THE ADVANCED DIPLOMA IN INTERNATIONAL TAXATION

June 2018

MODULE 3.04 – UPSTREAM OIL AND GAS

OPTION

SUGGESTED SOLUTIONS
 Module 3.04 – Upstream Oil and Gas option (June 2018)

PART A

Question 1

Part 1

Seller Warranties

Warranties are essentially promises that circumstances apply. A breach of a warranty gives
rise to the right to damages under the SPA. The following are examples of seller warranties,
which may be included in the SPA: (candidates need to provide five clear examples to qualify
for full mark on this part of the question)

a) The companies being sold have field with the appropriate Governmental Bodies and
all Tax Returns required to be filed on or before the Valuation Date with respect to its
assets, income or operations;
b) All items of income, gain, loss, deduction, credit and other tax items (the Tax Items)
required to be included in each such Tax Return have been so included;
c) All Taxes owed by the Companies or owed with respect to its assets, income or
operations or owed in connection with the Block Interest Documents, or which are paid
on behalf of the Company by the Operator, including all Taxes required to be withheld
or deposited with a Governmental Body, have been timely paid in full;
d) There are no Encumbrances (other than Permitted Encumbrances) on any of the
Company Assets that arose in connection with any failure (or alleged failure) to pay
any such Tax;
e) As of the Execution Date, neither Seller nor the Companies have been served on any
claim, and to Seller’s knowledge, there are no claims threatened by any applicable
Governmental Body in connection with any such Tax;
f) As of the Execution Date and to the Seller’s knowledge, none of such Tax Returns is
now under audit or investigation by any Governmental Body;
g) As of the Execution Date and Closing, except as provided under the JOAs, the
Companies are not a party to any Tax indemnity or make a payment to any Person in
respect of any Tax for any past, current or future period;
h) As of the Execution Date, Seller has never been served of any claim made by a
Governmental Body in a jurisdiction in which the Company does not file Tax Returns
that it is or may be required to file a Tax Return in that jurisdiction;
i) As of the Execution Date and Closing, the Companies have been treated as a tax
resident of the country of oil operations only;
j) As of the Execution Date an Closing, to Seller’s knowledge, the Companies will not be
required to include any amount of income for any taxable period ending after the
Execution Date as a result of a change in accounting method for any taxable period
ending on or before the Execution Date or pursuant to any agreement with any
Governmental Body with respect to any such taxable period, or to include any period
ending after the Execution Date any income that accrued in a prior period but was not
recognised in the prior period;
k) As of the Execution Date and Closing, the Companies have no permanent
establishment outside the country of oil operations; and

Seller has not been notified of any failure of Operators to operate in full compliance with all Tax
incentive programs applicable to the oil and gas industry in the country of oil operations.

Part 2

Indemnity Clauses

a) The seller may agree to provide buyer with protection on capital gains and transfer
taxes by an indemnity clause in the SPA to confirm that the seller is responsible for
these taxes.

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b) The clause includes liability for taxes prior to closing, but is then extended to liability for
tax on the sale. The clause also extends to potential tax on previous transfers of oil and
gas assets which have not yet been paid.
c) The actual benefit of such protection depends on whether the company giving the
indemnity has sufficient assets to meet the potential obligations, whether the total of
indemnities under the contract is capped at a sufficiently high amount, and whether
there is a sufficient time limit on indemnities under the SPA.

Part 3

Share Sales

a) The negotiation of the SPA is a commercial process, however and there may be
limitations on the buyer negotiating optimal tax clauses. The seller may, for
example, be able to obtain more favourable terms, such as lower financial limit on
tax indemnities, if the buyer is keen to acquire the oil and gas assets.
b) As a threshold issue, there may be a bid letter from the buyer to the seller prior to
negotiation of the SPA. The bid letter may set out the essential terms including the
amount offered to the seller. The bid letter is generally not a contract. However,
there may be legal penalties for failure to proceed with the bid. The bid letter should
therefore provide that the offer is subject to full tax and legal due diligence.
c) The buyer should ensure that the SPA excludes them from liability for the seller’s
taxes on the sale. Care is required to ensure that indirect taxes and transfer taxes
are also excluded. The buyer should also ensure that the SPA allocation
responsibility for taxes prior to closing, contract closing, when final payments are
made, and the title to assets or shares is transferred.
d) The SPA may provide tax indemnifications from the seller, for example that all
taxes have been paid or that there are no outstanding tax disputes, and may
include the amount of tax losses or PSC allowable cost balances. Tax
indemnification can result in specific payments to the seller in case of breach.
However, care is required as to whether the indemnifications are limited in value,
which party is providing the indemnifications, and whether the indemnification is
time limited.
e) The SPA may provide the buyer with the right to intervene in existing tax disputes.
This typically arises where the buyer is not indemnified against additional tax
arising from the dispute.

