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UK Oil and Gas Tax—A Shock to the System

8 August 2011
Mayer Brown Article

The UK Budget 2011 delivered something of a shock to the UK oil and gas sector. In an effort to help balance the books, the UK government announced a significant increase in the tax applied to North Sea oil and gas producers, effective from 24 March 2011. This article is a short summary of the tax changes that were announced in the UK Budget 2011, the market reaction and the status of the changes at the time of writing. References to oil should be read as including gas, and references to the United Kingdom include the UK continental shelf.

UK Oil and Gas Tax—a Brief Summary

The taxation of profits derived from the extraction of oil in the United Kingdom is quite complex. Companies can be subject to some or all of petroleum revenue tax (PRT), corporation tax and the supplementary charge.

PRT is applied at 50 percent to the profits derived from the production of oil from specific oil fields (broadly, those licensed prior to 16 March 1993). It has its own basis for calculating profits and expenses, which is different to the basis used for corporation tax and the supplementary charge. Further, PRT is allowed as a deductible expense for the purposes of calculating profits for corporation tax and the supplementary charge.

Corporation tax is applied to the profits of all companies which are tax resident in, or have a permanent establishment in, the United Kingdom. For oil companies, in broad terms, any oil extraction activities in the United Kingdom, or any exploitation of oil rights related to the United Kingdom, are treated as a separate trade (they are “ring-fenced”). Ring-fenced profits are taxed at 30 percent; companies subject to the corporation tax ring-fence regime do not benefit from the reductions in the main rate of corporation tax announced at the Budget (decreasing from 28 percent to 23 percent over the next 4 years), except to the extent that they are also involved in taxable activities that are not taxed under the ring-fence rate, but instead are taxed under the main corporation tax rules. Ring-fenced profits cannot be reduced by losses arising from other (non-ring fence) trades. Again, there are numerous specific rules that relate to the calculation of deductible expenses, in particular in relation to capital allowances (the United Kingdom’s tax depreciation rules).

In addition to the UK corporation tax ring-fence rate, companies falling within that regime are subject to a supplementary charge that is applied to their adjusted ring fence profits in the relevant accounting period. These are the profits that would be subject to the main ring-fence corporation tax charge, assuming that financing costs and loss relief are left out of account in computing the profits and losses of the ring fence trade for the accounting period in question. Until 24 March 2011, the rate of the supplementary charge was 20 percent.

The Budget Tax Grab

It was announced at the Budget that the supplementary charge will increase to 32 percent, effective from 24 March 2011. As a result, those subject to the UK corporation tax ring-fence regime and supplementary charge now face a combined 62 percent rate of tax (rising to 81 percent for companies whose older fields are subject to petroleum revenue tax)—however, the complex system of allowances and reliefs can reduce the profits that are subject to that tax rate. This rate change made all the headlines, but there were some other, more subtle changes:

  • Legislative changes will ensure that the “intangible fixed assets” tax regime (which broadly taxes intangible assets, including goodwill, on an income basis in accordance with accounting entries) does not permit a company to obtain a debit in calculating its profits where it acquires an oil licence or an interest in an oil licence from another company.  Oil licences and interests in them are already excluded assets under the intangible fixed assets rules—this exclusion is now being extended to cover all goodwill and any other intangible asset which relates to, derives from or is connected with an oil licence or an interest in an oil licence.  This is being introduced because HM Revenue & Customs became aware of oil companies interpreting accountancy practice in such a way as to recognise goodwill on the acquisition of an oil licence or an interest in an oil licence.  This was considered to be contrary to the intention of the intangible fixed assets rules.  This change is effective from 23 March 2011.
  • The government announced its intention to introduce rules in Finance Bill 2012 (with effect from the 2012 Budget) to restrict tax relief for decommissioning expenses to the 20 percent rate of the supplementary charge.  The government said that it will work with the oil industry with the aim of announcing “further, longer term, certainty” on decommissioning at Budget 2012.
  • An interesting feature of the new rate of supplementary charge will be the linking of the rate to a “fair fuel stabiliser.” The effect of this will be to reduce the rate of supplementary charge back down towards 20 percent “on a staged and affordable basis” where the oil price falls below a set “trigger price.” The trigger price was initially announced as US$75 per barrel (subject to ongoing consultation with affected parties).
  • One small crumb of comfort for the industry was confirmation (more than one year after they were first announced) that changes to reinvestment relief would be enacted in Finance Bill 2011 (but with effect from 24 March 2010) which extend reinvestment relief to exploration and development expenditure.

