On 26 May 2022, Chancellor Rishi Sunak announced a temporary windfall tax on the profits of oil and gas companies called the Energy Profits Levy. This new tax follows mounting pressure to offer support to households facing a record squeeze on living standards especially in increased energy bills.

How will the new levy work?

The levy will be charged on the profits of oil and gas companies that arise on or after 26 May 2022 from operations in the UK and on the UK Continental Shelf at the rate of 25%. Companies with accounting periods that straddle 26 May will be required to apportion their profits to periods before and from that date.

Currently, oil and gas companies pay corporation tax at a special rate of 30% on profits from their operations within the ‘ring fence’ along with a 10% supplementary charge (40% in total). The effect of the levy will be to bring the total tax charge on profits to 65%. The intention is that the levy will raise around £5 billion in its first year of operation and will be phased out as oil and gas prices return more to historical norms. The legislation will include a ‘sunset clause’, meaning that the tax will be removed after 31 December 2025.

There are some significant technical details regarding the workings of the levy. For example, finance costs and decommissioning costs will be left out of account when calculating the profits subject to the levy. This is to ensure that extraordinary profits generated by the recent large price spike are not reduced by decommissioning expenditure.

Existing losses will not be available to set against profits subject to the levy, although levy losses can be carried back for a 12-month period, carried forward against future levy profits or surrendered through group relief to a related company that is also subject to the levy.

Investment allowance

Along with the introduction of the levy came the announcement of an investment allowance. An ‘allowance’ will be generated on investment expenditure (capital expenditure as well as some operating and leasing expenditure) at a rate of 80%. This allowance can be used immediately to reduce the amount of profits subject to the levy. To the surprise of many, this investment allowance is not linked to investments in renewable energy.

Will the new tax impact the electricity generation sector?

Missing from the Chancellor’s announcement was any mention of a new tax on the electricity generation sector which has already been flagged as making extraordinary profits due to the impact of rising gas prices. However, the Chancellor did state that the Treasury will be evaluating urgently these extraordinary profits and what should happen next. This may herald a new levy in the electricity generation sector later in the year.

How will this impact the oil and gas sector?

Interestingly, in the last few years only 35 oil and gas groups have paid any corporation tax because of losses and decommissioning allowances with the top seven of these responsible for 95% of all tax payments. The concern of the oil and gas industry had been that the effect of any windfall tax would be to discourage further investment in the UKCS where many fields are coming to the end of their useful lives, and it is becoming increasingly expensive to extract the remaining resources in those fields. It remains to be seen whether the 80% investment allowance will be sufficient to overcome this concern.

There is also the risk that, despite the sunset clause, the continuing global instability initiated by the war in Ukraine may result in the levy becoming a permanent feature of the UK oil and gas taxation code.