Consideration should be given to the impact of tax-related items, such as balance of tax losses,
on the closing payment. For example, the purchase price may be reduced if tax losses are
substantially less than represented by the seller. The SPA should also specify which party is
responsible for preparation of corporate tax returns and other tax functions prior to the closing
date.

Source: Abrahamson, J. 2014. Tolley’s International Taxation of Upstream Oil and Gas. First
Edition. Reed Elsevier, GB. Pp, 103-05

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Question 2

Part 1

Ref: Abrahamson 2014 18.1 to 18.21

a) When and oil and gas company has significant production coming from their ongoing
project it should consider the set of a group company for trading of the oil and gas. This
will significantly optimize the cost of using a third party oil trader securing that the
margin or fee charged by a third party remains in the group’s profits. This trading
company will have the objective of not only purchasing and selling of the hydrocarbons
at spot prices, but also entering into forward and option contracts to allow the use of
the best possible prices on acquisition and sale of the product and arranging insurance,
delivery and funding when the required.

b) Given the nature of the profitable activity, oil and gas company normally choose to set
an independent company in a low tax rate jurisdiction or a country where the setting up
of trading companies is incentivised through specific regimes or benefits. This will allow
the profits from the provision of trading services to be taxed at rates lower than the
applicable in the host jurisdiction or in the country where the oil and gas company is a
resident.

c) However, it is very important that the planning takes into consideration the required
economic substance to pursue this activity and make sure the trading company is
properly staffed to deliver the proposed services. This will include local directors,
traders, trading supervisors, transaction execution, risk, performance and capital
management. The compliance with the necessary economic substance requires not
only that these workers are localized in the trading company jurisdiction but that
effectively the decisions and meetings are taken and held in the country. Some of the
other supportive services, like IT and HR may be provided by other group companies
under service agreements as they are less linked to the trading profits.

d) Switzerland, is the world’s most used country for this type of activity and is where some
of the world biggest trading companies are located (e.g. Vitol and Glencore). In this
jurisdiction, trading company normally use the mixed company regime requiring that
the company has its profits arising predominately from foreign activities (around 80%).
IF this is the case, companies can achieve an exemption between 75% to 90% from
Swiss tax, resulting in effective tax rates between 9% and 11%.

e) Singapore has been an up and coming jurisdiction for trading companies to set up in
since 2001. The Government has put in place a Global Trader Program offering a
corporate tax rate of 10% to traders which can be reduced to 5% if certain conditions
are met (e.g. hiring levels and use of national banking facilities).

Main tax and planning issues to consider with these trading company structures are transfer
pricing given that oil and gas normally set up these companies mainly to trade their own oil. So
attention must be paid to finding comparable transactions to assure that the trading activity is
complying with the transfer pricing principles and market prices. This may be difficult to achieve
in situation where the host country oil and gas agreement or PSC impose a specific sales price
(e.g. Norway) for tax assessment and TP purposes.

With respect to Switzerland, on major issue is whether the granted benefits to the trading
company may constitute state aid and be contrary to EU agreements with Switzerland. Also, in
case a new company is set to begin the trading activity with absence of prior experience in the
sector, it may become difficult for the company to secure other business from third parties as
normally sector experience is required and a commercial guarantee which, where the company
has no assets may represent an obstacle to obtaining business.

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Part 2

a) Options – This derivative constitutes a right to purchase or sell oil or gas at a later date.
You can have two types of options: A call is the option to purchase at a later date and
price and a put is the option to sell at a later date and price. The person writing the
option normally charges an option premium or fee. Main tax considerations are whether
the option premium is subject to tax and the moment when tax is paid as, in some
countries, this taxation can be delayed to the future sale of the oil or gas acquired with
the option.

b) Forwards and futures – This instrument is also a right to purchase or sell at a specific
later date. The difference from an options is that there is no contingency or choice as
to whether buy or sell, thus there is no option on whether to exercise it or not. These
derivatives can be openly traded on security exchanges and sold before the forward
date arrives. Main tax consideration on this instruments is the understanding on
whether the gain or loss is taxed as accrued or only when exercised which may vary
from country to country.

