Readers will be pleased to learn that after over two years of discussions, HMRC has finally accepted that the tax treatment of farm-ins that had been in operation for the last 20 years is in fact in accordance with the law.

HMRC have said that they will amend their manuals to make the position absolutely clear and will give industry a chance to comment on these amendments before the manuals are reissued.

Although HMRC had given industry comfort that while the discussions were continuing they would not seek to impose their new view (apart from in respect of abusive transactions), this had still left companies planning a farm-in at a later date with an element of uncertainty.

The issue that originally triggered the HMRC review of how the rules worked was an intra-group transaction in respect of a non-UK licence where relief was being obtained againstUKtax with no prospect of anyUKtax being collected from subsequent profits from the licence, presumably as a result of double tax relief.  HMRC have commented that if they see companies using the farm-in rules in a way they believe is abusive they will not feel constrained in recommending to Ministers a change in law, and in the current climate there is no reason to believe that any such change would not be made with retrospective effect.

Comment

CWE has been actively involved in the discussions between HMRC and industry in which industry has consistently set out why they believed the interpretation put forward by HMRC in early 2010 was incorrect and it is pleasing to see that our views have finally prevailed.  The change of heart by HMRC will also provide some much needed assurance for industry on the way this type of transaction is taxed.

Decommissioning Relief

Readers will be aware of the on-going discussions between industry and Government to provide for a “contract of assurance”, to effectively guarantee decommissioning tax relief in accordance with the current tax rules.  Part of this process will be to agree a definition of “decommissioning expenditure” for these purposes. 

Readers will also be aware of the restriction of relief for decommissioning costs for SCT purposes to 20%, which was announced in Budget 2011, and is being enacted in FB 2012.  Government is keen to align  the definitions of decommissioning expenditure used for the purposes of the contract of assurance and the cap on relief (and indeed the costs which when creating or enhancing a loss for corporation tax and supplementary charge purposes can be carried back to 2002).

We reported in our Budget newsletter (at Point 6) that we understood that the cap on decommissioning relief was to apply only to end of field life decommissioning.  This comment was based on the comments made to industry as part of the debate on the draft Finance Bill clauses published in December 2011.  It has however now become clear that Government intend that the cap should apply to not only end of field life decommissioning but midlife decommissioning and also exploration and appraisal wells. This is because Government believes there would be an incentive to decommission early given there is a possibility (albeit it currently looks very unlikely) that the tax rate will reduce in the future, and they don’t want companies’ commercial decisions affected by tax. Although the scope of the cap set out in the Finance Bill remains unchanged the draft legislation now includes a provision to enable Government to extend the scope of the cap by Regulation.

Comment

We continue to believe that it is fundamentally unfair for a tax system to tax profits at one rate and give relief for expenditures at another.  If this feature was not present there would be no incentive for companies to advance decommissioning.  We believe the extension of the cap to exploration and appraisal wells to be particularly unwelcome as it will clearly increase the cost of, and therefore deter companies from, drilling such wells, which is completely at odds with the other changes to the tax system that Government is making and indeed the stated Government policy of maximising the exploitation of the UK’s hydrocarbon reserves.

May 2012

The Chancellor announced in his Budget speech today that the Government will introduce a package of oil and gas measures intended to secure billions of pounds of additional investment in the UK Continental Shelf.

 1.   Decommissioning certainty

Legislation is to be introduced in 2013 giving the Government statutory authority to sign contracts with companies operating in the UK and UK Continental Shelf under which they will be given certainty on the relief they will receive when decommissioning assets.

There have been extensive discussions between industry and Government over the last 12 months concerning the possible introduction of some form of contractual assurance arrangement. The Government will consult with industry further to finalise the details of the arrangement.

 Comment:

This is one of the most important developments for the industry in the fiscal area. It has been promoted as a no cost option for the Government, but the Government estimates that it will cost £115 million in 2012-13, but with significantly increased future taxes from 2013-14 onwards,  presumably from additional developments and assets changing hands to parties willing to invest, both encouraged by the change.

There has been considerable uncertainty for many years as to the precise level of relief that will be available to oil companies for expenditure incurred on decommissioning UK oil and gas infrastructure. The existing legislation is complex and the effective level of tax relief depends very much on the precise historic profile of the taxpayer.  This is particularly true for PRT but also relevant for corporation tax (CT and SCT) since effective relief for abandonment costs requires the entity incurring the expenditure to have sufficient current, future, or past taxable profits of the appropriate nature. There are uncertainties as to how the existing tax rules apply in a number of areas and a number of anomalies have been identified where full effective relief may be denied, and there has always been a perception that there is significant risk of law change which may prevent companies obtaining any relief, particularly with respect to PRT and SCT.

These risks have led to an increasing difficulty for assets to change hands.  For example, sellers of field interests typically request security to be provided on a pre-tax basis.  Whilst this increases the cost of providing the security, the main downside of this requirement is that the obligation restricts a purchaser’s borrowing base. 

Additionally, for field interests where the decommissioning costs are significant compared to the overall net value, the difference between the seller’s position that full tax relief will be available for the decommissioning costs, and the buyer’s risked valuation that there may not be full effective relief, can be too big to bridge. We are aware of a number of transactions which have failed as a result of these factors.

