In the Autumn Statement (5 December 2014), one announcement causing surprise and consternation to the UK North Sea oil and gas sector (UKCS) was that a ring fence was to be introduced in relation to certain UKCS profits made by an oil contractor, and that, within that ring fence, a cap was to be imposed on the amount deductible for lease payments made to an associated company.
The measure provoked a strong adverse reaction from both contractors and oil companies, and, following an informal consultation, some ameliorations have been announced – the class of affected asset is now limited to drilling rigs/ships and accommodation units, the amount of the cap has been increased (from 6.5% to 7.5%), and the fact the asset may be laid up between jobs is taken into account. Also, the impact of the regime will be reviewed after one year of operation. But the fundamental proposal remains pretty much as originally announced.
Draft legislation was published on 1 April 2014, and is open for consultation until 9 May 2014.
The new rules apply to a contractor if it carries on activities (oil contractor activities) which are
- exploration or exploitation activities in, or in connection with which, it provides, operates or uses arelevant asset in a relevant offshore service, or
- otherwise carried on in, or in connection with, the provision by the contractor of a relevant offshore service.
Relevant offshore services are the provision, operation or use of a relevant asset in, or in connection with, the carrying on of exploration or exploitation activities in a relevant offshore area by the contractor or any associated person.
The relevant offshore area is UK territorial waters and the UK continental shelf.
A relevant asset is a structure (including a ship or other vessel) that
- can be moved from place to place (whether or not under its own power) without major dismantling or modification
- can be used to
- drill for the purposes of searching for, or extracting, oil, or
- provide accommodation for individuals who work on or from a structure used in a relevant offshore area for, or in connection with, exploration or exploitation activities,
- is leased (in whole or part) (whether by the contractor or not) from an associated person; and
- has a value of £2 million or more.
As would be expected, associated person is defined widely, including
- the contractor
- any person who is, or has been, connected with the contractor
- any person who has acted, acts, or is to act, together with the contractor to provide a service (excluding a case where the only involvement is as the unconnected lessor of the relevant asset)
- any person connected with a such a person.
Lease and leasing are also given a wide meaning.
Connected also has a wide meaning, including an extended definition of common control.
The ring fence
Oil contractor activities will now be treated as forming a separate trade of the oil contractor, subject to tax at the normal corporation tax rate (not the higher rates applicable to oil companies). The ring fence requires that the profits of that activity are segregated from any wider trade, and are subject to restrictions in terms of loss reliefs (broadly, losses arising outside the ring fence cannot be sheltered by profits within it) and deductions for interest expenses and exchange gains and losses. However, the principal restriction is on the deduction for hire payments in respect of relevant assets (see further below).
Lease payment cap
The amount of lease payments paid for relevant assets that is deductible within the ring-fence is limited to, broadly, 7.5% of the capital cost of the asset to the relevant group.
If payments subject to restriction are made by more than one company, the cap is split between the payers on a just and reasonable basis.
If the asset is not used in the relevant offshore area throughout the relevant accounting period, the 7.5% is time apportioned, by reference to the period of relevant offshore area use to total use. If the accounting period is less than 12 months, the 7.5% is time apportioned.
Lease is widely defined, and includes hire purchase, conditional sale etc.
The capital cost is the consideration given to acquire the asset when first acquired by an associated person, plus incidental expenses (other than financing costs) and any capital improvement expenditure (which increases the value of the asset) since acquisition. If the asset is leased from a third party which is not an associated person, the capital cost (and incidental costs) is the amount that would have been paid had the asset been purchased not leased, plus any improvement expenditure. If items have been removed from the asset since acquisition, the cost is reduced to reflect this.
An anti-avoidance provision disregards any arrangements entered into with the main or one of the main purposes of avoiding the cap on payments.
If the cap results in the whole of the rental not being deductible, the excess amount is available to be taken as a deduction outside the ring fence, or surrendered by way of group relief, if the oil contractor has other UK taxable activities.
The ring fence regime and cap apply from 1 April 2014; if that falls in the middle of an accounting period, one period is treated as ending on 31 March 2014, and another as commencing on 1 April 2014. Losses carried forward can only be used within the ring fence if they would have fallen into it had the rules applied at the time the loss was made.
Restriction for oil companies where no lease between associated persons
This is intended to apply where an oil company leases a relevant asset directly, in circumstances where the restriction would have applied had the asset been leased to the oil contractor. For example, the oil company could lease a drilling rig from one member of a group, and obtain the related services from a separate company. In this case, the cap applies to the oil company within its normal UKCS ring fence (with the result that the impact of the cap may be more significant, because of the higher rate of tax applicable to oil companies). Again, an anti-avoidance provision applies to arrangements which have a main purpose, or one of their main purposes, as the avoidance of the restriction.
The new rules give rise to some interesting issues, which no doubt will be raised during the consultation process. For example:
- It would seem that is some cases, because of the breadth of the definition of “associated person", the cap may apply by reference to the original cost incurred by an unrelated third party
- Normally, if the oil contractor were resident in a jurisdiction with which the UK has a double tax agreement, the lease payments would have been deductible in full in working out its UKCS permanent establishment profits, provided the rent did not exceed market value. However, it would appear that the double tax agreement may not prevent the cap from operating, even where it means the effective tax deduction is lower than the double tax agreement would normally permit, as the full deduction is still being allowed. It is the ring fence which may prevent the deduction being fully utilised, and this does not appear to be something a double tax agreement provides protection from
- Although the title of the rules refers to bareboat charters, there seems nothing in the rules which limits them in this way. In this case, any non-bareboat charter would likely already be being taxed, so far as the lessor is concerned, wholly within the UK. But there does not seem anything which prevents the cap applying to the lessee where this is the case, and there is no corresponding reduction in income for the lessor.