UKCS are subject to a special fiscal regime and, prior to Budget 2016, profits arising from such activities were subject to ring-fence corporation tax (RFCT) at a rate of 30 per cent, SC at a rate of 20 per cent and, if development consent was obtained prior to 16 March 1993, PRT at a rate of 35 per cent. This gave an effective marginal tax rate of 67.5 per cent for PRT fields and 50 per cent in other cases.

Investment in the UKCS is encouraged by tax relief being provided for expenditure on research, exploration, appraisal and production, either through capital allowances (broadly, the UK’s form of allowable “tax” depreciation) and also, once production has commenced, through tax deductions for expenses incurred wholly and exclusively for the purposes of an eligible trade. However, a ring-fence applies to all fields (irrespective of when development consent was obtained) which prevents profits arising within the ring-fence (which are subject to RFCT, SC and, historically, PRT) from being sheltered by losses arising from activities carried on outside the ring-fence.

The majority of expenditure on exploration and development in the pre-production phase is eligible for 100 per cent tax relief in the form of mineral extraction allowances. Expenditure on research and development, before significant reserves have been found, is generally eligible for 100 per cent tax relief in the form of research and development allowances. Other capital expenditure is generally eligible for relief in the form of plant and machinery allowances.

Even before the most recent measures announced in Budget 2016, the UK Government introduced measures in 2014 and 2015 to support its objective of providing “the right conditions for business investment to maximise the economic recovery of the UK’s oil and gas resources at a time when the North Sea industry is facing considerable challenges”. These measures included:

(a)  the introduction of a “cluster area allowance” in Budget 2014, with effect in relation to investment expenditure incurred on or after 3 December  2014, which is intended “to support the development of high pressure high temperature (HPHT) oil and gas projects and encourage exploration and appraisal within the surrounding area”. The cluster area allowance reduces adjusted ring-fence profits which are subject to SC by 62.5 per cent of the capital expenditure incurred in relation to the cluster area;

(b)  the introduction of an “investment allowance” at Budget 2015, with effect in relation to accounting periods ending on or after 1 April 2015, which is intended “to encourage investment in the UKCS, leading to increased production of oil and gas, helping to increase the UK’s energy security, balance of payments and supporting jobs and supply chain opportunities”. The investment allowance is also designed “to simplify and replace the historic regime of field allowances”. The investment allowance serves to reduce profits subject to SC by 62.5 per cent of the investment expenditure incurred. The field allowance regime, which was introduced in 2009  and which the investment allowance replaces, was designed to provide an incentive “for the development of new economic but commercially marginal oil and gas fields”. The field allowance operated by reducing the amount of adjusted ring-fence profits which are subject to SC but was considered to be overly complicated and to create an unnecessary administrative burden on UKCS participants;

(c)  the reduction of SC from 30 per cent to 20 per cent with effect from 1 January 2015 (announced in Budget 2015); and

(d)  the reduction of PRT from 50 per cent to 35 per cent for all chargeable periods ending after 31 December 2015 (also announced in Budget 2015).

The trend in recent years has been for the Government to reduce the fiscal burden on licensees, with a focus on incentivising investment in the more challenging and technically demanding fields in the UKCS.
 
This has continued in the announcements made in Budget 2016 in relation to investment allowances and cluster area allowances, but Budget 2016 also included important announcements in relation to decommissioning and PRT.

Effective abolition of PRT

The announcements in Budget 2016 in relation to the effective abolition of PRT and the reduction in the rate of SC must be viewed in the context of sustained periods of falling revenues for the Exchequer from the UKCS (see figure 1) and falling oil production in the North Sea (see figure 2). In particular, in the year to 30 June 2015, PRT profits had declined by 55 per cent to £1.116bn and PRT revenues had declined by a similar proportion to £473m, with eight fields out of the total 54 fields having generated 86 per cent of all PRT.¹ The figures in figure 1 show the significant reduction in fiscal revenues from UKCS activities when compared with the total corporation tax receipts from both UKCS and non-UKCS activities received in the same period.

On the one hand, the fact that many companies engaged in UKCS activities are not currently in a taxpaying position will mean that the reduction in the rate of PRT to zero does not provide these companies with any immediate cash-flow benefits.

However, rather than abolishing PRT in its entirety, the reduction of the rate of PRT to zero means that it will still be possible to carry back losses arising in respect of PRT fields to set against historic PRT liabilities in previous accounting periods, and there is no restriction on the number of accounting periods in which any such losses can be carried back.