Given that Government cannot give a commitment that the UK tax regime will not be changed in the future, a company by company contractual approach is to be introduced under which the Government agree to meet a certain level of the decommissioning cost. We understand that the view is that Government would not be able to easily renege on their contractual obligations (although we have seen some concern expressed about the impact of possible Scottish independence).

Industry and Government have already done a significant amount of work in developing the concept, but there will be further work needed on the detail before the arrangement can be finalised. However  this announcement should be very welcome to all companies with a presence in the North Sea and should encourage other companies to take a closer look at the investment opportunities. 

 2.   Oil and gas field allowances

The Government has announced that a number of new field allowances are to be introduced, and a framework put in place to enable the existing field allowance regime to be extended to cover existing fields as well as new fields. The stated objective is that these changes are specifically designed to increase investment and production in fields that are economic, but for tax reasons are considered to be commercially marginal.

 2.1   West of Shetlands

A new field allowance for particularly deep fields with sizeable reserves, principally targeted at the  West of Shetland area is to be introduced.

New fields” that meet the following criteria will qualify for this new relief:

• Water depth greater than 1,000 metres; and
• Minimum reserves of 25 million tonnes; and
• Maximum reserves of 40 million tonnes, with a straight line taper to no allowance at 55 million tonnes.

The maximum allowance is £3bn, such that at the current supplementary charge rate of 32%, and ignoring discounting, the maximum value of the relief would be £960m for a relevant new field. 

A new field for these purposes will be one with development authorisation on or after 21 March 2012 (i.e. the date of the Budget).

The Government have stated that the new allowance is principally expected to apply to the area West of Shetland and that they will continue to work with industry to encourage further investment in the region.

Comment

It is thought that the reason that the measure includes a minimum field size is to prevent it being available for fields which would otherwise be sub economic, since the stated objective of these field allowances is to encourage development which would not be feasible absent the current tax regime.  In the same way, presumably it has been decided that fields with reserves in excess of the maximum would not need any additional fiscal assistance.  

 2.2   Small Field Allowance

The maximum amount of the small field allowance introduced in Finance Act 2009 will be doubled from £75 million to £150 million. The qualifying criteria will also be relaxed.

The maximum allowance will be available for fields which have reserves in place of 6.25 million tonnes (approximately 45 million barrels) or less, tapering to no allowance at 7 million tonnes (approximately 50 million barrels). The previous thresholds were 2.75 million and 3.5 million tonnes.

Again, for these purposes a new field will be one with development authorisation on or after 21 March 2012.

When originally introduced the maximum tax value of small field allowance was £15m, being £75m multiplied by the supplementary charge tax rate of 20%. By contrast the new allowance will be worth a maximum of £48m (£150 million at 32%) per relevant field.

Comment

Fields which have recently received development consent where the reserves in place exceed the original 3.5m threshold miss out but presumably this is consistent with Government stated policy, since by definition those fields have not needed this incentive to bring them to development.    

2.3   Other Field allowances

 2.3.1    Brown Field Developments

The field allowance regime will be extended to deal with brownfield redevelopment. Details of this measure are to be discussed with industry but an amendment to the field allowance legislation will be introduced giving HMRC the power to extend it to oil and gas fields that have already received development approval and are to undergo additional development.

This will open the way for specific statutory instruments to be introduced to deal with specific instances of relief.

 2.3.2   HPHT

Government have also announced that they will continue to consider potential changes to the existing allowance for High Pressure High Temperature fields.

Comment:

Government have demonstrated by these further measures that they are prepared to legislate to give targeted assistance to the development of fields where the existing high level of taxation provides a disincentive. Following the introduction of the field allowance regime in 2009  interested parties have been lobbying Government to secure such targeted relief on a case by case basis, and this further set of measures indicates that Government are prepared to listen and act on what they perceive to be deserving cases.  The existence of these field allowances does however perhaps make it less likely that there will be any significant reduction in the rate of supplementary charge in the near future, except for the possible operation of the fair fuel stabiliser (see 3 below).

Field allowances are available to shelter the supplementary charge on ring fence profits of a company holding an interest in a field with the appropriate characteristics.

After introduction of these measures there will now be 6 separate field allowances.

1.1      The small field allowance of £75 million for fields which received development consent before 20 March 2012;

1.2      The new small field allowance of £150 million for fields which receive development consent on or after 20 March 2012;

1.3       The ultra heavy oil field allowance of £800 million;

1.4       The high pressure / high temperature allowance of £800 million;

1.5       The deep water gas field allowance introduced in 2010 applying to fields where 75% or more of the reserves are gas, where water depth is more than 300m and the export pipeline is at least 120km; and

1.6     The new £3 billion deep water “Sizeable reserves” field allowance.  

The Government estimate that the measures will cost £155 million for 2012-2014 but then show increased tax receipts from 2014-15 onwards totalling approximately £95 million to 2017.

 3.   Rate of SCT and the Fair Fuel Stabiliser

The rationale for the increase in the rate of Supplementary Charge to 32% in Finance Act 2011 was to fund a Fair Fuel Stabiliser (FFS) when oil prices are high.

