EXECUTIVE COUNCIL

CONFIDENTIAL

Title of Report:

Oil Readiness Review –Tax Legislation

Paper No:

71/13

Date:

26 March 2013

Report of:

Financial Secretary

1.0 Purpose

1.1 To present policy recommendations following the review of oil and gas related

taxation legislation.

2.0 Recommendations

2.1 Honourable Members are recommended to give approval:

(a) To engage appropriate consultants to undertake further consideration of the

following specific areas recommended as needing review:

Valuation of petroleum (5.4.1);

Taxation of contractors and relief for leasing costs (5.4.2);

Tax relief for financing costs and interest payments (5.4.3);

Definition of intangible drilling costs for 100% first year allowances

(5.4.4);

(b) For the recommended minor amendments to correct ambiguities and

inconsistencies in legislation outlined in the Appendix to be passed to the

Attorney General’s office for the preparation of draft legislation;

(c) That the following tax policies are adopted/continued:

No changes to the legislation regarding decommissioning expenditure

(5.3.1);

No reinvestment relief will be allowed (5.3.2);

No indexation relief (5.3.3);

The taxation of gains on share disposals will remain within the ring fence

(5.3.4);

The commencement of a ring fenced trade is when the decision is taken to

proceed with commercial development (5.3.5);

The Royalty regime is not amended (5.3.6);

The valuation of hydrocarbons will be at export point on a standard FOB

(free-on-board) basis (5.4.1);

Adjusting for hedging or derivative activities will not be allowed in the

valuation of hydrocarbons (5.4.1);

Depreciation Allowances (Writing Down Allowances) on capital

equipment will be based on the overall cost and life of a rig (5.4.2);

That no changes will be made to the treatment of base costs for capital

gains purposes (6.3.1).

(d) Note the letter from Falkland Islands Petroleum Licensees Association (FIPLA)

Tax Working Group and the responses proposed in 6.0;

3.0 Summary of Financial Implications

[Redacted for tendering purposes]

4.0 Background

4.1 Following a tender process for the Oil Readiness Review, Aberdeen University

Petroleum & Economic Consultants (AUPEC) were engaged for Lot1: Review of

Tax Legislation to undertake a review to identify possible ambiguities or

inconsistencies within current Falkland Islands tax legislation relevant to oil and

gas development. In addition the review was required to deliver a set of

recommendations on future policy and legislation for FIG.

4.2 The report sets out a number of suggested policy recommendations and these are

summarised as follows:

1. Allowance of decommissioning expenditure requires attention;

2. Reinvestment relief within the ring fence is not appropriate at this time;

3. Taxation of gains on share disposals should remain within the ring fence;

4. A statement on the commencement of trade within the ring fence is

needed;

5. Valuation of hydrocarbons should take place at the export point;

6. Measurement of taxable profits of contractors should be simplified;

7. Protection against interest and intergroup charges should be introduced;

8. No reason to amend the Royalty provisions.

4.3 The report also sets out a number of other issues and minor amendments to

legislation and those that are recommended for immediate inclusion in the

drafting priorities list are set out in the Appendix. There are a few areas which

require further work. The majority of these can be resolved internally between

FIG Taxation Office, Attorney General’s Chambers and the contracted resources

of HMRC Oil Specialist and Tax Legislative Drafter It is suggested that these

form part of the drafting requirements but that any policy decisions falling out of

this working group review are submitted to ExCo in due course.

4.4 One issue discussed in the body of the report is considered to be high priority and

requiring more in-depth policy review (Intangible Drilling Cost Definition). This

has been included in the FIG review below (5.4.4).

5.0 FIG review of AUPEC recommendations

5.1 One clear piece of advice from the Norwegian Ministry of Petroleum and Energy,

Norwegian Ministry of Finance and the FIG Specialist Oil and Gas Advisor is to

give clear and firm policy decisions on taxation issues. This prevents negotiation

confusing the issue and gives the oil industry (and their future investors) some

assurance that the tax regime will not be continually changing.

5.2 Some of the recommendations from AUPEC are caveated with the phase “not at

this time”. It is suggested that in these cases, where also supported by HMRC

and the FIG Specialist Oil and Gas Advisor, that these policy issues are stated

outright.

5.3 It is proposed that the following recommendations are accepted without need for

further review:

1. Decommission expenditure

5.3.1 AUPEC note that Decommissioning relief is an end-of-field-life decision and is

unlikely to affect a commercial decision to develop. This view has been echoed

by the Tax Office’s HMRC oil specialist. At present allowances are available

and can be carried back for three accounting periods. The UK have extended this

time frame effectively allowing higher tax deductions. Given the stage of the

Falklands basin no change to the legislation is proposed.