c) Plain vanilla swaps – This derivative is intended to exchange financial instruments

between two parties, normally, the cash flow arising from one financial instrument is
swapped with the cash flow of the others party financial instrument. This instrument is
mainly used for hedging transactions where oil and gas companies want to limit or cap
their risk wither on interest rates, oil prices or foreign currency exchange. This is very
significant for companies who do not report in USD as the oil and gas price world
markets runs on USD only. To execute the swap parties normally use a notional
principal amount basis

d) Special swaps (credit default and total return) – Credit default swaps aim to provide
insurance for a company defaulting in their loan obligations and the total return swaps
are an instrument where the holder of the swap can obtain the income and capital gains
from an investment without having to hold the investment directly. This may be used in
situations where there are specific limitations to holding that investment (e.g. Chinese
equity or private companies). Main tax considerations for swaps are withholding tax on
payment to non-residents as the instrument may not be qualified as an interest payment
in some jurisdictions.

Part 3

a) Norm pricing regimes are regimes where the oil and gas company gross income is not
determined on the basis of realized prices but determined with the use of reference
prices put forward by public authorities. This would then be used to determine the
taxable amount on which tax¬ applies. As a general rule, the price determination of the
petroleum produced is left to an independent public body.

b) The justification for States to use the norm price regime is the common interest that
often exists between producer and purchaser and the special market structure. This
could occur in situation where the production activity of oil and gas Is largely sold to
affiliated companies abroad. Thus, to assess whether the prices agreed by affiliated
companies are comparable to those that would have been agreed by two independent
parties, the authorities set norm prices that must be used when calculating taxable
income for the tax assessment. The purpose is to get a valuation of petroleum that
reflects the market price without being affected by an affiliation between seller and
buyer. Another potential reason for States to use a norm pricing regime is to avoid the
volatility in the oil price market by using an average price on a certain period of time.

c) One of the main issues around norm price is the inversion of the burden of proof. In the
case of a norm price, the tax¬payer has to contest the stipulation of this price either by
an administrative appeal or by bringing this before the courts which is different to an
arm’s length case where the tax authorities have to contest the taxpayer’s prices and

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establish some kind of proof that the prices are affected by a relationship between the
seller and buyer.

d) One other issues with norm price regimes is the considerations of the particularities of
the crude oil and costs related to insurance and transportation and timing of sale. As a
general rule, the norm price is established based on a geographic location and does
not take into consideration the specific type of crude. Different crude types have
different handling specification and costs may significantly vary which could mean the
norm price is not adequate to the specific crude oil subject to it. Also, as the oil price is
volatile there may be significant differences between the time of actual realization of
the sale and the period for which the norm price is set by the State creating differences
between realized price and norm price. A final concern of norm prices is the possibility
of the State to artificially inflate the taxable revenue of companies through the use of
artificially high prices creating big gaps between realized price and norm price for tax
purposes.

e) One example of a norm price regime is Norway where the norm price is an important
part of the Norwegian petroleum tax system. The management of this price evaluation
system is done by Petroleum Price Board who stipulate the Norm Prices and the Tax
Authorities who apply such prices in assessing taxable income. The norm price should
correspond to the price at the petroleum could have been sold for between independent
parties in a free market. Another example is Angola where the determination of the
Petroleum Income Tax is made by use of a crude oil valuation at the market price
calculated on the free-on-board (FOB) price for an arm’s-length sale to third parties.
The Ministry of Petroleum and the Ministry of Finance analyse the data and jointly
determine the market price to be used by the oil companies for determination of the
Petroleum Income Tax.

