If a company extracts oil then, even if this is done on behalf of a fellow group member holding the production licence, all of its service income – including that derived from administrative, engineering and technical support services - falls within the ring fence higher rates of tax.
That is the effect of the First-tier Tribunal’s decision in Centrica Energy Storage Limited, costing the taxpayer an additional £5 million and carrying significant implications for groups that structure their UK oil and gas operations through associated service companies.
Background
CESL operated and maintained the Rough gas field assets on behalf of its wholly owned subsidiary, COUK, which held the production licence. Under a Services Agreement, CESL provided all services and works required to produce recoverable gas from Rough and was reimbursed at cost plus a 15% mark-up.
CESL treated the income from those services as falling outside the ring fence and therefore subject only to the main rate of corporation tax, but HMRC disagreed. It concluded that CESL’s activities constituted “oil extraction activities” within the meaning of section 272(3) CTA 2010 and were therefore subject to ring fence corporation tax (at 30%) and the supplementary charge (at 10%).
Two questions arose: must the company performing the oil extraction activities hold the licence or have a beneficial interest in the oil to fall within the ring fence, or is it sufficient that the company is physically extracting oil under a licence held by an associated company?
And which of the provided services qualify as "oil extraction activities"? Here, this included administrative, engineering and technical support services.
RFCT and SC apply regardless of interest held
The Tribunal was categoric: the statutory language was “clear and unambiguous” and encompassed a company that physically extracts oil under rights held by an associated company, regardless of whether it has any interest in the oil itself.
The Tribunal’s reasoning confirms HMRC’s broad reading of section 272(3): what matters is the nature of the activities and the corporate relationship, not whether the company performing the work holds any interest in the oil or gas.
Ring fence extends to all services supporting extraction
A critical finding was that “oil extraction activities” encompass not merely the direct physical act of removing hydrocarbons from the ground, but the entire suite of ancillary services, including administrative, engineering and technical support, where those services are carried out by a company associated with the licence-holder.
The Tribunal held that all services provided under the Services Agreement were “sufficiently proximate and operationally integral” to extraction to constitute "oil extraction activities" and that there was “no sensible dividing line” beyond which those services fell outside the ring fence. Its refusal to draw a line between “core” extraction and ancillary support significantly limits the scope for apportionment of the fees between oil and gas extraction activities and other matters.
The third-party distinction
It is the connected-party relationship that brings these ancillary services within the statutory definition. Had CESL not been associated with the licence-holder, its 15% mark-up would not have been a ring fence receipt. Because CESL is associated with COUK, however, all of its receipts under the Services Agreement were held to be for “oil extraction activities” and therefore subject to substantially higher rates of tax.
This produces a striking difference between the position of connected and third-party contractors. Under the Tribunal’s reasoning, the provision of identical administrative, engineering and technical services will constitute “oil extraction activities” only when performed by connected parties.
One can understand the rationale of allowing oil extraction losses of a company to be set against profits of the licence holder, with the corollary that the company must also be within the ring fence for the purposes of its profits. However, with the introduction of the supplementary charge (10%), retention of the ring fence corporation tax rate at 30% while the main rate reduced, and now the Energy Profits Levy (currently at 38%), the associated/unconnected third-party distinction is now commercially very significant.
Commercial implications
Groups operating in the UK oil and gas sector through structures in which an associated company, rather than the licence-holder itself, provides operational services should review their tax positions as a matter of priority. The decision makes clear that income earned by such companies in connection with extraction may attract ring fence corporation tax, the supplementary charge and, for accounting periods from 26 May 2022 onwards, the Energy Profits Levy. The combined rate differential is substantial and the financial exposure may be material.
Groups may wish to consider the extent to which ancillary activities could sensibly be outsourced to a third party rather than remaining within the group, while recognising that this will have other commercial implications which may offset the more attractive ring fence position.
The breadth of the Tribunal’s findings on the scope of services covered is also noteworthy. Groups that have allocated only a portion of associated-company service income to the ring fence, on the basis that certain support services are too remote from extraction to qualify, should recognise that this approach may not withstand challenge. The Tribunal was unwilling to apportion the fees to different services where these were provided under a single contract directed at production operations.
Other author: Nicholas Gardner, Partner
