The past year has seen major developments affecting the oil and gas industry and UK taxpayers generally. New industry-specific measures provide some relief after the shock introduction of the supplementary charge to corporation tax (SCT); an EU tax decision has led to changes in transfer pricing and a broader challenge to tax planning is becoming an international phenomenon.
Industry-specific changes
Changes under the Finance Act 2004 include:
supplement for exploration and appraisal expenditure qualifying for SCT and corporation tax relief, which primarily benefits new UK industry entrants; and
a petroleum revenue tax (PRT) relief, designed to encourage new tariffing business and the use of the existing infrastructure.
Exploration expenditure supplement
Over the years, exploration activity in the UK Continental Shelf (UKCS) has decreased because of the increasing risk and high costs of exploration and appraisal (E&A). The rig count in July 2004, despite the oil price hitting new highs at the time of writing, was at its lowest since January 2000 following the 1998 oil price collapse. After some lobbying, in April 2003 the government consulted with the oil industry seeking suggestions for ways in which exploration could be encouraged, and the economic recovery of resources within the UKCS maximized.
Some months later the Chancellor announced his intention to enhance tax relief on exploration costs for new entrants to the UKCS. The industry was disappointed that the government neither sought to offer the wider ranging fiscal incentives which were hoped for, nor chose to take the opportunity to raise exploration and appraisal activity levels across the UKCS by broadening the benefit to all companies active in the UKCS.
The government proposed a much more limited relief, which provides only a marginal uplift to the net present value of resultant tax losses.
The Finance Act 2004 introduced the new measures, which increase the economic value of carried forward losses and affects expenditure incurred on or after January 1 2004. Unused capital allowances carried forward will benefit from the exploration expenditure supplement (EES). For a maximum of six years the EES provides an annual uplift of 6% on a cumulative basis, of the value of the unused E&A capital allowances carried forward. In addition, the amount of expenditure qualifying for EES will be reduced by any ring-fence profits arising in another group company.
Where any E&A expenditure is incurred before the company is considered to be trading for tax purposes, generally capital allowances on the E&A expenditure can be claimed when the company begins to trade, that is, when the decision to develop a field has been made. However, the 6% EES uplift will begin to accrue as the expenditure is incurred.
This proposal will be of most benefit to new start-ups and companies that, on a group basis, are not paying ring-fence corporation tax.
Also, because tax losses are carried forward indefinitely, the benefit of the uplifted capital allowances arising on the investment expenditure is deferred, rather than having an immediate impact.
The proposals put forward in the Finance Act 2004 are not wide ranging, and affect start-ups and those companies that are not paying tax. This reduced impact is a disappointment after the hopes of the industry were raised during consultation.
PRT exemption on new tariffing business
During 2002 it became apparent that pipeline owners in the UKCS were at a commercial disadvantage in the competition for tariff income in respect of gas from Norwegian gas fields. This disadvantage was because of the PRT charge that would result where income was derived from an asset that was inside the PRT rules, that is, the same pipelines. A new Norwegian pipeline might have been able to charge a lower tariff because of the absence of the PRT cost. Industry representatives put forward proposals to government to alleviate this competitive disadvantage.
During the consultation process, one of the government's big concerns was the requirement for any change in tax law to have the desired commercial effect by increasing UK tariff incomes and extending UK infrastructure life. This concern was addressed when the industry agreed to pass on the benefit of the PRT reduction in the form of lower tariffs.
In the 2003 Budget, the Chancellor announced the introduction of a new tax-exempt tariffing receipt (TETR) whereby qualifying tariff receipts were to be exempt from PRT. The legislation is included in the Finance Act 2004. Unfortunately, determining whether a tariff receipt is a TETR is not straightforward.
A tariff receipt is a TETR if it is received (or is receivable) by the participator in a chargeable period ending on or after June 30 2004 under a contract entered into on or after April 9 2003 and is in respect of a tax-exempt business. A tax-exempt business requires the use of a qualifying asset, or the provision of services or other business facilities of any kind in the connection with the use (other than by the participator in the oil field) of a qualifying asset.
A qualifying asset is one that is used in respect of:
a new field or oil won from a new field, that is, for which consent for development was granted on or after April 9 2003; or
a qualifying existing field, that is, an existing field that must not have made use of a disqualifying asset in a UK area at any time in the six years before April 9 2003.
A disqualifying asset is the use of a qualifying asset used by a participator in relation to an oil field, unless it was an excepted asset. Excepted assets include (among other things) qualifying assets that were permanently situated inside the boundaries of the field.
In summary, a TETR is a tariff receipt receivable on or after June 30 2003 in respect of which a qualifying asset is used in connection with a new field (development consent on or after April 9 2003) or a qualifying existing field.
Expenditure incurred on or after January 1 2004 relating to assets in respect of which TETRs are receivable is not an allowable deduction in calculating profits chargeable to PRT. To determine the amount that should be disallowed, the expenditure must be apportioned between exempt and non-exempt business on a just and reasonable basis.
