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Bareboat Tax

News / / Bareboat Tax

If a drilling contractor is non-resident in the UK it is only subject to tax on profits or gains from “exploration or exploration activities” which are defined as “activities carried on in connection with the exploration or exploitation of so much of the seabed and subsoil and their natural resources as is situated in the UK or a designated area.

Most mobile rigs working on the UK Continental Shelf (“UKCS”) are bareboat chartered into the operating company from an overseas owner within the world-wide group resident in a low-tax jurisdiction. Traditionally HM Revenue & Customs has accepted that where a rig is bareboat chartered, the owner is not carrying on “exploration or exploration activities” in the UK or the Continental Shelf and, therefore, the associated rental costs may be claimed as a deduction against the UK profits of that contractor.

This all changed on 5 December 2013, when the Chancellor of the Exchequer, George Osbourne stated that the Government would “end the abuse of... offshore oil and gas contracting...”.

Measures

George Osbourne confirmed in the Budget on Wednesday, 19 March 2014 that the Government intended to cap the amount deductible for intra-group leasing payments for large offshore oil and gas assets and introduce a ring fence to ensure that the resulting profit is not reduced by tax relief from unconnected activities. The legislation will therefore see profits previously claimed as a deduction, taxed at standard corporation tax rates.

Following a consultation with the industry the government published draft legislation on 1 April 2014 which sought technical comments up until 9 May 2014. The final legislation will be enacted by the Finance Bill 2014 and the Government will review the impact of the legislation a year after its implementation.

The legislation provides that in respect of leasing payments made on or after 1 April 2014, there will be a “hire cap” of 7.5% of the historical capital cost of the asset which is subject to the lease and that the pro-rata calculation will be based on a worldwide utilisation of the vessel. In addition, contrary to previous statements, the scope of the measure will be limited to drilling rigs and flotels.

Reaction

Unsurprisingly the proposal and announcements have been met with a good deal of hostility within the industry and also from the Scottish Government. It is expected that any unilateral action taken by HM Revenue & Customs and HM Treasury which increases the tax burden on rig owners will be passed on to the operators. However, discoveries in the UKCS are smaller than other areas competing for investment and exploration is currently at the lowest it has been in the history of the industry in the UK. Therefore, even with a pass through there is a real danger that a higher tax regime will directly affect day rates that contractors can hope to achieve if operators choose to look elsewhere.

What do you do?

This legislation will be a prima facie change in the law. Where the law changes and creates a new liability, such liability will fall with each party as the contract provides. If the contract is silent, it will be a matter of construction and interpretation to determine with whom the parties intended the liability to fall. However, we would expect most contracts to contain a change of law clause either as a standalone clause or within the tax provisions that will determine which party will be responsible for picking up the cost of any change in the tax law.

Contractors currently negotiating contracts need to ensure that any liability resulting from a change in tax law falls to the operator from the point that a bid is submitted up until the contract is executed. Key points that should be considered when drafting a clause include:

  •  a proper definition of “change of law” that captures the anticipated measures but does not affect the force majeure provisions or any other rights of termination under the contract;
  •  a proper allocation of risk expressly stating which party should bear the costs of the anticipated change to the tax regime;
  •  who will determine when and if a change in the tax law has occurred; and
  •  the inclusion of a mechanism to determine how contractors should be compensated for any loss of profit brought about by the Government’s measures.

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