Breaking shale

Mark Howard and Martin Griffiths explain how tax breaks should kick-start shale exploration.

The government is embarking on a journey to introduce new tax reliefs for the shale gas sector. It published a consultation on 19 July 2013 proposing a variety of tax breaks. While shale could represent a means of extending security of supply, many have balked at likely high costs compared with more conventional techniques.

The most significant of its proposals is to reduce the effective rate of tax from 62 per cent to 30 per cent on income generated from shale gas, but the proposed regime provides a number of further subtleties of interest to the broader UK oil and gas sector. This could be the start of a long and bumpy road navigating various political, economic and social issues.
Currently, profits derived from conventional oil and gas extraction can be taxed at 62 per cent, which is levied through two separate charges:

•    on “ring fence” profits (generally all the profits from oil exploration and production activity), at 30 per cent;
•    a supplementary charge of 32 per cent.

In addition, some enterprises may fall within the petroleum revenue tax regime (PRT), which is charged on the profits of individual fields. Though PRT was abolished for fields given development consent on or after 16 March 1993, for those still falling within the regime the effective tax rate may be as high as 81 per cent.

To counteract the prohibitively high cost of setting up shale gas operations, the consultation is proposing that similar allowances from the supplementary charge will be available for expenditure incurred in setting up shale gas “pads”. Production income from shale gas will be exempt from the supplementary charge in proportion to the amount of capital expenditure on the pad site. This aims to acknowledge the disproportionately high costs involved at the commencement of activities.

However, matters are not as simple as just providing an allowance within the existing legislation, because shale gas fields do not necessarily have clearly delineated boundaries, as is the case for more conventional fields. The proposals are therefore for the allowances to apply at “pad level”, that is, upon each particular drilling site.

The new regime is envisaged to operate as follows. A company owns two pads, both of which have yielded a profit of £100,000 in the tax year. Significantly greater expenditure was incurred on pad 1 for geological reasons, so let’s say £120,000 was incurred on pad 1 and £50,000 on pad 2. It is expected that all of pad 1’s profit would be exempted from the supplementary charge, with the excess of £20,000 being carried forward. Only half of pad 2’s profit would be exempted from the supplementary charge, with the remaining £50,000 being subject to the rate of 62 per cent. The excess expenditure from pad 1 could not be applied against pad 2’s profits.

However, pad allowance is only attractive where there are profits against which to offset allowances, which is likely to be several years away for shale gas. To combat and complement this there are two important proposals:

•    Conventional oil and gas companies may use the allowance across their existing conventional business income within the “ring-fence”, for example, profit from the UK continental shelf. This means that established businesses can benefit their existing business, while planning for future income streams from shale gas.
•    The extension of the existing regime of losses.

In addition to allowances from the supplementary charge, conventional oil and gas companies benefit from enhancements to pre-trading expenses. Such expenditure is uplifted by 10 per cent and is available to offset against profits for up to six accounting periods, within the ring-fence.

The government is proposing that such tax breaks go further for shale gas and companies may carry such losses forward for up to ten accounting periods. The proposed extension of the period within which losses can be utilised reflects the fact that the lead-in time for shale gas sites to become profitable may be longer than for conventional sites.
However, before businesses rush to jump aboard, they are likely to wish for greater certainty regarding the proposals. In particular, the size of the exemption from the supplementary charge is yet to be announced and given the likely costs involved in starting up, it is likely to take more than a token gesture to convince established businesses that the time is right to invest in shale.

Mark Howard, partner, and Martin Griffiths, associate, at Charles Russell LLP