On October 21, 2014, the B.C. government released draft legislation introducing a liquefied natural gas (LNG) income tax (LNG Tax) on liquefaction activities that take place at LNG facilities in the province. The draft legislation provides details of the proposed new tax and answers questions that were left open in the high level discussion of the tax in the 2014 B.C. provincial budget released in the spring. We discussed the proposed tax in our March 2014 Blakes Bulletin: B.C.'s Proposed LNG Tax – Some Answers, Many Questions. In this bulletin we address the changes made to the original proposals and summarize the most significant aspects of the proposed tax.
The government has proposed a new natural gas income tax credit under the B.C. Income Tax Act that will apply to a corporate LNG taxpayer that has a permanent establishment in B.C. The credit will allow a maximum reduction in the corporate income tax rate to 8% from the general 11% rate, but the amount of the credit is limited to 0.5% of the cost of natural gas acquired. The credit will apply only to corporations, including corporate partners of partnerships carrying on LNG activities.
This is a summary of the proposed tax:
- The LNG Tax will be a two-tier tax
- The Tier 1 tax will be 1.5% of "net operating income" (revenue less expenses, with a partial deduction of an adjusted capital investment account (as described below) based on a rate to be prescribed)
- The Tier 2 tax will be 3.5% of the amount by which aggregate net proceeds exceeds the amount of the capital investment account (as described below), meaning that no Tier 2 tax will be payable until the capital investment account has been recovered. The Tier 2 rate will increase to 5% for taxation years beginning on or after January 1, 2037.
- The Tier 1 tax paid will be deductible against the Tier 2 tax with the exception that the tax for any given year cannot be reduced below the Tier 1 tax. In this way the Tier 1 tax will operate like a minimum tax.
- The LNG Tax will apply to taxation years beginning on or after January 1, 2017
- The LNG Tax will be calculated on a facility-by-facility basis
- The LNG Tax will apply to the liquefaction of natural gas for export as well as domestic consumption.
Generally, the structure of the LNG Tax is the same as that proposed in the 2014 B.C. provincial budget, incorporating elements of both the B.C. Mineral Tax Act and the federal Income Tax Act, but the draft legislation adds detail to what was a very general outline of the tax in the 2014 B.C. provincial budget. The highlights of the draft legislation are the reduction of the Tier 2 tax rate from 7%, the addition of a partial deduction of the capital investment account in the computation of Tier 1 tax and the addition of transfer-pricing rules and detailed valuation rules relevant in computing the income subject to the tax. In addition, many of the questions posed in our previous bulletin have been answered. Below we provide some of the answers to our previous questions and review important points related to the new tax.
How will income subject to the LNG Tax be determined?
Generally, a taxpayer will be subject to the Tier 1 LNG Tax on net operating income from an LNG source and the Tier 2 tax on net income from an LNG source. Both net income and net operating income are based on a determination of the taxpayer's income for the taxation year from a business or property that is in respect of the LNG source. The determination of income is based generally on the provisions of the federal Income Tax Act but with numerous modifications, including:
- No deduction for capital cost allowance; instead, a deduction is allowed for capital costs by means of the capital investment account, in the case of net income, and the adjusted capital investment account, in the case of net operating income
- No deduction for any type of financing charge, including interest
- No inclusions or deductions for income derived from hedging activities
- No inclusions or deductions for income or loss derived from foreign exchange fluctuations.
How will the capital investment account be determined?
The capital investment account will generally include the cost of all capital investment property, which includes tangible and intangible personal property connected with LNG activities other than debts, shares and trust interests less proceeds received from sales of such property.
For purposes of determining net income to which the Tier 2 tax will apply, a deduction of up to the entire amount of the capital investment account will be allowed with the balance reduced by deductions taken in previous years. In this way, Tier 2 tax will not apply until a taxpayer has recovered the full amount of its qualifying capital expenditures.
For purposes of determining net operating income to which the Tier 1 tax will apply, a deduction will be allowed of an amount in respect of an adjusted capital investment account, which will include only tangible, as opposed to intangible, capital investment property. The amount deductible will be based on a prescribed rate multiplied by 75% of the balance in the adjusted capital investment account. Unlike the capital investment account, the adjusted capital investment account will not be reduced by amounts claimed in prior years. The prescribed rate has not been released.
How will the cost of gas be determined?
The LNG Tax generally seeks to tax the income attributable to the liquefaction process including the increase in value of the natural gas, if any, derived from that process.
The cost of natural gas purchased from an arm's-length person within a feedstock pipeline or at the inlet to the LNG facility will be valued at the amount paid for the gas adjusted for any transportation costs within the feedstock pipeline.