The Government also stated that, if the oil price fell below a set trigger price on a sustained basis, the rate of Supplementary Charge would be reduced back towards 20%.

The Government  has now announced that the FFS will be implemented and that a trigger price will be set at £45 sterling (equivalent to approximately $75 based on the latest OBR exchange rate forecast for 2012). The review will be carried out every three years. Whether the trigger price is met will be assessed annually on the first working day of February, starting in 2013. This assessment will be based on two FFS reference prices:   

• The average daily dollar oil price (per barrel) in the three months immediately prior to the date of assessment, and
• The average daily dollar oil price (per barrel) in the week before the date of assessment

In each case the dollar price will be converted to sterling using the average daily Bank of England exchange rate across the period.

Both reference prices are required to be met for the trigger price mechanism operates.

Comment

There is no attempt in the mechanism to recognise the disparity between oil and gas prices which will be a disappointment to a number of companies with predominantly gas assets. There is also no indication as to the level of reduction in SCT that will arise if prices fall below the trigger. Given the current oil price it seems unlikely that this measure will be relevant for the foreseeable future.  

4.   Ring fence capital gains

The press notices confirm that draft legislation which was published last year dealing with the application of the supplementary charge to capital gains will be enacted. This draft legislation changes the law to bring ring fence capital gains arising after 6 December 2011 within the scope of the supplementary charge, and prevents such gains from being transferred to group companies which are not within the scope of supplementary charge. 

Comment

The guidance notes published with the legislation make it clear that HMRC’s view is that the change to bring ring fence gains within the scope of SCT has been made simply to clarify the position and that, notwithstanding the change, they are of the view that the existing law did bring ring fence capital gains within the charge to SCT. Presumably any company wanting to challenge this view will have to litigate to determine whether this is indeed the case.

For those companies who have realised such gains but made an election to hold these over, it is clear that these held over gains will now be taxed at the increased supplementary charge rates. Representations were made that this was anomalous but Government have refused to make any changes to deal with this issue.  

As originally enacted the rules in s171A enabled a capital gain or loss to be moved from a seller into another group company by means of a deemed transfer of the asset immediately prior to sale. The changes made in Finance Act 2009 allowed the actual loss or gain to be transferred. This opened up the possibility of transferring ring fence capital gains within the charge to SCT into an entity which was not carrying on ring fence trade. Without a ring fence trade SCT cannot apply, and therefore the gain would only be subject to CT. This measure prevents any transfer of gains in these circumstances.

5.   Restriction on the rate of oil and gas decommissioning tax relief

As announced at Budget 2011, the Government will introduce legislation restricting the rate of decommissioning tax relief to 20 per cent for supplementary charge purposes.

Comment

The draft legislation was published on 6 December 2011 and there have been a number of discussions with industry concerning the precise scope of this restriction.  Further detailed legislation has not been made available but it is expected that the cap will apply to substantially all expenditure incurred on decommissioning fields, but not expenditure incurred in advance of final decommissioning, such as the plugging and abandoning of redundant wells whilst the field is still producing.

6.   Loss carry back

The Government have also announced that the scope of the extended loss carry back rules that apply to companies with ring fence trades, which currently only applied to losses generated from expenditures qualifying for the special decommissioning relief rules within the plant and machinery legislation, will now apply to losses arising from mineral extraction allowances in respect of decommissioning expenditure.

Comment

The extension of the loss carry back rules is welcome. The intention is that expenditures where relief is capped for supplementary charge purposes are capable of contributing to a loss which could fall within the extended loss carry back rules.

7.       Ring Fence Expenditure Supplement

The Statutory Instrument giving rise to an increase in the rate of RFES from 6% to 10% has now been laid before the House of Commons and will come into force on 23 December 2011 with effect for accounting periods beginning on or after 1 January 2012. No further announcement was therefore necessary in respect of this item. 

8.       Other corporate measures

8.1   Capital gains where non sterling functional currency

There is to be a consultation this summer on whether companies with non-sterling functional currencies should be able to compute capital gains in that functional currency rather than in sterling as is currently required. While the HMRC Press Release only refers to companies, this is one of the issues that industry has been discussing with HMRC in connection with the taxation of decommissioning trust funds.

Comment

The industry may  want to bring the inclusion of decommissioning trusts into these discussions.   

8.2   Corporation tax rates

The mainstream rate of corporation tax is being reduced by a further 1% over and above the previously announced changes such that it will be reduced by 2014 to 22%. The ring fence CT rate remains at 30% and the SCT rate at 32% for the following year.

Comment

There was a suggestion in the Chancellor’s speech that the long term objective is to get down to a single rate of 20% applicable to all companies, but it is assumed that this doesn’t apply to those with ring fence profits.

8.3   Controlled Foreign Companies (CFCs)

The new CFC regime, which has been widely consulted on, is to be included in the Finance Bill with the new provisions applying to accounting periods commencing after January 1 2013. The new regime will contain a number of potential “get outs” starting with an initial gateway test to determine whether the CFC regime is applicable in the first instance. If a company is within the regime the other possible exclusions will need to be examined.