The term "just and reasonable" is not defined, but the Inland Revenue has stated that:
the average cost attributable to TETR use should be calculated on a throughput basis; and
a cap of 50% of the gross tariff should apply to operating costs and some capital costs, but not to abandonment expenditure, where arm's length terms apply.
Alternatively, the actual incremental cost, if higher than 50% of the tariff, can be deducted if agreed with the UK Inland Revenue.
Operating expenditure, which is subject to the cap, is defined as non-specific field costs, including manpower, onshore support, transportation, general maintenance and overheads. It excludes capital and decommissioning expenditure. The minimum disallowance should be the incremental cost (that is, the additional cost to the host field or system of processing and transporting exempt production), and the maximum will be the average cost.
As detailed above, the 50% cap applies to some types of capital expenditure. Expenditure that is incurred in tying-in the user field to the host platform or system, modifying host assets or acquiring assets specifically for user field production are costs that normally fall to the user field. Where the host field incurs the expenditure, the costs will normally be disallowed.
However, expenditure incurred in relation to the ongoing maintenance of assets that are part of the infrastructure in respect of which the TETR is receivable should be disallowed on the same basis as the operating expenditure. In other words, the average basis is capped at 50%, because the assets can be used by more than one field or system.
Abandonment expenditure will not fall within the expenditure considered in determining the disallowable amount using the capping method. The disallowances will be made on the average basis.
Overall, these complicated rules aim to exclude from PRT a best estimate of, or proxy for, the net incremental profit generated from TETRs.
UK:UK transfer pricing
It has long been argued that UK transfer pricing legislation in relation to cross-border transactions is contrary to EU law, because transactions between UK companies have generally been exempt. The European Court of Justice's decision in the Lankhorst-Hohorst case (C-324/00) supported this argument. In response, the government has extended the scope of the transfer-pricing rules to cover transactions between related UK taxpaying parties, and the measures are included in the Finance Act 2004.
Some relief from these measures is given by exempting small and medium-sized enterprises from all transfer-pricing legislation (that is, both UK:UK and cross-border transactions), though this exemption does not apply to business transactions with related entities resident in territories with which the UK does not have a double-tax treaty with a non-discrimination article.
An entity is small or medium-sized if it has an annual turnover of less than €50 million ($60.4 million) or a balance-sheet total of less than €43 million. Nevertheless, the new legislation allows the Inland Revenue to require a medium-sized enterprise in cases of blatant manipulation to apply the transfer-pricing legislation to some or all of the entity's transactions.
Also, the transfer-pricing rules dated April 1 2004 do not apply to companies that were dormant for at least three months before March 31 2004, for periods during which they remain dormant. The exemption does not apply to entities that became dormant after March 31 2004.
Where the new legislation serves to impute an adjustment in respect of a transaction between two UK entities, a compensating adjustment can be made in the books of the advantaged entity for tax purposes. The legislation also allows the advantaged entity to make a balancing payment.
For accounting periods ending on or before March 31 2006, penalties for inadequate transfer pricing will be waived temporarily. The legislation also sets aside temporarily the tax-geared penalty for negligently preparing an incorrect return, where the reason for the negligence is the absence of records demonstrating the use of arm's length principles.
The extension of the obligations is onerous for large companies. However, the legislation also acts to reduce the requirements for small and medium companies, because they are exempt in respect of both cross-border and UK:UK transactions. For upstream oil and gas companies that are subject to the UK ring fence, there is already experience of some transfer pricing of transactions crossing the ring fence. Larger diverse groups will find these changes burdensome and simply a further addition to the cost of tax compliance.
Disclosure of tax avoidance schemes
The 2004 Budget introduced obligations on tax advisers that promote tax schemes, taxpayers that implement them and on the UK Inland Revenue itself. The legislation contained in the Finance Act 2004 sets out the framework of the provisions. The final regulations made on the July 22 2004 and the Inland Revenue's guidance notes indicate how the rules are to be interpreted. The regulations are widely drafted and, without practical experience and guidance, it is still not completely clear what may or may not be caught.
The rules came into effect on August 1 2004 but have a degree of retrospection. The rules operate from March 18 2004 for onshore promoters of employment products, April 23 2004 for offshore promoters and in-house users of employment products, and from June 22 2004 for financial products. There are also separate arrangements for value-added tax (VAT).
In trying to understand how the regulations will work practically, commentators have considered notification requirements in other overseas jurisdictions. Many expected that an analysis of the US tax shelter rules would provide useful insight. However, the rules bear few similarities.
What is caught?
Schemes and arrangements need to be notified to the Revenue if they satisfy three tests:
The scheme must be one of those specified in regulations as being "connected with employment" or "connected with financial products" (see below);
The scheme must give rise to a tax advantage; and
The tax advantage must be a main benefit or one of the main benefits that might be expected to arise from the scheme. Because the test looks to benefit rather than purpose, commercially driven transactions can be caught.
