When is Expenditure incurred on Decommissioning for claiming capital allowances?

Speed read

As a number of fields in the North Sea Basin are approaching the end of their useful economic life, tax relief for decommissioning expenses is becoming increasingly important. Whilst for years these costs have been an important part of taxpayers' financial models, now that significant amounts of such costs are actually being incurred, significant claims for tax relief for the expenditure incurred are being made and actively scrutinised by HMRC.

The decision in Marathon Oil U.K., LLC v The Commissioners for Her Majesty's Revenue & Customs [2017] UKFTT 0822 (TC) is the first major tax tribunal case regarding tax relief for decommissioning expenses.  Whilst this arose in the context of a specific prepayment arrangement, the Tribunal's guidance on deciding which expenditure qualifies for relief will be of broader interest to taxpayers engaged in oil and gas decommissioning activity in the North Sea as it provides some judicial commentary concerning the requirements to obtain relief.

Background

The case concerns a structure implemented by Marathon in respect of the costs of decommissioning its North Sea oil operations. Sections 163 and 164 of the Capital Allowances Act 2001 enable capital allowances to be claimed in respect of expenditure "incurred on decommissioning plant or machinery" which forms or formed part of an offshore installation or submarine pipeline used for a ring-fenced trade (such allowances being referred to in the legislation as "special allowances"). 

This presented two problems to Marathon. The first was that decommissioning costs largely arise towards the end of an asset's useful economic life, when its revenues, and therefore the taxable profits which may be offset by the capital allowances, are significantly reduced. The second was US tax: the parent company, Marathon Oil Corporation ("MOC"), was resident in the US for tax purposes. Marathon's UK operations were run mainly by Marathon Oil U.K. LLC ("MOUK"), a Delaware company resident in the UK for tax purposes but also subject, as a US corporation, to Federal Income Tax, and included within MOC's consolidated return. 

UK taxes paid by MOUK could generate foreign tax credits to offset against MOC's US tax liabilities. In the US, any such foreign tax credits could be carried forward or back to other tax years, subject to certain conditions, and could therefore be used efficiently to reduce MOC's liability to US tax. However, if any UK tax payments giving rise to credits were later refunded, those credits would no longer be available and MOC's Federal Income Tax liabilities for the year against which those credits were used would have to be recalculated. The unpredictability of this process would make clear tax planning and optimisation difficult, as refunds could cause credits to be withdrawn after allocation to a tax year. 

MOUK incorporated a subsidiary, Marathon Oil Decommissioning Services Ltd ("MODS"), which was also incorporated in Delaware but resident in the UK for tax purposes. MOUK subsequently entered into a contract with MODS whereby the latter would provide decommissioning services in return for a payment of USD 300 million, made in December 2008. MODS then lent USD 329.75 million to MOC, in order to hold the money elsewhere within the group before it was needed for decommissioning, and entered into contracts with other Marathon subsidiaries for them to provide certain services and personnel in relation to decommissioning activities. MOUK claimed a special allowance in 2008 of USD 300 million. The actual amount of billed costs for decommissioning work between 2008 and 2016 was almost USD 50 million. 

The effect of this structure was to frontload the decommissioning expenditure. Instead of waiting for expenditure to become necessary as costs arose, MOUK's structure was designed to ensure that expenditure was incurred for UK capital allowance purposes in advance of the actual performance of decommissioning works. 

The Key issue

The issue in dispute was whether the payment of USD 300 million made by MOUK to MODS was "incurred on decommissioning". Both parties accepted that expenditure had been incurred by MOUK (as the obligation to pay the amount was unconditional), and that all other statutory conditions for the special allowance had been satisfied except for the linkage between expenditure and decommissioning. HMRC argued that on a realistic view of the facts, setting aside the contractual arrangements:

• the money was not spent on decommissioning, but instead on setting aside funds to meet the costs of decommissioning as they arose;
• the special allowance would only be available for expenditure on specific, identifiable works; and
• it would be impossible to determine in advance whether all of the conditions for the availability of the special allowance would be met in respect of the entirety of the MOUK payment. 

MOUK argued that incurring expenditure on decommissioning meant incurring expenditure for the purpose of decommissioning, irrespective of when the decommissioning took place. It noted that at the time of the payment, there was no requirement that the expenditure and the relevant works should take place within a certain timeframe, though subsequent changes to the legislation made in response to that particular arrangement now restrict the amount of any allowance which may be claimed in a given accounting period to the amount of the costs of work actually performed in that accounting period. Those subsequent changes were cited in argument by MOUK, as evidence that there was previously no requirement for a temporal connection between expenditure and decommissioning works. 

Decision

Adopting a purposive construction of the relevant UK capital allowances legislation in sections 163 and 164 of the Capital Allowances Act 2001 on the basis of the Ramsay line of cases, the Tribunal agreed that the money was not incurred on decommissioning but rather to set aside funds for the purposes of decommissioning. The Tribunal held that MOUK's construction of the statute would arguably distort its proper purpose and produce an absurd result, by making the special allowance available for an indefinite amount of time – perhaps decades – before the decommissioning works themselves were undertaken and even if no relevant works ever actually took place. Conversely, the Tribunal held that HMRC's construction would make the special allowance available to MOUK as and when expenditure was incurred on actual works, which was a sensible outcome in accordance with standard practice for similar taxpayers. 