Comment

It is thought that most if not all oil and gas operations should fall outside the CFC regime.

 8.4   GAAR

It has been announced that a general anti-avoidance regime (GAAR) is to be introduced in the 2013 Finance Bill, with a consultation taking place this summer on the precise terms of the legislation.

Comment

It is to be hoped that the many well publicised drawbacks of such a regime, not least the huge amount of uncertainty it will create, will not have too much of an adverse impact on the normal operations of the oil and gas industry. 

8.5.    R&D

An “above the line” R&D credit will be introduced for large companies in 2013, as announced in the Autumn Statement 2011. This will make the credit more visible and is expected to encourage R&D activity.

CW Energy LLP – 21st March 2012

1. Cap on relief for decommissioning costs

It was announced at the time of the 2011 Budget that a cap would be introduced to restrict the relief on abandonment expenditure for supplementary charge purposes to 20%, notwithstanding the increase in the supplementary charge rate to 32%.  This is to be achieved by increasing the supplementary charge profits by an amount calculated as (SC-20%/SC), where SC is the rate of supplementary charge for the period in question, multiplied by the amount of decommissioning expenditure which is deducted in computing the supplementary charge profits for the period.  The adjusted profits for supplementary charge purposes will then all be taxed at the 32% rate.

Decommissioning expenditure for these purposes includes expenditure incurred in connection with:- 

• Demolishing plant and machinery (P&M)
• Preserving P&M pending reuse or demolition
• Preparing P&M for reuse
• Arranging for reuse of P & M, or
• Restoration of land (including landscaping)

The restriction will apply to expenditure incurred in connection with decommissioning carried out on or after Budget Day 2012.

There are provisions for determining when decommissioning expenditures are used where they form part of a loss.  Where such a loss is group relieved the claimant and surrendering company must identify the extent to which a decommissioning cost is included within the loss.

Following the Budget 2011 announcement it was pointed out to HMRC that the effect of this restriction would be to reduce the overall effective rate of relief for a fully PRT paying field to 69%, notwithstanding that the combined CT, SCT and PRT rate of tax had been increased to 81% as a result of Finance Act 2011.  HMRC indicated that this was not their intention and the draft Finance Bill 2012 includes a further measure to ensure that the overall effective rate of relief for decommissioning costs for a fully PRT paying field is preserved at the pre Finance Act 2011 level of 75%.  This is achieved by means of decreasing the supplementary charge profits using the same fraction as set out above, but in this case multiplied by the PRT reduction that arises as a result of decommissioning expenditure taken into account in the relevant PRT assessment.

Comment:

HMRC have chosen to redefine the scope of decommissioning expenditure rather than use one of the existing definitions, for example that in section 163(4A) CAA 2001, in this new definition land restoration is included but decommissioning is not restricted to activities carried out in order to comply with an approved abandonment programme.

There are rules for determining how one establishes how to attribute a PRT reduction to losses which include decommissioning expenditures and these rules include the flexibility for companies to choose the order in which such offset shall be regarded as being made.  This would be relevant, for example, where the field was not fully PRT paying because of oil allowance.

2. Capital Gains and the Supplementary Charge

As the liability to supplementary charge is based on a different definition of ring fence profits from the charge to ring fence CT, some in industry have suggested that it did not cover ring fence capital gains.  HMRC have moved to legislate for their view that ring fence capital gains are within the scope of the supplementary charge.  The legislation applies to disposals from 6^th December 2011, the date of publication of the draft Finance Bill.

Comment:

The guidance notes published with the legislation make it clear that HMRC’s view is that this change has been made simply to clarify the position and that, notwithstanding the change; they are of the view that the existing law did bring ring fence capital gains within the charge to SCT.  Presumably any company wanting to challenge this view will have to litigate to determine whether this is indeed the case.

The draft explanatory notes suggest that ring fence gains include all gains on the disposal of an oil licence.  This of course is not correct as only disposals of licences which include determined fields (material disposals) fall within the scope of the ring fence. 

For those companies who have realised such gains but made an election to hold these over, it is clear that these held over gains will now be taxed at the increased supplementary charge rates.

3. Election to transfer capital gains

HMRC have also moved to close a loophole which was opened up when the capital gains tax gains and loss transfer rules were amended in Finance act 2009 (section 171A).

The change prevents transfers of ring fence gains arising on a material disposal in the period into companies which do not carry on a ring fence trade.  This change will also be effective for any gains accruing on or after December 6^th 2011.

Comment:

As originally enacted the rules in s171A enabled a capital gain or loss to be moved from a seller into another group company by means of a deemed transfer of the asset immediately prior to sale.  The changes made in Finance Act 2009 allowed the actual loss or gain to be transferred.  This opened up the possibility of transferring capital gains within the charge to SCT, into an entity which was not carrying on ring fence trade.  Without a ring fence trade SCT cannot apply, and therefore the gain would only be subject to CT.  This measure prevents any transfer of gains in these circumstances. 