Market (and Political) Reaction

The Budget announcements provoked a considerable amount of reaction from industry players and commentators, with some estimating that almost £2bn was wiped off the market values of North Sea oil and gas producers immediately following the Budget.

Many commented on the fact that the industry is subject to regular changes of fiscal policy (leading to difficulties in assessing the future returns on investment) and that the oil and gas industry is already subject to high tax rates, and that, as a result, further increases damage investment. In a press release after representatives from Oil & Gas UK (the trade association for the UK offshore industry) gave evidence to the Energy and Climate Change Committee (a cross party committee—not part of the UK government) on 4 May 2011, Malcolm Webb, Oil & Gas UK’s chief executive, said: 

We need to find means to re-incentivise investment in the UK’s oil and gas developments …. Doing so will reduce the risk that these fields will be decommissioned in the near future and their infrastructure removed, limiting the industry’s ability to recover small remaining reserves of oil and gas nearby.

The treatment of gas in the proposals is also arguably unfair. First, the price of gas has (as a broad generalisation) increased significantly less than has the price of oil in recent years. Yet, because the United Kingdom generally taxes gas in the same way as oil, gas is subject to the same increase in the supplementary charge. Second, the fair fuel stabiliser (see above) is linked only to the price of a barrel of oil, which is currently considerably in excess of the price of an equivalent amount of gas. Thus, in some sense, gas extractors are unfairly pegged to the price of oil.  Furthermore, in relation to oil, the trigger price has arguably been set too low, given that most industry observers would predict the price of oil will be well above the proposed US$75 per barrel in the short to medium term. If that turns out to be true, the “fair fuel stabiliser” won’t stabilise anything.

The increase in the supplementary charge is uniform across all oil and gas fields. This is likely to have a greater impact on those fields where the profitability (before tax) is already considered marginal. In a publication titled “UK Continental Shelf Tax Regime – Options for Reform” released on 10 June 2011, the Scottish government suggested that the higher tax rates should be linked to some form of investment rate of return (so that the higher tax rates only apply once a certain rate of return has been reached).

A number of companies also publicly stated that they would review their UK Continental Shelf operations given the changes. In a press release on 14 July 2011, Deloitte revealed a survey showing that UK oil and gas drilling had fallen by as much as 52 percent in Q2 2011 when compared to Q2 2010. It is too early to say how much of that drop results from the Budget 2011 changes.

The First Step Back from the Cliff?

On 5 July 2011, the UK government announced a change to help mitigate the increased taxes as a result of the Budget. The industry hopes that this is the first of a number of steps to help mitigate the tax changes.

The government announced that with effect from 1 January 2012, the annual rate of the ring-fence expenditure supplement (RFES) will increase from 6 percent to 10 percent. The RFES is a special allowance for companies within the ring fence, and it allows such companies to increase the value of certain losses carried forward by a certain percentage on an annualised basis. In broad terms it increases the value of the losses over time (and thus to some extent recognises the time value of money). It is helpful in an industry where early stage expenditure can often outstrip income for many years.

The government also announced that it will “continue to engage with oil and gas companies on the case for new categories of field qualifying for field allowance.” While not a concrete measure, any increase in the categories of field allowance would also be welcome by the industry. The reason is that field allowances are a special form of allowance that are specific to the supplementary charge (and, in broad terms, can reduce the amount of profits that are subject to the supplementary charge until such allowance is used up). At present, field allowances are only available to certain types of fields, including ultra heavy oil fields, ultra high pressure/high temperature fields, and certain small fields.

Industry response to the announcement has been positive, albeit guarded. A number of large producers that had indicated that they would shut down or reduce investment in the UKCS as a result of the Budget increase, responded to the government’s announcement by saying they would now reappraise their positions in the UKCS. However, there is a feeling that the government has not gone far enough in repairing the damage done as a result of the Budget announcements. In a press release, Malcolm Webb, Oil & Gas UK’s Chief Executive, said:

This is a first step in the right direction. We made it clear after the Budget that Government actions and not just words would be required to begin to rebuild trust and restore the confidence of investors. This will help some new players but much more action is needed including on other reliefs and on the important decommissioning problem in the light of the Budget. However this has to be seen as an encouraging first sign of some real progress.

It is unclear if or when the UK government will issue further announcements, so Oil & Gas companies should continue to “watch this space.”

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