2. Reinvestment relief within the ring fence is not allowed

5.3.2 Reinvestment relief has been introduced in other regimes where the basin has

been in decline to encourage further exploration and development. The Falklands

are not in this situation. The recommendation not to allow reinvestment relief has

also been supported by the HMRC oil specialist and FIG’s Specialist Oil & Gas

Advisor.

5.3.3 AUPEC also recommend that the Falkland Islands should not give indexation

relief on past costs due to the stage of development of the basin. Again this is

supported by FIG’s Specialist Oil & Gas Advisor.

3. Taxation of gains on share disposals should remain within the ring fence

5.3.4 AUPEC see no need for Falkland Islands legislation in this area to be amended

to match UK legislation. Leaving the legislation as it is at present allows the

Falklands Islands to tax any harvesting of its natural resource.

4. A statement on the commencement of trade within the ring fence is needed

5.3.5 AUPEC advise a statement should be made on the commencement of trade.

Such a statement has been issued in the past to the Falklands Offshore Sharing

Agreement Group (FOSA) in 1998. FIG see no reason to amend this statement

and therefore the commencement of trade would be treated in line with the UK

practice i.e. what used to be referred to as “Stage 3” (now replaced by HMRC

OT20250) that is the decision to proceed with the commercial development of a

discovery (as opposed to the decision that commercial development is considered

worthwhile) determines the date trade commences. It is therefore recommended

that the previous policy is maintained and communicated to the oil industry.

8. Royalty provisions are not amended

5.3.6 AUPEC see no reason for this to be amended as the Falklands have an industry

wide low corporation tax and the royalty provides an early yield and significant

element of the overall tax take.

5.4 The following items require some element of further review prior to the full

policy advice being made:

5. Valuation of hydrocarbons should be at export point

5.4.1 AUPEC recommend that the valuation of hydrocarbons should be at the export

point on the standard FOB (free-on-board) valuation and that no adjustment for

hedging or derivative activities should be allowed. The principles of this are

strongly supported by HMRC and FIG’s Specialist Oil and Gas Advisor and it is

recommended that these policies be made at this point.

However, the method for the actual valuation requires defining.

6. Measurement of taxable profits of contractors should be simplified

5.4.2 AUPEC have recommended that this legislation should be simplified and

clarified with particular reference to permanent establishments, double tax

agreements, measurement of profits and capital allowances. AUPEC do not

recommend that the Falklands adopt practices similar to the UK statement of

practice on bareboat charters and support the Falkland Islands Tax Office (and

HMRC) recommendation to calculate writing down allowance based on the cost

and life of a leased asset. Whilst a policy recommendation can be made on the

latter of these at this time further work is proposed on the wider issue of

contractors’ taxation (including leasing costs). The FIG Specialist Oil and Gas

Advisor has also recommended that clarity is provided to the industry on leasing.

7. Protection against interest and intergroup charges should be introduced

5.4.3 AUPEC recommend additional, more restrictive, protection be introduced

against interest and intergroup charges which can often be used to transfer profits

to a lower/zero tax jurisdiction. This is supported by HMRC however further

information on how this can be achieved is required therefore it is recommended

that further work be undertaken in this area.

Intangible Drilling Costs

5.4.4 AUPEC recommends that intangible drilling costs need a clearer definition but

have not provided any details as to what this should be. Further review is

recommended in this area and this is supported by FIG’s Specialist Oil and Gas

Advisor.

6.0 FIPLA Letter

6.1 In early 2013 the Falkland Islands Petroleum Licensees Association (FIPLA) was

created by the oil industry. A sub-group of this was also formed to look at

taxation issues.

6.2 The Head of Policy recently received a letter from the Chair of this sub-group.

At present the only response sent has been a holding response as FIG were

awaiting the AUPEC review to see whether this provided any clarity on the issues

raised. Three main issues were raised in the letter:

Capital Gains Tax – Base relief;

Corporation Tax – Treatment of lease costs;

FIG infrastructure – Liaison and resource.

6.3 Capital Gains Tax – Base Relief

6.3.1 The letter contains a few inaccuracies. Firstly it states that capital gains only

relate to oil & gas where in reality ITQ sales are also subject to capital gains

taxation. The letter goes on to imply that no relief is available for base costs.

This is inaccurate as Section 141 (3) and Schedule 2 paragraph 1 allow for

deductions against the gain. Similar queries have been raised by one Oil

company in recent months and it is believed that this refers to the fact that the

legislation does not allow the farmer out to deduct a cost for the value of the

capital passed to the farmer in. The reason for this is to avoid double relief being

given; once in the capital gains computation and again as capital expenditure in

the depreciation allowance pool of the farmer in.