As a result, it may be possible to generate substantial PRT repayments from expenditure on PRT fields for participants with interests in PRT assets. As set out in the latest available government figures (see figure 1), the Government is aware that substantial claims for PRT repayments will be made, as the Government is anticipating that the Exchequer’s revenues from PRT will be negative in 2015–16, with more than £500m of PRT repayments being claimed (see figure 1).

The UK tax legislation also enables unused PRT expenditure and PRT losses  to be transferred by an old participant (the seller) in a PRT field to a new participant (the buyer) in the event of a sale of the seller’s interest in a PRT field. However, the legislation is more restrictive in relation to the transfer of losses by the buyer to the seller following the sale of an interest in a PRT field: in those circumstances, the position is, broadly, that the maximum amount of losses which can be transferred from the buyer to the seller is capped at the amount which had previously been transferred by the seller to the buyer (as referred to above). As a result, it is not possible for a non-taxpaying buyer to surrender PRT losses  arising from expenditure incurred by the buyer in relation to a PRT asset to the seller, which has historically paid PRT in order to generate a PRT repayment in the seller’s hands.

A group which has interests in both PRT and non-PRT fields may, as a result of the ability to carry back losses to effect repayments of PRT as summarised  above, be incentivised to incur expenditure in connection with PRT fields rather than non-PRT fields as a result of the PRT repayments which could be generated as a result of incurring such expenditure.

The rule, arguably, creates an asymmetric position in that if a seller carries out significant capital expenditure in respect of a PRT field in question, this may enable the seller to obtain immediate tax relief in circumstances where the buyer would not obtain tax relief for carrying out the same expenditure on the same asset following the transfer of the seller’s interest in the licence.

Reduction in SC

The reduction in the rate of SC should, however, improve the viability of future projects for all companies from a financial modelling perspective. The Chancellor hopes that reducing the rates of PRT and SC will encourage investment, but in the context of ongoing macro-economic pressures on global oil prices, the less high-profile announcements in Budget 2016 relating to investment allowances and cluster allowances may have a more immediate effect (as to which, see below).

We would not anticipate that the reduction in the value of deferred tax assets resulting from the reduction in the rate of SC would be of significant concern, particularly for those companies which are currently non-taxpaying, because the deferred tax asset would only be of real economic benefit when the entity in question becomes taxpaying. A possible issue could arise, however, if a write-down in the value of deferred tax assets included on a company’s balance sheet significantly reduces the assets of the company in question.

Investment allowance and cluster area allowance

Prior to Budget 2016, the investment allowance and cluster area allowance were only “activated” (meaning made available to be set off against profits subject to SC) once income from production in the relevant field had commenced. However, following Budget 2016, the investment allowance and cluster area allowance may be activated when tariff income is received. “Tariff income” is expected to include fees payable to the owners of infrastructure (such as pipelines and platforms) on the UKCS, but we await the publication of the relevant secondary legislation which will contain the definition of “tariff income” for these purposes and details of any commencement provisions of the new legislation.

This proposal should assist companies investing in tariff-generating infrastructure which should, in turn, lead to improved efficiency and reduced ongoing repair and maintenance costs following an upgrade of aging infrastructure on the UKCS.

Decommissioning

In the context of the current macro- economic challenges facing the North Sea oil and gas industry, decommissioning issues, and particularly the question of with whom the economic burden of decommissioning liabilities should lie, have frequently been a significant challenge to transactions involving the transfer of UKCS licence interests.

A combination of commercial factors has led to certain transactions being structured such that the seller retains some or all of the decommissioning liabilities in question. Purely from a tax perspective, as many companies operating on the UKCS are not currently taxpaying, tax relief in respect of decommissioning costs may be of greater value to a taxpaying seller than to a buyer which is likely to be non-taxpaying for a number of years.

Provided certain conditions are satisfied, expenditure incurred on decommissioning qualifies for tax relief in the form of capital allowances.² The relevant legislation does not, however, state whether a person incurring expenditure on decommissioning must hold an interest in a UKCS licence at the time the expenditure is incurred.