4. Ring Fence Expenditure Supplement

The Statutory Instrument giving rise to an increase in the rate of RFES from 6% to 10% has now been laid before the House of Commons and will come into force on 23 December 2011 with effect for accounting periods beginning on or after 1 January 2012.  

CW Energy LLP

7^th December 2011

Comment

RFES is available to uplift a company’s ring fence trading losses for a maximum of six periods. A group must have an overall ring fence loss in order to enjoy this relief. The Statement included an estimate of the cost of the increase, starting at £5m in 2013/2014 and peaking at £50m in 2015/16. These figures would appear to under-estimate the potential value of this measure to industry, particularly as we believe that there may be a number of planning opportunities available for groups to optimise their position.

There appears to be nothing in the documents dealing with the proposed 50% cap on relief for decommissioning expenditure that was announced at the time of this year’s Budget. However draft Finance Bill 2012 clauses, and all of the supporting information is to be published on 6 December 2011, and we expect this measure to be included.

The Statement also announced that the fuel duty increase of 3.02p per litre that was due to come into effect on January 1 2012 has been deferred until August 1 2012, and that the inflation increase due to come into effect on that latter date is to be abolished. These changes are projected to cost the Exchequer nearly a £1bn a year from 2012-13.

Comment

Readers will be aware that it was a desire to finance a fuel duty saving that led to the unwelcome increase in supplementary charge in this year’s Budget, and it is to be welcomed that Government have not sought to use that financing tool again!

November 29, 2011

Comment:

This announcement seems to have dashed all hope that the SCT changes announced in this year’s Budget would not be applied to new fields. In this sense the announcement may be seen as a disappointment for many who had hoped for this.

The announcement restates Government’s intention to continue to look at the possibility of extending the categories of field allowance.

An issue with field allowance is that it has limited value for loss making groups and doesn’t therefore have much impact on marginal project economics. The increase in RFES will not directly tackle this issue but will enhance the value of losses to compensate in part for this.   

For a number of companies in the start- up phase or with significant developments the announcement will be welcome. However the existing restrictions on RFES remain, namely that RFES can only effectively uplift the net ring fence loss of the group (the group must have an overall ring fence loss for it to apply) and that for any particular company RFES is only available for a maximum of 6 periods.

This change may require companies to rethink their strategy on claiming RFES, and we would be happy to discuss the options now available with any interested readers.

CW Energy LLP

5th July 2011

Whereas the changes made to the market value methodology for oil were driven by a revenue protection motive it seems that the main driver for a possible change to the gas regime is a desire to reduce the amount of time which HMRC must necessarily spend in agreeing values. The existing methodology for gas provides that the market value is the value which the gas in question would realise in a sale under a hypothetical arm’s length contract, having regard to all circumstances relevant to the actual disposal.

This requirement means that in practice HMRC have been obliged to agree valuations on a case by case basis with each company, as the precise circumstances surrounding each sale will differ.  There is a practical difficulty in that finding actual arm’s length contracts against which proposed valuations can be tested is often difficult, since the terms of those contracts will themselves represent the specific circumstances surrounding the disposal of the gas in question.

HMRC have expressed a concern that the lack of uniformity leads to a lack of transparency and consistency between companies.  As a result it is also difficult to assess whether the current methodology does ensure that appropriate values are captured within the upstream tax regime.

There are three issues for consultation

1. The valuation point: Whether the existing requirement for market value to be determined at the beach should be retained or NBP valuations should be used which would be more in line with open market practice
2. The market value methodology: What market prices should be used, for example day ahead, month ahead, or some combination of these
3. Whether there should be an adjustment to the pricing methodology for production risk

For companies which have already agreed a methodology with HMRC for a period of time there is a suggestion within the document that these agreements might possibly be grandfathered.

The document states that representations should be made by August 2.

Comment:

The consultation period, given it will fall partly in the summer holiday period, is not very long, particularly as this is a complex area where HMRC have taken over a year to pull their thoughts together, but it is understood that HMRC are prepared to extend this period.

We believe that the main weakness of the existing methodology is the uncertainty which it generates for companies.  It is possible to obtain an agreement with HMRC in advance, but agreeing a methodology can be time consuming.  In some circumstances companies have therefore taken the view that a better result can be obtained by simply entering into agreements on terms which they believe are arm’s length and making sure that they are in a position to support those agreements on enquiry if necessary.

A statutory basis may not give an “appropriate” transfer price in every circumstance.

In our experience HMRC already seem prepared to agree “straightforward” methodologies based on day ahead, or month ahead prices, perhaps on the basis that the values produced over a period of time represent a reasonable proxy to those values which would result from more complex arrangements. The current somewhat flexible system would therefore seem to give a satisfactory result for many companies and the move to a statutory basis may represent an unhelpful development for those who may wish to adopt more complex transfer pricing arrangements.

We will be reviewing the document in more detail in due course, and would be happy to discuss the issues raised with companies if they have particular concerns.

CW Energy LLP

A number of amendments from Aberdeen based Liberal Democrat MPs, who were concerned about the impact of the Budget changes on investment, were withdrawn following the debate.

A Labour amendment requiring the Government to produce a report by the end of September this year, to assess the impact of the ring fence tax regime on oil and gas investment in the UK, was voted on but rejected.