6.3.2 No change to this is recommended and the response should be as such.

6.4 Corporation Tax – Treatment of lease costs

6.4.1 The treatment of lease costs (primarily in terms of an FPSO lease) are one that

FIG TO have been aware of for a while and were hoping that the AUPEC review

would resolve. This hasn’t been the case and this is covered in the

recommendation detailed in 5.4.2.

6.5 FIG Infrastructure – Liaison and resource

6.5.1 FIPLA raise concerns over having a specific contact for queries. The point of

contact continues to be the Head of Taxation, though as this post has been vacant

for a number of months this could have been the reason for the concern.

Recruitment for this post has finished and the postholder is expected to arrive in

June 2013.

6.5.2 However, the Taxation Office has one tax specialist resource which is an HMRC

Oil Specialist on contract. During the recruitment for the FIG Specialist Oil and

Gas advisor it became apparent that there are individuals in the market who have

oil tax experience from the industry side. It may be worthwhile appointing an

individual on a retainer basis to be able to provide advice on the policy decisions

that are coming over the future months. This would be to complement the advice

and work provided by HMRC with a focus on policy rather than assessment and

would also provide FIG with insight from both views i.e. tax authority and

industry background.

6.5.3 The AUPEC report also discusses whether there is a need for a comprehensive

oil tax manual. This seems a sensible idea, however it is recommended this is

undertaken once the further review has been completed.

6.6 Other issues raised

6.6.1 The letter also raised the following issues which have been covered in the

AUPEC report above:

Market price for crude sales – see 5.4.1;

Intangible versus tangible costs – see 5.4.4;

Indexation relief – see 5.3.3;

Reinvestment relief – see 5.3.2.

7.0 Financial Implications

7.1 Should approval be given for the next review stage a closed tendering process

will commence. This will target organisations known to undertake such work

and be closed only due to the sensitivities around oil work in the Falklands. All

other tendering instructions will be complied with.

7.2 It is recommended that further funding be approved for the appointment of

retainer advice on oil taxation.

7.3 As a result of savings made on another of the legislative reviews some of this can

be funded from existing budgets in 2012/13.

8.0 Legal Implications

8.1 At present it is not believed that there is a need for legislation to be drafted for

these policy decisions as the majority are the decision to not change the

underlying legislation. Some drafting will be needed to make the minor

amendments and potentially in the future to incorporate the full review decisions.

9.0 Human Resources Implications

9.1 None for the purposes of this paper.

AUPEC Report on Taxation Legislation

Appendix

Minor Amendments

Title 69.1 - Taxes Ordinance

Section 28(7) Corporation tax rates This refers to the “lower maximum amount” while the previous text refers only to the “threshold amount”. Recommendation: replace “lower maximum amount” with “threshold amount”.

Section 40(1)(b) Set-off of losses against surplus of franked investment income This refers to S. 39(3), which has been repealed. Recommendation: delete subsection 40(1)(b) and change “(c)” to “(b)” in the subheading of paragraph 40(1)(c). Section 44(5) Changes in rate of ACT and payment of ACT This refers to subsection 47(2), which has been repealed. Recommendation: delete “Subject to section 47(2),”. Section 49(1) Tax credits for certain recipients of qualifying distributions This refers to the “basic” rate of income tax while earlier text refers only to the “lower” and “upper” rates. Recommendation: replace “basic” with “lower”. Section 51 Provisions supplementary to section 50iii* This refers in detail to S. 50, which has been repealed, but the situation is clarified by footnote iii. Recommendation: delete subsections 51(1) to 51(5) inclusive but leave the heading and footnote in place, inserting “*Spent+” in the way that other sections are marked “[Repealed]”. Compared with deletion this has the benefit of avoiding the renumbering of all later sections and references to them. Section 57(1)(p) Exemptions The word “and” implies that paragraph 57(1)(q) is the end of the list while in reality paragraph 57(1)(s) is. Recommendation: delete “and”. Section 70(5)(b) Carry-forward of relief This refers to section 66, which has been repealed. Recommendation: delete paragraph 70(5)(b) and remove “(a)” from the previous subheading.