Where natural gas is owned by the same person that owns the LNG facility, such that no actual sale occurs when the natural gas arrives at the inlet to the LNG facility, a sale will be deemed to have occurred and the cost of the gas will be determined based on a reference price set monthly by the Minister of Natural Gas Development using the market price of natural gas at Spectra Station 2 adjusted for transportation costs to the LNG facility.
The cost of other natural gas, such as natural gas purchased from a related party or purchased upstream from the feedstock pipeline, will be determined based on the reference price adjusted for transportation costs to the LNG facility.
How will revenue from the sale of gas be determined?
In determining revenue, a deemed sale will occur if the taxpayer owns liquefied natural gas, natural gas liquids, or natural gas immediately before and immediately after it leaves an LNG plant. Such a sale is then subject to the transfer pricing rules (described below).
If the gas is sold to an arm's-length party when it leaves the LNG plant, the sale will be considered to have occurred at the price set between the parties.
How do the transfer-pricing rules work?
The LNG Tax contains transfer-pricing rules that apply in determining the cost and sale price of natural gas after it passes through an LNG facility between non-arm's-length parties and may also apply to internal dealings within a taxpayer. The approach is novel in that it deems different "activities" carried on by a taxpayer to be separate taxpayers with respect to the "dealings" between those activities. These rules, unlike most transfer-pricing rules, do not require non-resident parties to be involved.
In addition to the situations described above, the transfer-pricing rules will also apply to other transactions between non-arm's-length taxpayers related to an LNG facility, such as payments for services and rent.
How will interest expense be treated?
In our previous bulletin, we mentioned that, while interest expense is generally deductible under the federal Income Tax Act, the B.C. Mineral Tax Act allows for an increase to the capital investment account by an amount of imputed interest. In contrast, the LNG Tax will not allow any recognition of interest expense or any other "financing charge" in the computation of income or the addition of notional interest expense to the capital investment account.
What are the implications where an LNG facility is subject to a lease?
Liquefaction activities include owning an LNG facility, therefore, it seems that rent received for the use of an LNG facility will be subject to the LNG Tax. The lessee of the LNG facility should be able to deduct lease payments made to the lessor in determining income subject to the LNG Tax.
How does the LNG Tax apply where the LNG facility processes gas for a fee?
The LNG Tax will apply to income from liquefaction activities carried out at or in respect of an LNG facility. Liquefaction activities include acquiring, owning or disposing of liquefied natural gas, natural gas liquids or natural gas that is at an LNG facility and operating all or part of an LNG facility, among other things. Therefore, the LNG Tax will apply to persons that merely operate an LNG facility where such persons do not actually own the natural gas being processed by the facility. The LNG Tax will apply to income earned by such a person from the operation of the LNG facility. In addition, the LNG Tax appears to apply to income earned by the person who owns the natural gas even if it is processed at an LNG facility operated by another party. In these circumstances, an owner of natural gas may have no capital investment amounts to deduct against income and so would be immediately subject to the Tier 2 tax.
The answers to this question and the previous question suggest the breadth of application of the LNG Tax. Persons involved with LNG facilities will need to confirm whether they have income from liquefaction activities and so are subject to the LNG Tax.
How are entities other than corporations taxed?
Partnerships will be treated similarly under the LNG Tax and the federal Income Tax Act, with partnership income computed at the partnership level while being subject to tax at the partner level. However, rather than incorporate the federal income tax provisions applicable to partnerships, the LNG Tax provides its own rules.
Trusts will be deemed to be individuals for purposes of the LNG Tax and are not permitted to deduct distributions to beneficiaries from income subject to the LNG Tax.
Will the LNG Tax be deductible for federal income tax purposes?
Based on the draft legislation it is unlikely that the LNG Tax will be deductible for federal income tax purposes unless a specific provision allowing such a deduction were to be introduced. Although such a specific provision does exist with respect to provincial mining taxes, there is no indication at this time that the federal government intends to allow such a deduction with respect to the LNG Tax. Likewise, federal and provincial income taxes are not deductible for purposes of the LNG Tax.
What is missing?
As originally announced in the spring, the proposed legislation contains the substantive measures regarding implementation of the LNG Tax, but does not contain administrative and enforcement measures. Such measures would include more detail on filing requirements and timing of remittance of tax. In the spring, the government stated that administrative and enforcement measures would be released in 2015. Regulations should also be released that will contain, among other things, the prescribed rate relating to the adjusted capital investment account deduction under the Tier 1 tax.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.