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Assessing the Impact of the New UK North Sea Tax Regime

09 September 2011

The UK Government has been roundly criticized for the March budget tax increases on North Sea oil and gas, taking rates up to 62%; even 81% for some older fields. Its supporters have tried to argue that with oil prices still at historically high levels, the industry can afford it. But this ignores some unpalatable truths.

Investment decisions by multinational companies are made on the basis of the relative global returns, and the March rises are likely to make the UK less attractive for oil investment compared to other locations. This is not only in terms of absolute tax rates but also in looking at the stability of the tax regime and the risk of future increases. Already a number of projects have been put on hold while operators reconsider their options.

It seems as if this message may have hit home, and some media reports have suggested that the government is considering requests to extend the tax allowances for the development of new fields, perhaps by including a new category of small-field tax allowances to try to overcome the problems. But North Sea production is based on a complex web of inter-relationships and a tax allowance to encourage small-field exploration ignores the need for big-field infrastructure on which the small fields piggy-back.

Most recent discoveries in the UK continental shelf are an order of magnitude smaller than those of earlier decades their marginal economics do not justify the construction of new export routes to shore. Instead, these fields rely on larger, older fields whose production is now declining which gives them spare capacity in their export pipelines.

However, this is a difficult balancing act. If the older "host" field ceases production, the full costs of operating the pipeline may fall on the owners of the smaller "satellite" fields, a situation which could drive them to cease production early. The key is to maximize the life of the host installations. It is of small benefit to give tax allowances to new satellite fields if the host field has itself been driven to early decommissioning by increased taxes.

Further muddling the picture is the decision to cap tax relief for decommissioning at the level applied before the recent tax increase. Generally, decommissioning costs can be set off against tax, so the higher the tax rate, the more scope for setting off costs.

The government's thinking may have been that oil companies would look at its promise to bring down tax rates if the oil price falls and might decide to decommission early to obtain the benefit of that high rate of tax relief. To avoid incentivizing early decommissioning, the government chose to cap the tax relief. Unfortunately, the combined impact of the tax increase itself, and more importantly the lack of trust in government engendered by the change, may encourage some operators to bring forward decommissioning plans precisely the reverse of what was intended. Industry is as determined to challenge this "decoupling" of tax rates and tax relief as it is to challenge the increase in corporation tax on oil revenues.

A related challenge is the application of tax relief to decommissioning security. In essence, if an oil company sells an interest in an oil field and the new owner fails to pay for decommissioning, the UK government has the right to make the former owner pick up the bill. This ensures that the taxpayer is not left to clean up the mess and quite right, too. However, in practice it is very rare indeed for oil companies to default on their decommissioning obligations and these wide-ranging powers have had unforeseen and damaging consequences.

To avoid the risk of having to pay costs in relation to assets they have sold, sellers require purchasers to give security (usually in the form of a letter of credit from a bank) for the estimated costs of decommissioning, including a big contingency. If everything goes smoothly, much of this cost is likely to be set off against tax (and therefore in effect paid for by government). However, asset sellers are concerned that for various reasons such tax relief will not be available if the new owner defaults. The recent decision by the government to cap tax relief has just added to their worries on this score. Therefore, they insist that security for decommissioning costs is given gross, without deduction for tax relief. Effectively, this means that buyers have to give security for government's share of the costs.

Many small companies have to put up collateral to persuade their banks to give the necessary letters of credit, or to deduct it from borrowing limits making less available to invest to develop the asset. In the long run, everyone loses as investment is reduced.

In its budget announcement the Treasury indicated its willingness to try to tackle this issue but it's not an easy nut to crack. One of the features of the UK oil industry is the very high degree of cooperation on industry issues between industry and government, and the working group set up to address this particular problem is a prime example. Recent events may have placed a strain on relationships but both sides are working hard to put things back on track. Perhaps in the process, the industry can persuade the Treasury that in the oil sector things are perhaps not quite as simple as they appear on the surface.