In many cases it will be the promoter (that is, the adviser) that notifies the Revenue, but where there is no UK promoter (and the overseas promoter is not making the notification), or a scheme is devised in-house, then the taxpayer is required to do so. The time limit for notification by a promoter of a scheme is five business days from the date that the scheme is made available for implementation (although some guidance is provided, it is by no means clear exactly when this arises) and for other promoters within five days of the promoter becoming aware of any transaction forming part of the notifiable arrangements. Where there is an overseas promoter, the taxpayer has five days from the start of implementation to notify, but if the scheme is devised in-house then the taxpayer needs only to notify at some point before the filing date for their tax return but in practice this means before the return is to be filed.
The information required must be sent to the new Avoidance Intelligence Unit and is set out in the regulations, but, broadly, the Inland Revenue must be supplied with enough information to enable it to establish how the scheme works. The promoter is not, however, required to disclose the name of the taxpayer concerned. The Inland Revenue will then, within 30 days, provide the necessary number for inclusion on tax returns.
What are arrangements connected with employment?
These include, broadly, arrangements involving securities or associated rights (where these are acquired by reason of employment), loans to employees, payments to employee benefit trusts, and payments to third parties where the third party is entitled to, or required to apply, the funds for the benefit of employees. There are limited exemptions for arrangements that fall within statutory exclusions (for example, approved share schemes) and, although much of the straightforward employment planning is excluded, it is far from clear what falls into the rules; it is possible that some of the employee incentive schemes used in connection with transactions could be caught. Interested parties at the time of writing are still discussing the application of these rules with the Inland Revenue.
What are arrangements connected with financial products?
The rules in this area catch a wide range of transactions. For an arrangement to be caught it must satisfy three tests:
the arrangement includes a financial product as defined in the regulations;
an expected tax advantage, which is a main benefit of the arrangements, arises to a large degree, from the inclusion of the financial product in the arrangement; and
the financial product does not fall within the three listed exclusions (see below).
The financial products listed include loan derivatives, repos, stock loans, shares, and anything that is in substance a loan or the lending money. Assets held within an individual savings account, personal equity plan or anything that is accounted for as a finance lease need not be disclosed.
In terms of determining whether an expected tax advantage arises, there must be a direct link between the financial product and the tax advantage. Whether the tax advantage arises to a significant degree is a question of fact, though where the link is minor and trivial the arrangements need not be disclosed.
The listed exclusions are:
the premium fee test, where the promoter would be able to obtain a premium fee;
the confidentiality test, where the promoter would wish to keep the tax avoidance element of the arrangement confidential to preserve a competitive advantage (rather than for client confidentiality purposes); and
the off-market terms test, where the promoter is a party to the financial product.
Where all three tests are met, the arrangements need not be disclosed to the Inland Revenue.
Penalties
The financial penalty regime does not involve particularly large amounts (unlike the equivalent VAT rules, which link the penalty to the amount of VAT at stake) and the Inland Revenue seems to be relying on the fact that potential damage to the reputation of the taxpayer and adviser will be the main incentive to ensure compliance.
What are the VAT arrangements?
From August 1 2004 these measures require businesses with an annual turnover of £600,000 ($1.06 billion) or more to disclose the use of known avoidance schemes that will be placed on a statutory list (Designated Schemes). The list of Designated Schemes will be extended as and when Customs sees fit, and probably in consequence of disclosure by businesses or promoters of the hallmarked schemes. Although the rules are aimed at schemes entered into with the sole or main purpose of obtaining a tax advantage, schemes entered into innocently will also need to be notified. Businesses with an annual turnover of £10 million ($17.74 million) or more will also be required to disclose where arrangements are used which have certain characteristics or hallmarks of avoidance. Hallmarked schemes are schemes that include, or are associated with, one or more of the features listed in the regulations that could indicate that one of the main purposes of the scheme is to obtain a tax advantage and a claim or return is affected by the use of the scheme.
Businesses will be required to notify Customs of such schemes within 30 days of the return becoming due for the first VAT period in which the planning takes effect. The penalty for failure to notify any of the Designated Schemes is 15% of the VAT saving. The penalty is for failing to disclose the scheme, even if the scheme is held to be legally effective by the Courts. The penalty for failure to notify a scheme including a provision associated with or included in a scheme (which is not a Designated Scheme) is £5,000 ($8,873).
In summary, these changes (which are not yet fully understood) may have a large impact on taxpayers and their approach to tax planning, and will require great care. For now, the jury is out on whether these rules will be effective in meeting the government's objectives, and whether an undue burden is placed on taxpayers and their advisers.
For further information please contact:
Derrick Parkes - KPMG LLP (UK)
Tel: + 44 20 7311 4920
Email: derrick.parkes@kpmg.co.uk
Jeremy Maynes - KPMG LLP (UK)
Tel: + 44 20 7311 4487
Email: Jeremy.maynes@kpmg.com.uk
The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP (UK). All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity. KPMG LLP is the UK member firm of KPMG International, a Swiss cooperative.