Section 71(1)(b) Non-approved schemes: payments by employers This refers to section 66, which has been repealed. Recommendation: delete paragraph 71(1)(b) and remove “(a)” from the previous subheading. Section 74(2) Commutation of pension This refers to the “basic” rate (of income tax) while earlier text other than subsection 49(1) (see above) refers only to the “lower” and “upper” rates. Recommendation: replace “basic” with “lower”. Section 97D(a) Power to make rules about allowable deductions This paragraph refers to paragraph 97A(1)(g), which does not exist. The reference should be to paragraph 97A(g). Recommendation: delete “(1)” in “97A(1)(g)”. Section 98(7) Restriction on deduction of emoluments before payment This subsection refers to section 94, which has been repealed. Recommendation: delete subsection 98(7). Section 139(6) Interpretation of Chapter IV Two subsections have this subheading. Recommendation: renumber the second subsection 139(6) as subsection 139(7). Schedule A1 P. (2) Low tax territories The subheading of the second paragraph of this schedule is inconsistent with that of the first. Recommendation: replace “(2)” with “2.” Schedule 1A P. 6(4)(a) Exemption and relief from charge under section 100A This sub-paragraph refers to “the donor” whereas the whole of paragraph 6 otherwise refers to disposal by sale. Recommendation: replace “donor” with “seller”. Schedule 1A P. 8(1) At the end of the second line “either?” should be replaced with “either-“. Schedule 1A P. 10(6) This sub-paragraph refers to a person assessed to tax under sub-paragraph (2), which does not refer to assessment of tax. Recommendation: replace “(2)” with “(4).”

Schedule 2A P. 5(2) Provision not at arm’s length This sub-paragraph begins “Subject to paragraph 11(2) below”, which does not exist. Recommendation: replace “11(2)” with “10(2)”. Title 69.1.3 - Payment on Account of Tax (Employees’ Deductions) Regulations

P. 12(1A) Accounting for deductions and payments on account

Two adjacent sub-paragraphs have been given the number 12(1A), as noted in footnote vi to the consolidated text. The second sub-paragraph 12(1A) begins “A person to whom this paragraph applies” whereas it should effectively read “A person to whom the first paragraph (1A) applies”. Recommendation: replace the second “12(1A)” with “12(1B)”, which already exists as does 12(1C), and make all necessary consequent changes.

P. 12(1B) Reference is made at the end of this sub-paragraph to a return “under paragraph (1) above.” Sub-paragraph 12(1) does not refer to a return. Recommendation: replace “(1)” with “(1A)” being the first (1A) in the consolidated text. P. 12(2) This sub-paragraph begins “The reference in paragraph (1)(b) above to deductions”. Sub-paragraph 12(1)(b) does not refer to deductions. Recommendation: replace “(1)(b)” with “(1A)(b)”, being the first (1A)(b) in the consolidated text. P. 12(3) This sub-paragraph refers to a remittance in accordance with sub-paragraph 12(1)(b), which does not refer to a remittance. Recommendation: replace “(1)(b)” with “(1A)(b)”, being the second (1A)(b) in the consolidated text and therefore preferably to be replaced by “(1B)(b)” in line with an earlier recommendation. P. 12B(1)(a) Determination of remuneration and earnings This sub-paragraph refers to a return in accordance with regulation 12(1A)(a). The first sub-paragraph 12(1A)(a) in the consolidated text does not refer to a return, but the second sub-paragraph 12(1A)(a) does. Recommendation: replace “12(1A)(a)” with “12(1B)(a)”, provided the earlier advice to renumber the second sub-paragraph 12(1A)(a) has already been taken. Also, consider for the sake of clarity and consistency whether the word “regulation” should be allowed to replace the word “paragraph” anywhere in this Title, “paragraph” being the being the word generally adopted in it, and act accordingly.

P. 13(5) Information and preservation of records Two adjacent sub-paragraphs have been given the number 13(5), as noted in footnote vii to the consolidated text. Also the word “or.” At the end of the first sub-paragraph 13(5) should be deleted. Recommendation: delete “or.”, replace the second “13(5)” with “13(6)”, and in the new sub-paragraph 13(6) replace “A person to whom this paragraph applies” with “A person to whom paragraph 13(5) applies”. Title 69.1.5 Taxes (Benefits in Kind) Rules

P. 4(8) This sub-paragraph refers to the third column of Table B, a column which does not exist. Recommendation: replace “third” with “second”.

P. 5(2)

The first reference to paragraph (2) occurs within paragraph (2) itself. Recommendation: insert a sub-heading (3) immediately before this reference, re-number subsequent paragraphs accordingly and make any other consequential changes required.

P. 5(6)(a) In this sub-paragraph “but –otherwise they apply” *in respect of rule 3(1)(d)+ should be replaced with “but otherwise it applies”. Title 69.2 - Taxes and Duties (Special Exemptions) Ordinance

P. 9A(4)(b) Exemption of persons in defence-related employment This sub-paragraph begins “may be granted to as to”. Recommendation: replace “to as to” with “so as to”. Title 69.3.1 - Embarkation Tax Regulations

Schedule, P. (3)(e) Persons exempt from payment of the tax This sub-paragraph includes “an employee of the ......... Meteorological Officer ........” All other references are to organisations. Recommendation: replace “Meteorological Officer” with “Meteorological Office”.