In the 2014 provincial budget, the British Columbia government announced its intention to introduce income tax legislation later in the year applicable to the LNG industry (the LNG Income Tax). The B.C. government stated that these measures are in furtherance of its efforts to develop and implement a competitive tax and policy environment to assist with LNG development in the province. The LNG Income Tax is separate and additional to both federal and provincial income tax and may apply to taxpayers not subject to federal or provincial income tax.
Draft legislation to implement the LNG Income Tax was released by the B.C. government on October 21, 2014 (LNG Act). The LNG Income Tax is proposed to be effective for taxation years beginning on or after January 1, 2017. The draft legislation provides details about the computation of the tax base upon which the proposed LNG Income Tax will be imposed.
The proposed LNG Income Tax will be a two-tier tax with a Tier 1 rate of 1.5% until such time as net operating losses and capital costs have been recovered, and a Tier 2 rate thereafter at a rate of up to 3.5% for taxation years beginning prior to 2037 and 5% for taxation years beginning in 2037 or later. The Tier 2 rate has been reduced to 5% from the 7% originally proposed in the 2014 provincial budget.
Tax Base for Purposes of the LNG Income Tax
As detailed in the newly released draft of the LNG Act, the base upon which the LNG Income Tax is to be applied is broad and encompasses a wide range of activities and functions that touch upon the liquefaction of natural gas and the ownership of the natural gas which is the subject of liquefaction.
The determination of the tax base begins with an “LNG Facility” (as defined in the LNG Act). The LNG Income Tax is proposed to be levied on a facility-by-facility basis. As a result, income and losses and LNG Income Tax liability will be calculated separately for each LNG facility. The LNG Income Tax will apply to all LNG facilities in the province regardless of whether the LNG is exported or for domestic use.
An “LNG Facility” for the purposes of the LNG Act is defined expansively to include, inter alia:
- an “LNG Plant” (as defined in the LNG Act);
- the land underneath the LNG Plant, and land that is contiguous with the land underneath the LNG Plant that is used or held for the purposes of the operation of the LNG Plant (with “land” defined to include any foreshore and any land covered by water); and
- any tangible personal properties or improvements on that land if such property or improvements are used for activities that support the construction, administration, operations and maintenance of the LNG Plant.
An “LNG Plant” is defined expansively to include, inter alia, tangible personal property and improvements that are:
- part of the series of systems used or intended to be used for liquefying natural gas, including the entire “train,” including property used for (i) delivering natural gas to, or receiving and measuring natural gas delivered to, the series of systems, (ii) extracting, separating and storing natural gas liquids and (iii) storing of liquefied natural gas;
- part of a series of systems used for measuring, loading (or supporting the loading) for shipment, or transmission of liquefied natural gas or natural gas liquids, if such systems immediately follow the liquefaction series of systems; and
- power generation facilities that are used or intended to be used to generate electricity for use primarily by the liquefaction series of systems.
The LNG Income Tax is imposed on income derived from “Liquefaction Activities” (as defined in the LNG Act) at an LNG Facility. The definition of “Liquefaction Activities” is expansive and includes:
- operating all or part of an LNG Facility;
- acquiring, owning or disposing of liquefied natural gas, natural gas liquids or natural gas that is at an LNG Facility (or the right to acquire, own or dispose of these commodities that are at an LNG Facility);
- acquiring, owning or disposing of all or part of an LNG Facility, or a right to use all or part of an LNG Facility;
- disposing of electrical power generated at the LNG Facility; and
- acquiring, owning or disposing of intangible personal property (or a right to that intangible property) that is used or exploited for the operations of the LNG facility or for the liquefaction activities described above.
Special rules are provided in the LNG Act with respect to determining the amount of income associated with the acquiring, owing and disposing of liquefied natural gas, natural gas liquids or natural gas that is at an LNG Facility. Essentially, the income is determined as the difference between the inlet price and the outlet price, determined as follows:
- Inlet Price–To the extent that there is no actual acquisition of natural gas at the inlet, the party that owns the natural gas both immediately before and after the inlet valve to the LNG Facility is deemed to have purchased that natural gas from itself at the inlet valve. Any non-arm’s length acquisition at the inlet, which includes a deemed acquisition, is deemed to occur at a reference price which is set monthly by the B.C. Minister of Natural Gas Development using the market price of natural gas at Spectra Station 2, as adjusted for the cost of transportation. The price of arm’s length acquisitions is also adjusted for the cost of transportation.
