Our experts outline the general tax landscape for oil and gas exploration and the new shale gas regime.
The government is ambitious to support industry in its exploitation of shale gas as a new source of energy supply, and is anxious to ensure that there are as few tax disincentives as possible to unlocking early exploration.
HM Treasury and the Department for Communities and Local Government issued a consultation document in July - 'Harnessing the potential of the UK's natural resources: a fiscal regime for shale gas'. It sought views on its tax proposals and to stimulate debate on the shape of the new regime. The government has now given its response to that consultation and debate.
Finance Bill 2014 will make provision for the new regime.
Introduction: the general tax landscape for oil and gas exploration
The taxation of profits from oil and gas exploration is a specialist area of the tax code. Broadly, it can be divided into two distinct taxes:
Ring-fenced corporation tax
Standard corporation tax principles are used to determine the amount of tax due. There is, however, an added layer of complexity - profits arising from oil and gas extraction in the UK cannot be reduced by losses arising from other activities. Exploration activities are seen as a separate trade of a company, insulated from other activities.
The current rate of corporation tax for profits in the ring fence is 30%.
Support to encourage exploitation of commercially marginal projects is given through the 'Ring Fence Expenditure Supplement' (RFES). Current rules on RFES enable companies to increase their pre-trading expenditure or losses by 10 per cent per year for up to six accounting periods. The effect of such enhancement is to maintain the time value of expenditure/losses, and both to reduce and to defer tax on future profits.
This is an additional charge on ring-fence profits but after increasing taxable profits by adding back expenditure on financing costs. The rate of the supplementary charge is 32% of the adjusted profits. Field allowances (a species of capital allowance) reduce profits subject to the supplementary charge.
What do the new proposals look like?
The proposals are relevant to both corporation tax and the supplementary charge.
- An extension of RFES to shale gas projects, and enhancing its attraction to all onshore projects: allowing an uplift in losses by 10% per year for shale gas projects, and extending the period for which this can be done. This is relevant to ring-fenced corporation tax.
- An innovative 'pad allowance': similar to (but distinguishable from) the current field allowance for conventional oil and gas. This allowance is more tailored to the particular circumstances of shale exploration. This is relevant to the supplementary charge. Significant improvements have been made over the shape of the allowances as originally proposed, which are detailed below.
Ring fence expenditure supplement
RFES is to be extended to shale and other 'unconventional' hydrocarbon projects - those using hydraulic fracturing to extract oil and gas. In a change to the original proposal, the RFES regime is to be extended from six years for a further four accounting periods for those companies continuing to generate losses for all onshore projects (and not just the 'unconventional' ones).
The original proposal looked to place restrictions on this extension, so imposing a degree of practical complication:
- Only where a company is in loss at the end of year six and some of those losses have been generated from onshore unconventional activities will it be able to claim additional RFES.
- Losses from onshore activities will have to be disaggregated from the company's total loss pool, with RFES available only for onshore activities.
Distinguishing between production from conventional and unconventional sources is now thought to be administratively too complex, and so (in a welcome move) the government has decided to extend RFES to all onshore oil and gas losses and pre-trading expenditure.
The consultation paper recognised that 'unconventional' reserves (such as shale) did not fit neatly into a tax regime designed for more conventional energy resources. A field-based regime (which has been at the heart of taxing such activities since the earliest days of energy taxation) is inappropriate for shale. Instead, a 'pad allowance' was proposed - with the 'pad' being the drilling and extraction site.
The pad allowance acts as an investment incentive, intended to relieve a portion of production income from the Supplementary Charge. The effect is significant - reducing the rate of tax on that proportion by more than half, from 62% to 30%.
It was originally proposed that any excess allowance in an accounting period could be used to set against ring-fenced corporation tax - such excess can only be carried forward and set against future liability to the Supplementary Charge.
The concept of the pad allowance is to be welcomed. Restrictions placed on its use, however, have been criticised:
- Allowances non-transferable between pads: Without the ability to transfer allowances between unsuccessful (or underperforming) pads and successful ones owned by the same company, allowances are 'stranded' and of no use. This results in the overall value of the allowance being discounted in making investment decisions. A 'cross-pad relief' would avoid this issue.