4th May 2011

The Finance Bill has the effect of increasing the SCT rate from 20% to 32% with effect from 24 March 2011.  For periods that straddle this date the Bill as originally published provided that an average rate should be used, such that, a company with a 12 month period ended 31 December 2011 would apply an effective SCT rate of 29.3% for the period.  It has been pointed out to government that this has the effect of retrospectively applying the increased rate to profits which had already accrued as at Budget Day, for example in situations where asset sales had been completed before that date.

Comment: This change is very welcome.  Companies may not be in a position to determine whether the election is beneficial until later in the year but it will be worth all companies which are expected to be tax paying in 2011 to carefully review the position.  Based on our experience at the time of the introduction of SCT, where companies were faced with a similar choice it may be possible to generate a significant tax saving using a “just and reasonable” basis as compared to a simple daily average.   

3rd May 2011

The following topics are discussed below:  Part A – the Increase in the SCT rate; Part B – Minor Oil & Gas Tax changes; Part C – Capital Gains Tax De-grouping changes; Part D – Branch Profits Exemption; Part E – Capital Gains Tax Value Shifting; and Part F – Intangible Assets.

Part A   

Increase in the SCT rate

As predicted in our previous Newsletter the Finance Bill has been drafted on the basis that the increase in SCT announced in the Budget is to apply to accounting periods which straddle Budget Day on a simple time apportionment basis. Therefore the effective combined rate of CT and SCT for 2011 for a company with a December 31 2011 year end is 59.3%. The proposal to cap relief for decommissioning costs to a 20% rate of SCT is not however contained in the current Finance Bill, and will presumably be contained in FB 2012.

Comment:

Unlike when SCT was introduced there is little scope to allocate the profits of the straddling period to mitigate the effect of the rate change. This could be seen as unfair if profits have not accrued evenly over the year. It will nevertheless be worthwhile reviewing the position towards the end of the year in the light of actual prices, lifting patterns, exchange rates, major transactions, etc. to determine whether any planning can be carried out.

Industry has been pointing out the adverse effects that this change will have on future investment in the North Sea, both as a result of the adverse effect on returns but also the signal such a major change gives investors as to the stability of the UK tax regime.

Companies who have not already done so should express their concerns to Government. There have been some reports that Government may be prepared to introduce measures to assist particular developments, beyond the “marginal gas” scenario mentioned in the Budget papers.

There will be discussions between Government and industry concerning the formula to be introduced to adjust the SCT rate should the oil price fall. We believe that these discussions may be an opportunity to build in a mechanism to enable the differential value of gas and oil to be recognised. 

The new 32% SCT rate was substantially enacted on 23rd March 2011under a resolution passed under the Provisional Collection of Taxes Act 1968, which will be relevant for quarterly accounting. One may also be required to disclose the deferred tax effect of the proposed restriction to 50% on the rate of tax relief for abandonment.

Instalment Payment Impact

The legislation is to treat the additional tax which arises as a result of the SCT rate during the straddling period, as an additional liability for that period.

This will mean that for a company with a December year end there will be six instalment amounts to calculate for the 2011 liability.  As is the case under existing law there will be three instalments to collect the 50% liability, payable on 14 July, 14 October and 14 January 2012.  In addition there will be three further instalments payable on7 October, 7 January, and 14 January 2012 to collect the additional 9.3% SCT mentioned above.

Part B

Minor Oil & Gas Tax Changes

The most significant of these “minor” changes is the one which extends capital gains tax reinvestment relief such that reinvestment in exploration and appraisal expenditure qualifies for the relief for disposals after March 24th 2010. Following industry representations the wording now makes clear that appraisal, as well and exploration and development, costs are included.

Comment:

This change is extremely beneficial to the industry and effectively means that any reasonably active player should be able to plan to avoid capital gains tax on the sale of its North Sea licence interests. It also significantly changes the risk reward analysis for drilling wells where a group has sold on an asset at a gain.

As dealt with in previous Newsbriefs, the Finance Bill includes amendments to changes introduced in recent Finance Acts, following lobbying by industry.  These changes clarify the rules which extend a field life beyond the date the licence expires where not all the assets are situated in the UK; allows re-commissioned fields to qualify as new fields for the purposes of the SCT Field Allowance rules; and amend the development licence swap rules so that adjustments to the consideration for interim period cash movements do not prevent the provisions from applying.

Comment:

These changes are to ensure that the provisions operate in the way they were originally intended, and it is to be hoped that following the new procedure of putting most new legislation out for comment before it reaches the Finance Bill stage, this will mean that such type of changes will rarely be needed the future.

Part C

Capital Gains Tax De-grouping changes

As anticipated in previous Newsbriefs, the Finance Bill includes the draft clauses to provide for an effective exemption from the de-grouping charge where a transferee company leaves a group as a result of its shares, or those of another group member, being sold.

The clauses now incorporated in the Bill are virtually unchanged from the previously published draft.