- Outlet Price – The price of a non-arm’s length disposition by the owner of liquefied natural gas, natural gas liquids or natural gas when it leaves the LNG Plant is subject to adjustment under the LNG Act to an amount that would have been the price if the taxpayer made the disposition to a person with whom the taxpayer was dealing at arm’s length. To the extent that there is no actual disposition when the product leaves the LNG Plant, the owner at that point is deemed to have disposed of the product in a transaction with a notional person with whom the owner does not deal at arm’s length for the amount that would have been the price if the taxpayer made the disposition to a person with whom the taxpayer was dealing at arm’s length.
In the determination of the outlet price, the LNG Act places heavy reliance on the arm’s length principle, which is also reflected in the transfer pricing rules in the federal Income Tax Act. The proposal also references the OECD guidance as being relevant in applying the arm’s length principle for purposes of the LNG Act. The LNG Act proposes transfer pricing rules which are based upon, but not identical, to the transfer pricing rules in the federal Income Tax Act. Although the B.C. Government states that “the arm’s length principle is a widely used and well understood basis for valuing non-arm’s length transactions for international income tax purposes,” the application of the arm’s length principle for purposes of the transfer pricing rules in the federal Income Tax Act continues to be the subject of evolving guidance from the Canadian courts in significant tax disputes. The Canadian cases to date suggest that the application of the arm’s length principle to any particular transaction remains a subject of considerable commercial uncertainty.
The starting point under the federal transfer pricing rules is the terms and conditions agreed upon in an actual transaction by a taxpayer with a non-arm’s length person. The actual price may be adjusted to the extent that the agreed terms are inconsistent with what arm’s length parties would have agreed upon. Application of the arm’s length principle to a notional disposition under the LNG Act may be problematic as there are no agreed terms. Under Canada’s bilateral income tax treaties, certainty on transfer pricing may be obtained under an advanced pricing agreement, which is entered into with the tax authorities for the two countries in question. Canada’s tax treaties also provide an alternative mechanism for resolving pricing disputes through negotiation by the competent authorities and in some cases arbitration. The mechanisms available for resolving federal transfer pricing disputes may not be applicable to resolve disputes arising under the LNG Act. The LNG Income Tax proposals do not indicate whether the B.C. government intends to provide alternative mechanisms to obtain tax certainty or resolve transfer pricing disputes without litigation.
The LNG Income Tax applies only to the extent that the taxpayer has net operating income as determined under the rules in the LNG Act. Those rules start with the computation of income for federal income tax purposes on the Liquefaction Activities, but are modified to exclude interest, dividends, and hedging gains and losses. In addition, no deduction is permitted for financing charges (including interest) and capital cost allowance.
A separate capital investment allowance is provided in recognition of capital costs incurred in relation to an LNG Facility. Generally, the costs associated with constructing an LNG Facility will be included in the taxpayer’s “capital investment account,” upon which the capital investment allowance is claimed.
Until such time as the taxpayer has generated sufficient net operating income to recover any net operating losses and deduct its capital investment account, the LNG Income Tax will apply at the Tier 1 rate of 1.5% of net operating income (i.e., income prior to any deduction for net operating losses or capital investment allowance). Once any net operating losses and the capital investment account balance have been fully deducted, the LNG Income Tax will apply at the Tier 2 rate (subject to special transitional rate calculation rules that apply in the year in which the relevant net operating loss and capital investment account balances are exhausted). The Tier 2 rate will be 3.5% for taxation years beginning on or after January 1, 2017, and will rise to 5% in taxation years beginning on or after January 1, 2037.
The amount of the Tier 1 tax paid by a taxpayer on net operating income is added to a tax paid pool, the balance of which is credited against tax levied at the Tier 2 rate. This effectively results in the application of a reduced Tier 2 tax rate until such time as the tax paid pool is fully depleted.
Natural Gas Income Tax Credit
The B.C. government also proposes to provide a provincial corporate income tax credit for taxpayers with a permanent establishment in B.C. The credit will be calculated as 0.5% of the cost of natural gas acquired at the inlet to an LNG Facility using the pricing mechanics applicable to the computation of the LNG Income Tax. The credit may be claimed up to an amount which would reduce the B.C. provincial corporate income tax rate from 11% to 8%. This credit is a new measure not included in the 2014 budget announcement.