UK: Tax Reform, Captive Insurance Companies and Capital Allowances - Recent Developments

Emma Nendick of Herbert Smith’s Taxation Department takes a look at three recent developments in UK tax law affecting energy companies, namely changes that are likely to flow from a current Inland Revenue consultation; tax changes affecting captive insurance companies, and the significance of a Court decision relating to capital allowances.

In August 2002 the UK Inland Revenue published a consultation document which proposes significant changes to the UK company tax system. We have outlined below how the changes may affect oil and gas companies, utilities and financiers.

The main effects of the proposals:

• The move to an accounts-based system of tax depreciation will prejudice companies which do not depreciate equipment or land on their balance sheets or who write them down at a slower rate than they currently claim capital allowances (4% per annum straight line basis for assets with an economic life exceeding 20 years, 25% per annum reducing balance for other equipment).
• The taxation of all returns on land, buildings and equipment, including sale proceeds, as income will mean that indexation allowance (an allowance for inflation) will no longer be available on the sale of an asset. This will have the effect of increasing the tax liability on the sale.
• Revaluations reflected in the accounts would be taxable.
• It is possible that a form of "rollover" relief on disposals may be available, which would allow companies to defer paying tax on a sale provided the proceeds were reinvested in other land, buildings or equipment.

The consultation document makes no explicit reference to non-resident companies. However, gains made by nonresidents on the sale of North Sea assets are already within the UK tax net. On that basis, the effect on non-resident North Sea operators may be similar to those outlined under "UK oil and gas companies and UK utilities" above.

The absence from the consultation document of specific reference to non-resident companies makes it difficult to be definitive in this area. Overseas companies with a UK branch or permanent establishment ("PE") are currently subject to UK tax on gains on assets located in the UK and used in the trade of the UK branch/PE. It is logical that those assets would also be brought into the new accounts-based income regime.

Arguably of more concern is the position of overseas companies without a branch or PE in the UK. Currently such companies are not subject to UK tax on the disposal of capital assets located in the UK, such as land and buildings. By contrast, non-residents are generally taxed on UK source income. The proposal to tax gains as income could therefore for the first time expose non-UK resident companies with interests in UK land, buildings, equipment or certain shares to a UK tax charge on sale of the assets.

The impact of the proposals on leased assets is not covered in the consultation paper and is explicitly made the subject of further consultation. It is clear however that a move to an accounts-based depreciation regime may have considerable impact on the economics of finance leasing.

A transitional regime for the move to an accounts-based system of taxing capital assets is clearly contemplated. The document suggests that companies which acquire assets on or after the commencement date for the new regime would be taxed under the new rules in respect of those assets. Assets already held on the commencement date would continue to be taxed under the existing capital gains regime, unless the company marks the asset to market. This means that companies with long-term interests in land, buildings or shares may be subject to a long transitional period, with compliance cost implications.

That said, the document gives no indication of when or in what order any changes may be introduced. Overall, the document is short on detail in many places, particularly on the implications for non-residents and for finance leasing. This first consultation phase closes on 29 October 2002 and the proposals will almost certainly be refined as a result.

The use of captive insurance companies is relatively common in the oil and gas sector. Recent UK tax changes may make captive insurance companies located in Ireland less attractive.

Captives are often located offshore in order to take advantage of relatively benign tax and regulatory regimes. However, a UK company with an interest in a captive will need to ensure that the UK’s controlled foreign companies ("CFCs") rules do not have an adverse effect on the structure. If the CFC rules apply, the UK company will be taxed on its share of the profits of the CFC. The CFC rules confer automatic exemption where the overseas company is located in certain specified jurisdictions. This used to include Irish companies which satisfy certain conditions – Ireland has therefore been a popular location for captives.

From 11 October 2002, companies located in Ireland will no longer be automatically exempt from the UK CFC charge. The change has been made as a result of changes to Irish tax rules.

Companies with captives located in Ireland therefore need to consider whether they may qualify for another CFC exemption, or alternatively, consider moving the captive to another exempt jurisdiction.

In the longer term, the UK proposals to tax all gains as income (see "UK may extend accounts-based taxation to all assets" above) may increase the CFC tax charge on all UK companies with an interest in a CFC which does not qualify for an exemption from the CFC charge. This is because currently only the income of a CFC is subject to the CFC charge – gains are excluded. Bringing remaining gains within an income regime may therefore result in a greater CFC tax charge.

The UK High Court has recently decided in this case that capital allowances were not available to the finance lessor of a gas pipeline because, in the Court’s view, the lessor did not incur the expenditure on the provision of the pipeline. Instead the expenditure was incurred on creating a network of financial obligations such that the lessor would receive cashflows over a number of years which would recoup its outlay, plus a profit.

This decision has sent shockwaves through the leasing industry, but is it as bad as it seems?

The facts of the case are complex and the reasoning difficult to follow in places. That said, it appears that the key factors which tipped the balance against availability of capital allowances were:

• The lessor did not provide "upfront" finance for the acquisition of the pipeline – the transaction was effectively a sale and lease-back as the pipeline was already owned by the lessee. Upfront finance leasing would therefore seem to be largely unaffected by the decision.
• Nor was the transaction, it seems, a refinancing of borrowings originally taken out by the lessee to acquire the pipeline. The sum received by the lessee was not used to repay existing debt or to finance transactions or activities of its business. Such "bona fide" refinancings would also seem to be unaffected by the decision.
• Both the upfront capital money flows and the income cashflows during the primary period of the lease were almost completely circular. This degree of circularity is therefore best avoided.

© Herbert Smith 2002

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