The effect of the proposed legislation will be that any gain arising on a deemed disposal as a result of a company leaving the group will be treated as additional consideration for the disposal of the relevant shares; thus, if the disposal of the shares qualifies for the SSE, the whole of the gain, both actual on the sale of the shares, and deemed, arising as a result of the de-grouping charge, will be exempt. Any loss arising on such a deemed disposal will be added to the base cost of the shares but this is unlikely to be of any significance in practice.

The sale of the transferee shares would need to be within the charge to capital gains tax in order for this provision to apply.

The existing provisions which allow companies the ability to roll over the de-grouping gain or to reallocate the gain within the group will be repealed and in their place changes will be made to section 171A to allow for a de-grouping gain to be reallocated under those provisions. However if a company leaves a group otherwise that as a result of a sale of shares e.g. by means of a new issue of shares, the de-grouping charge will remain within the company.

Whereas the published Finance Bill clauses contemplate the provisions becoming effective from Royal Assent, since publication of the Bill the Government has announced that it will be possible to advance the effective date of the provisions, by election, to April 1 2011. The election must be made by the principal company in the group and will apply to all the companies in the group regardless of when the intra group asset transfers occurred. The election must be made before 31st March 2012 and must also be countersigned by any company which has left the group after 31st March 2011 but before the election is made.

Comment:

These provisions effectively mean that in most cases there will no longer be a chargeable gain arising in the company being sold as a result of the company leaving the group owning assets which have been transferred from other group members in the previous 6 years.  Care will need to be taken however with structures that involves issuing new shares to third parties which could cause the issuing company or any affiliate to leave the group otherwise than via a disposal to which SSE applies. The ability for groups to elect for the provisions to apply from 1st April 2011 is also welcome and will enable groups to plan without the uncertainty of when the Bill will become law.

Relaxation of SSE rules

There are also provisions amending the SSE rules to allow SSE to be available on the sale of the shares in a newly incorporated company, or a company which would not otherwise meet the investee trading company test, if assets are transferred into it from another group company. Previously it was necessary for the seller’s group to have owned the shares in the target company for at least 12 months and for that company to have been a trading company for at least this period of time.  The new provisions modify these rules by deeming the period of ownership of the transferee company to include any the time that the transferred assets have been used for a trade within the group.  In these circumstances the transferee company will also be treated as having carried on the trade for this same period.

Comment:

The effect of these rules is that a newly incorporated company can be used to sell trading assets providing those assets have been used as trading assets within the group for at least 12 months. Note however that for these rules to apply the assets must be used for trades carried on by both the transferor and the transferee so the transfer of exploration assets may not qualify under these rules in which case it would be necessary to hold the shares in the transferee for at least 12 months.

When trading assets are to be sold there is now a clear choice as to how this can be done.  The assets can either be sold by way of an asset sale (if for example it was expected that reinvestment relief can be claimed to exempt a ring fence gain) or they can be transferred to a fellow subsidiary and the shares in that company sold, without generating any capital gains charge, providing the conditions are satisfied.

This will mean that there will be no need to keep assets in separate companies, and all of a group’s interests can be amalgamated in fewer appropriate companies. This greatly simplifies group structuring for holding assets and will also mean, for example, that there is no need to retain dormant companies from which assets have been transferred in order to avoid the de-grouping charge. 

Part D

Branch Profits Exemption

The Finance Bill clauses dealing with the exemption for foreign branch profits and losses have a significant number of amendments to those published for comment in February, although the basic principle is largely unchanged. The rules have however been expanded to include more detailed provisions for the recapture of past losses and anti-avoidance.

Basic Principles

The clauses provide that if a UK resident company makes an election, the profits or losses attributable to all its non UK permanent establishments (PEs) are excluded from the profits and losses subject to UK tax.  The election, once made, applies to all accounting periods starting after the date of the election, and is irrevocable following the start of that first period.

The rules do not apply to “small” companies to the extent they have profits attributable to a PE in a jurisdiction with which the UK does not have a “full” treaty.

Comment:

It is thought unlikely that many E&P companies will be small even in the exploration phase so this limitation is unlikely to be of significance even if operations are undertaken in jurisdictions where there is not a full treaty.

It may not always be clear whether pure exploration operations will constitute a PE in the other jurisdiction.

Exempted Profits and Losses

The election will exempt all profits and losses (subject to some specific exemptions), including actual capital gains and losses (although some of the wording is difficult to interpret) attributable to non UK PEs, provided the company carries on a business in the other territory through a PE.

The profits and losses which are exempted are computed in accordance with the relevant treaty, or if there is no relevant treaty in accordance with the OECD Model Treaty.

If the PE has any plant and machinery there is a deemed disposal at tax written down value at the time the election becomes effective (subject to some anti-avoidance provisions), and it has to be assumed that allowances that would have been available, absent the election, are claimed each year in determining the profits of the PE going forward.

Any profits of the PE that are subject to UK withholding tax at source remain within the charge to UK tax notwithstanding the election having been made, as do profits from plant and machinery leasing.

If a UK resident company only has non UK PEs and makes the election it would nevertheless still seem necessary to prepare UK tax returns to demonstrate the calculation of the profits excluded each year, unless HMRC agree this will not be necessary.