- The real value of allowances not maintained: The value of activated (but unused) allowances degenerates over time. Their real value should be maintained over time and (like RFES) the original value should be uplifted by 10% per year until they can be used (subject to a 10 year cap).
- Allowances not transferable intra-group: activated allowances should be capable of surrender of transfer between companies in the same corporate group.
- Restricted value of allowances on sale: sellers cannot transfer allowances at a value greater than the equity proportion of 'unactivated' allowances.
- Restricted use of allowances: Allowances can only be used to set against profits from hydrocarbon sales from shale, and not from wider shale-related profits (e.g., tariff income and capacity payments).
- There are no incentives for new investors:
- Roll-over relief for replacement of business assets: the 'normal' reinvestment rules are too restrictive. They do not allow companies to roll-over gains on the sale of oil/gas assets except where reinvestment is in the UK Continental Shelf.
- Substantial shareholdings exemption (SSE): This provides exemption from tax on capital profits from the sale of shares by one company to another. Selling on some shares would help fund development. SSE does not extend to exploration and appraisal activities and, where such an activity were to be transferred to a subsidiary special purpose vehicle (SPV), that SPV would have to show a 12 month trading history before SSE is available.
The government has responded positively to a number of these points:
- It has accepted the case for introducing cross pad relief from unsuccessful to successful ones, but (in order to ensure no pad is abandoned prematurely for other than commercial reasons) transfers will only be allowed after three years.
- It has agreed that roll-over relief and SSE can be extended to exploration and appraisal activities.
- It has confirmed that allowances can be used to cover capacity payments, as well as non-arm's length transactions - but that it will not extend to tariff income or gas used for production purposes.
The government has rejected the concepts of intra-group transfer of allowances and uplifts in the value of allowances to maintain their current value. It will not allow transfers of allowances at anything greater than their equity value.
What expenditure is eligible for the allowance? The allowance is based on capital expenditure incurred in relation to the pad. The original proposal was that expenditure qualifying for the pad allowance would be the same as that qualifying for first year capital allowances.
The government has now decided to extend eligible expenditure beyond first year allowances. There will be further guidance - but qualifying expenditure will be extended to include: costs of the site (buildings, land access and some capitalised expenditure on leased assets); gaining access to hydrocarbons; restoring capital assets; and mid-life plugging and abandonment of wells.
Rate of pad allowance
The rate of the allowance was open for decision following consultation, but there is recognition of the possibility of a more generous rate than the current one for field allowances (which is currently set at a maximum of 20% of the total allowance activated each year). The government has now decided to set the rate of the allowance at 75% - a generous rate, driven by the objective of incentivising early investment.
Widening the scope of pad allowances
The consultation paper also asked about the extension of the scope of pad allowances to other onshore unconventional hydrocarbon projects; and to all onshore hydrocarbon activities (with a simplification of the regime by removing eligibility for field allowances for all onshore projects, so having the pad allowance as the single allowance regime for the Supplementary Charge).
Each participant in a pad would generate its own pad allowance, based solely on its capital expenditure. Unlike field allowances, there will be no need to divide allowances on the basis of a company's equity in the field. This seems to us to be a sensible and welcome simplification.
The government has now decided to extend pad allowances to all onshore hydrocarbons. This decision is based on the administrative burden that would result in the need to distinguish conventional from unconventional sources. There are some resulting complications:
- A production cap of 7 million tonnes of oil per project is to be introduced (this is consistent with the current small field allowance)
- For conventional hydrocarbons, the cap will be applied to the entire field.
- For unconventional hydrocarbons, the cap will apply to a pad
- There are various other detailed restrictions, and transitional provisions.
Conclusions - and how we can collaborate
It is clear from the tone and content of its response to the consultation paper that the government is serious about incentivising the exploration and extraction of shale gas and other 'unconventional' hydrocarbons. The proposals represent welcome support for the industry through the tax system. Some measures are already in force.