Despite the legislation having been enacted for many years in substantially the same form, at Budget 2016, the Government published a technical note setting out clarifications of HMRC’s interpretation of these provisions. This confirms that: (i) HMRC accept that in a scenario where a buyer and seller agree that the seller will remain liable for decommissioning expenditure after the transfer of a licence interest, the seller may be entitled to tax relief in the form of capital allowances in respect of such expenditure; and (ii) it is not a requirement in these circumstances that the seller holds a notice under section 29 of the Petroleum Act 1998 before a claim for capital allowances can be made by the seller. Albeit it is arguable that since these were not express requirements of the legislation, it would be surprising had it been necessary to satisfy these conditions in order to claim the allowances.

The technical note also states that, in HMRC’s view, the seller must be directly liable for the costs of decommissioning and must not simply contribute to the costs incurred by another person. HMRC consider this means that legal action could be taken against the seller in the event that those costs are not met. While the technical note does not specifically address how this should be achieved, we understand from HMRC that they would generally expect the seller to remain a party to the relevant joint operating agreement even after the seller has ceased to hold an interest in the licence itself. This may entail obtaining agreement of any relevant third parties, which may not be straightforward.

Given the significant costs of decommissioning and the factual differences in respect of each transaction, HMRC acknowledge and accept that taxpayers are likely to seek advance clearance from HMRC in order to confirm the tax treatment of decommissioning costs incurred by sellers in these circumstances.

Carried-forward losses

At Budget 2016, the Chancellor announced reforms to the UK regime relating to the use of corporation tax losses in future accounting periods.

Prior to Budget 2016, corporation tax losses could be carried forward to future accounting periods and could be used to set off against profits arising in the same company from future profits in the same trade.

From 1 April 2017, trading losses will be able to be carried forward to set off against total taxable profits (rather than just profits of the same trade) arising in any member of the company group for corporation tax purposes. However, from the same date, companies will only be able to use losses carried forward against up to 50 per cent of the profits above £5m arising in the group as a whole.

The changes to the use of carried-forward losses is likely to have profound implications for many companies subject to UK corporation tax. However, the Budget 2016 Policy Paper confirms these changes will not apply to the North Sea RFCT regime. Many such companies will, however, be subject to the new rules in relation to activities carried on outside the ring-fence.

Transferring unactivated allowances

Transactions relating to the transfer of UKCS licence interests are frequently structured such that a buyer provides consideration in the form of cash and the assumption of certain liabilities of the seller. The value of the aggregate consideration payable by the buyer is generally allocated between the parties to items qualifying for allowances (e.g. mineral extraction allowances, investment allowances, cluster area allowances, or plant and machinery allowances) with the balance attributed to the licence interest. This allocation will continue to be required after Budget 2016. This allocation should be made on a just or reasonable basis, otherwise there is a risk that adjustments to the allocation may be made by HMRC as a result of a failure by the parties to make a reasonable apportionment.

Documentation effecting transfers of UKCS licence interests in fields which do not yet generate tariff income and which are not in the production phase should now also include provisions which make clear that: (i) unactivated pools of investment allowances and cluster area allowances transfer to the buyer on completion; (ii) the buyer and seller agree to file their tax returns on this basis; (iii) any expenditure which is incurred in the interim period (i.e. between the effective date and completion) which is accrued by the seller but ultimately paid for by the buyer is not subject to claim for allowances by the seller; and (iv) subject to the bargaining power of the buyer and the level of potential allowances in question, the seller is incentivised to carry out a detailed review of expenditure incurred by the seller to maximise any claims for allowances by the buyer.

Conclusion

Only time will tell whether the Chancellor’s announcements in Budget 2016 will have the effect of promoting investment in the UKCS and, even then, if global oil prices rise, whether any increased oil production and tax receipts are attributable to the measures announced in Budget 2016 or simply to macro-economic forces. However, for current participants in UKCS activities which are in a taxpaying position, Budget 2016 should bring an immediate benefit in the reduction in the rates of SC and PRT. Furthermore, the measures summarised above are likely to result in PRT assets becoming of increasing interest, and companies are likely to review investment opportunities in infrastructure projects which may become more viable in the context of the amendments to the investment allowance and cluster allowance regimes. For both existing participants and new entrants to the market, the amendments to the decommissioning rules, which frequently
hamper the viability of projects and investments, may unlock new sources of capital and new entrants to the market.

Notes

1 Statistics of government revenues from UK oil and gas production, released January 2016.

2 Chapter 13 of Part 2 of the Capital Allowances Act 2001 and, in particular, sections 162 to 165 (inclusive).