The Tribunal reached several conclusions about the construction of these special allowance provisions, as follows:

• the availability of relief in respect of expenditure on a prescribed activity is dependent on whether the conditions were met at the time when that expenditure was incurred;
• expenditure must be incurred "on" one of four specified activities, namely demolishing, preserving, preparing for reuse, or arranging for reuse;
• expenditure "on" an activity must be distinguished from expenditure "for the purposes of" or "in connection with" an activity;
• although the code is described as dealing with "general decommissioning expenditure", it operates with reference to specific items of plant or machinery, and each specific item must satisfy the requirements concerning use and non-replacement; and
• the code did not set out a consistent chronological relationship between expenditure and decommissioning activity.

The Tribunal also held that at the time that Marathon implemented the prepayment structure, the code contained no explicit provision restricting the allowance to the period in which the associated decommissioning activity was actually carried out, though such a provision has subsequently been added in direct response to the Marathon arrangements. Marathon's argument that the interpretation of the legislation prior to amendments should be coloured by subsequent amendments was rejected, as they could intend either to reform or to clarify.

Relying particularly on Tower McCashback LLP 1 v HMRC [2011] 2 AC 457 and Samarkand Film Partnership (No. 3) v HMRC [2017] EWCA Civ 77, the Tribunal held that "in determining what expenditure is incurred "on", it is necessary to determine the purpose or object of that expenditure". 

The law looks at the intention of the taxpayer rather than the actual outcome or whether the purpose was achieved. However, on the facts of the case, the taxpayer's purposes were mixed. MOUK intended both to derive a tax advantage and to carry out its statutory decommissioning obligations. It was necessary to decide which of these purposes was relevant in ascertaining the object of the expenditure. The Tribunal held that the structure of the arrangements was entirely artificial, and comprehensible only as a tax planning device. Indeed, it was presented by the accountants who devised it primarily as an "acceleration technique" to crystallise the special allowance earlier and more predictably than would otherwise be possible. Accordingly, the Tribunal found for HMRC, holding that the relevant purpose of MOUK must have been to accelerate the special allowance in order to improve its tax position. 

HMRC had also raised a secondary argument that as MODS was not free to use the money as it wished, but was bound to spend it on decommissioning or on certain permitted investments (such as the loan to the parent company), the money was subject to a Quistclose trust in favour of MOUK and had therefore not been incurred on decommissioning. 

This argument was irrelevant to determining proceedings but was in any case dismissed by the Tribunal, which did not consider that the evidence supported such a trust being intended or that the payment would be returned to MOUK if it could not be used for the intended purposes. 

Wider ramifications for obtaining decommissioning allowances

Companies involved in decommissioning activity in the North Sea will be interested in the Tribunal's analysis of the scope of decommissioning allowances under sections 163 and 164.  In particular the Tribunal concluded that there were six key requirements for a person to obtain this allowance, as follows:

• the person must be carrying on a ring fence trade;
• the person must have brought the plant and machinery into use;
• the person must have incurred the expenditure on demolishing plant and machinery, preserving plant and machinery (pending reuse or demolition), preparing plant and machinery for reuse or arranging for reuse of plant and machinery;
• the plant and machinery must be or form part of an offshore installation or submarine pipeline;
• the plant or machinery must not be replaced; and
• the person must make a specific election for the allowance.

The Tribunal also considered (as obiter dicta in the light of its earlier finding that the expenditure was not incurred on decommissioning) whether all the statutory conditions for relief were satisfied at the time of the payment for which MOUK sought relief.  The Tribunal decided that the time of payment was the appropriate time to determine this as that was when the expenditure is incurred.  The Tribunal considered that "it is not clear … how the provisions are to operate in a normal situation…, where a condition is satisfied at the point when expenditure is incurred but subsequently ceases to be satisfied".  

The Tribunal discussed this by reference to two of the requirements listed above, namely that the person must be carrying on a ring fence trade and that the plant or machinery must not be replaced.  In relation to the former, the Tribunal considered that the draftsman may well have intended that a subsequent failure to meet the condition should have no effect on the allowance.  However, the Tribunal considered that the intention as regards the latter condition was unclear.  This leaves open questions such as how a taxpayer can prove that it will not replace the plant and machinery and whether an intention not to replace at the time of making the claim for the allowance would be sufficient.  

Implications of this case for claims for decommissioning allowances

As explained above, the prepayment scheme used by MOUK is no longer effective.  The special allowances code has been modified to limit the amount of capital allowances available in a taxable period to the sum of relevant expenditure incurred on works performed in that period and to include other anti-avoidance provisions.

More broadly, though, the judgment provides some useful discussion of the purpose and structure of the provisions relating to the special allowance for decommissioning expenditure.  It has also clarified the method of determining the object of expenditure for tax purposes: this is a question of the taxpayer's purpose in laying out the expenditure, and the immediate purpose of accelerating tax relief may be found to be the dominant purpose even if other, longer term commercial purposes exist. Provided expenditure is incurred on items which qualify for relief (as discussed above) capital allowances should be available although consideration may need to be given to the questions raised by the Tribunal as to when "forward looking" conditions for claiming the allowances need to be satisfied. Taxpayers should review these provisions carefully prior to making claims for allowances.