Comment:

It would appear that the capital allowance provisions have little practical impact other than in determining when pre commencement losses (see below) are absorbed or to prevent an asset being transferred out of the PE at a later date with a high TWDV. There are no corresponding provisions related to MEA or RDA allowances. 

Claw-back of past losses

If the company has accumulated brought forward losses (ignoring capital gains and losses) attributable to its PEs at the start of the first period following the date of the election, that have accrued in the accounting periods ending in the six years to that date (or longer if the losses are more than £50 million in respect of any one PE), all future profits of the PEs up to the cumulative amount of the losses remain within the charge to UK tax. If the company has more than one PE, it can make an irrevocable election to have this test applied separately to different permanent establishments.

There is now an anti-avoidance provision to prevent this rule being sidestepped by the transfer of the assets of a PE of another group company, which would seem to apply regardless of when the transfer occurs. 

Anti-avoidance measures

There are anti-avoidance provisions which keep trading profits and losses within the charge to UK tax if those profits are subject to a lower level of tax unless either they are less than £200,000 p.a., or there is no tax avoidance motive. A lower level of tax is tax less than 75% of the tax that would be payable on the profits if the profits were subject to UK tax (ignoring any foreign tax credit). There is no tax avoidance if in respect of any transaction undertaken by the PE which results in any reduction in UK tax, that reduction is minimal or it was not one of the main purposes of the transaction to avoid UK tax, AND avoiding UK tax was not one of the main reasons for the company carrying on the business in the permanent establishment. If the second but not the first test is met only a just and reasonable amount of the profits of the PE remain within the charge to UK tax. 

Comment:

It is thought that even though there are a number of non UK jurisdictions where oil and gas activities are undertaken that have “lower levels of tax”, these rules are unlikely to impact the oil and gas sector. E&P activities have to be carried out in the relevant jurisdiction such that the second test will always be met, and it is therefore only transactions for non E&P activities that might be caught.

Effective Date

The new rules become effective on Royal Assent which should be this summer, so it will be possible for companies to make an election in 2011 such the exemption will apply for the first time in 2012 (subject to there not being accumulated losses attributable to the PEs at that date in which case the exemption will be denied until past losses have been recouped).

Part E

Capital Gains Tax Value Shifting

As announced at the time of the Budget the CGT value shifting rules are to be amended as part of a number of simplification measures for Capital Gains Tax. The measure is essentially as previously announced with the existing regime being replaced by a new targeted anti-avoidance rule, to apply to disposals of shares after Royal Assent of Finance Act 2011 (probably July 2011). 

The new rule will apply where there is a disposal of shares or securities by a company, arrangements have been entered whereby the value of those share or securities is materially reduced, and the main purpose or one of the main purposes of those arrangements is to obtain a tax advantage.  In these circumstances any gain or loss on disposal of the shares or securities will be computed as if the consideration for the sale was increased by such an amount as is “just and reasonable” having regard to the value shift.

There is a specific exemption in the case of a value shift attributable to an exempt distribution, although this is narrowly drawn. Draft guidance on the application of the new law was issued at the beginning of the year.

The depreciatory transaction rules, which limit the amount of an allowable capital loss on a disposal where value has been stripped out of a company, are also being amended such that any depreciatory transactions that occur more than 6 years before the disposal can be ignored.

Comment:

Where the disposal of shares qualifies for the substantial shareholdings exemption the value shifting rules will have no effect.  However, there are a number of circumstances where disposals might not fall within the substantial shareholding exemption and care will need to be taken to ensure that the new rules do not create an unexpected tax charge, for example in the case of distributions made as part of a winding up.

Part F

Intangible assets

The Finance Bill includes clauses to ensure that any goodwill that relates to, or is derived from, or is connected with an oil licence (or an interest in an oil licence), is excluded from the scope of the intangible asset rules, as well as the licence itself. This change will apply for accounting periods ending on or after 23rd March 2011, and is treated as always having had effect.

Comment:

Under IFRS it is possible to create goodwill on the transfer of a licence interest where the acquisition is treated as a business combination. Previously, in our view, the write off or impairment of such goodwill could qualify under the intangible asset regime such that tax relief could be obtained for the full amount of the acquired asset as shown in the books of the company over time. HMRC have stated that this was not the intention of the legislation and this change ensures that an acquisition of a North Sea licence cannot generate goodwill qualifying for intangible asset relief and that no further deductions are available for existing goodwill for periods ended after 23 March 2011.As such the impact of the change is retrospective.

As a result of this we believe that the SCT rate change is “substantially enacted” for UK GAAP and IFRS purposes.  This may therefore impact companies’ quarterly reporting obligations.

We noted in our Budget note that there may be opportunities to minimise the impact of these provisions for 2011.  Readers may recall that when SCT was introduced there was no specific methodology included within the transition provisions for allocated profits such that companies were able to effectively choose whether to use on time apportionment basis (which is generally the default within the corporation taxes act) or based on actual.  However the wording included in the resolution provides that the apportionment of profits for 2011 is to be done on a simple daily basis.  The opportunities for planning will therefore be limited, but there may be some scope once the profit position for 2011 is known. 

CW Energy LLP