Out-Law Analysis | 04 Feb 2016 | 8:30 am | 5 min. read
For more in depth analysis on Pinsent Masons' research on oil and gas services, see our Ahead Of The Curve special reports.
HM Revenue and Customs (HMRC) is coming under increasing pressure to close the 'tax gap' and collect more tax, particularly from complex and multinational businesses. As falling profits from the UK Continental Shelf (UKCS) impact on corporation tax receipts, many businesses are reporting that employment taxes are becoming an ever-increasing burden.
At the same time the Organisation for Economic Cooperation and Development (OECD) has recommended limiting the tax deductions available to companies for interest payments, as part of its proposals for reforming the international tax rules to preventso-called base erosion and profit shifting (BEPS). This recommendation, which is intended to address its concern that multinational corporate groups can use interest payments to reduce their taxable profits in companies in high tax jurisdictions, could have serious repercussions for companies operating in the capital-intensive energy sector.
Companies operating in this space need to be aware of the need to manage their tax liability as well as increase their profit margins, and to ensure the best possible value out of any ongoing disputes with HMRC.
Recent research of oilfield services companies conducted on behalf of Pinsent Masons, the law firm behind Out-Law.com, found an extremely positive reaction to UK government attempts to reform the UKCS. Almost the entire respondent pool told us that they expected the UKCS to return to 'peak' profitability levels last seen in the first half of 2014, with 48% of respondents expecting this to happen over the next three to five years.
More striking still, however, was the fact that 28% of respondents told us that this could happen even faster once the impact of energy policy reforms, including the establishment of a new industry regulator the Oil and Gas Authority (OGA), began to be felt. The UKCS is seen as fundamental to the UK's continued economic growth, which means that the government may make substantial changes to the way in which oil and gas profits are taxed in order to revive growth and increase profitability.
The most recent change was the reduction in Petroleum Revenue Tax (PRT) from 50% to 35% as of 1 January 2016. Profits on oil exploration and production are subject to ring fence corporation tax (RFCT) at 30%, less allowances for capital expenditure, and an additional 20% supplementary charge, less any investment allowances.
Although considerably reduced due to the impact of these tax changes, the marginal tax rate on oilfield profits remains 67.5% for fields subject to PRT and 50% for other fields. Compared to a general corporation tax rate of 20%, which is set to reduce still further in April 2017, there is clearly scope for further tax reduction amidst unprecedented circumstances in the industry.
Diverted profits tax
A new diverted profits tax (DPT) was introduced by the UK last year, targeting "large multinationals who artificially shift their profits offshore". The new tax applies to any profits arising on or after 1 April 2015 and applies where a foreign company "exploits the permanent establishment rules" or where a foreign company with a UK-taxable presence creates a tax advantage through the use of transactions or entities that "lack economic substance".
This legislation has been widely criticised for its considerable reach and the likelihood that it will catch unintended targets. For example, a group company that pays tax at the normal rate of corporation tax which provides group functions to an oil and gas company subject to RFCT would, on the face of the legislation, be caught by the rules. DPT will generally be charged at 25%, however oil and gas companies operating within the ring-fence regime will be subject to a DPT rate of 55%.
HMRC is stepping up its oversight of payroll tax compliance, with figures obtained by Pinsent Masons at the end of last year showing a 13% increase in the number of investigations into suspected non-compliance opened between tax year 2013/14 and tax year 2014/15. Employment tax is a complex area, and HMRC can levy fines of up to 30% of the tax owed even in cases of genuine human error. In the oilfield services sector, where employees are often internationally mobile and payroll, HR and in-house tax compliance located in different jurisdictions, the position can be even more complicated - particularly in relation to short- to medium-term assignments.
Larger companies operating in the oilfield services space should also be aware of the UK government's planned 'apprenticeship levy', which is due to be introduced in April 2017 and will apply to all businesses with wage bills of £3 million a year or more. The levy will be charged at 0.5% of the company's wage bill, and will be payable through Pay as You Earn (PAYE) on a monthly basis.
International tax changes
Oil services companies, and others operating in capital-intensive sectors, could potentially be caught by proposals to restrict the availability of tax relief for interest deductions. These companies frequently use debt funding for commercial purposes, and deals are usually priced on the basis that deductions will be available for interest expenses. Should these deductions no longer be available - and there is considerable doubt that the measures as drafted could be adapted to protect existing projects - the higher tax costs would put an additional strain on projects at a time when access to capital is already constrained.
The OECD has recommended that interest deductions should not be permitted to the extent that net interest exceeds a percentage of earnings before interest, taxes, depreciation and amortisation (EBITDA). The new rules would apply even if there was no tax avoidance motive, any lending was purely on arm's length terms and even if the transactions and parties were based in the same jurisdiction. Countries would be free to select a percentage between 10% and 30% when implementing the proposals.
Despite the potential damage to the competitiveness of the UK tax system, the government has indicated that it proposes to introduce the restrictions and a consultation seeking views on how this should be done has recently closed. Until the UK finalises its approach, companies will face a period of uncertainty as to what their impact will be on project cash flows and will need to factor this in to cash flow projections for both new and existing projects.
For energy and infrastructure companies operating in the UK, the design of any public benefit exemption as permitted in the OECD's recommendations will be of the utmost importance. Even where projects are highly leveraged, they do not necessarily present a risk to the UK tax base – but it is not at all clear that the exemption envisaged by the OECD would cover every such project. It is vital that the UK government understands that debt financing and high gearing in relation to these projects is not driven by BEPS. Rather, in most cases it constitutes a commercial necessity - and the UK's public benefit exemption must be drafted to reflect this.
Heather Self is a tax law expert at Pinsent Masons, the law firm behind Out-Law.com.
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Editor’s note 09/02/2016: this story was updated to amend unclear language and remove a factual error.