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PART B

Question 3

Part 1

Ref: Abrahamson 2014: 26

Export Duty

a) Export duties on oil and gas are taxes on amounts of production exported from the
producing country. They are generally combined with other taxes, as in the following
example for Russia:
b) A substantial portion of the Russian income from upstream oil and gas is made under
the Export Duty regime at rates from 35% to 60% on crude oil, and natural gas at 30%.
There is no export duty on LNG.
c) The Russian government also impose Mineral Extraction Tax, which are royalties
based on crude oil RUB 446 per tonne, natural gas RUB 509 per 1,000 cubic metres,
etc.
d) Russia also impose Corporate Profit Tax at 20%.
e) The Russian government has provided exemptions from export duty for crude oil with
specific characteristics, and in relation to production from specific regions.
f) Export duties are substantially different from indirect taxes such as VAT, which may
provide exemption for exports.
g) The duty is imposed for the right of the country’s oil and gas, rather than as a tax on
production as VAT.
h) The amounts are imposed as an export duty so that domestic oil and gas prices are
not directly affected, and therefore target large scale oil and gas developments aimed
at generating profits from international oil and gas sale.
i) The issue of oil and gas developments impacting local prices is seen in a large number
of countries. For example the United States, where the potential issuing of LNG export
permits and terminal approvals is expected to increase US domestic prices. The use
of an export duty may partially address this issue by ensuring that part of the taxation
does not apply to domestic oil and gas sale.

Part 2

VAT and import duty

a) Value Added Tax (VAT) is imposed in many countries on the value of a company’s
sales, with the company allowed a credit for VAT paid on their purchase. VAT therefore
applies to the value added by each stage from production to final sale.
b) The export of oil and gas may be ‘zero rated’ for VAT purposes. The result is that VAT
is not chargeable on the export sale, however the company is entitled to a refund of the
VAT paid on its related purchase. Zero rating may then result in a credit refund issue.
c) The oil and gas company may be applying for refunds, as it has paid VAT on its
purchases, but does not charge VAT on its sale where export sales are zero rated. The
issue is whether refunds are allowed, are provided promptly, or there are substantial
delays.
d) There may also be an issue that VAT refunds may be restricted to the related joint
venture, rather than made available to the investing companies.
e) Tax regimes and PSCs may therefore provide specific exemptions from VAT to avoid
this credit refund issue. This may be extended to local suppliers to upstream oil and
gas companies.
f) Alternative methods of indirect taxation include the gross turnover taxes applied in
many states in the United States. These are essentially single stage taxes on the final
sale to the consumer.
g) Customs duties are a significant issue for the importation of oil and gas, and a related
issue is whether there are exemptions from customs duty under international

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agreements. Examples: the related exemptions between Canada, Mexico and the
United States under the North American Free Trade Agreement.
h) Related issues include whether crude oil and natural gas qualify as sources in a NAFTA
country under NAFTA rules of origin. For example, when oil and gas companies blend
crude oil with condensates or diluents from non-NAFTA states to transport the oil by
pipelines, or blend natural gas with gas origination in non-NAFTA states.

Part 3

Countries may also impose significant customs duties on importation of equipment for
exploration and production. Several countries allow specific exemption under PSCs or tax
regimes from indirect taxes such as VAT where equipment used in oil and gas activities is
subsequently exported after use.

Examples: The Brazilian Repetro regime, and the Indonesian Import duty.

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Question 4

Ref: Abrahamson 2014 20.1 to 20.20

a) Transfer Pricing principals, rules and methods are today unavoidable for oil and gas
companies. Most countries in the world have in some or other form adopted transfer
pricing domestic legislation normally based on the OECD principles. Transfer pricing
rules apply on transactions on goods and services between related companies.
According to the transfer pricing principles, a transaction between related parties
should occur at “arm’s length”, generally meaning what would be paid if the parties
were not related.

b) Countries aim to prevent profit shifting to lower tax rate jurisdictions. Where a company
in a high taxing country tries to reduce tax by charging excessive prices for goods and
services purchased from a relate company in a lower taxing country, the transfer pricing
provisions prevent excessive tax deductions for excessive prices by limiting tax
deductions to levels that an independent company would pay for the same goods and
services. This could lead to a double tax situation.

c) This is very important for countries with an oil and gas activity as the sum of government
take in oil and gas is normally higher that other areas of the economy. This leads
companies to look at optimization opportunities for shifting profits from those higher tax
jurisdictions. The transfer pricing rules look at avoiding provision by related parties of
highly leveraged debt finance at above-market interest rates, the claiming of excessive
management fees, deductions for headquarter costs, or consultancy charges paid to
related parties.

d) Oil and gas services is an essential part of the oil and gas activity. These include the
exploration services by way of seismic surveys, geological and geophysical studies but
also drilling services where the oil and gas companies internal team support a hired rig
to drill an identified prospect, to confirm the presence of hydrocarbons in enough
commercial quantity. The key transfer pricing consideration for oil and gas services is
at the time of deducting these costs under the PSC or Petroleum Agreement in the host
country. The services charged between related parties must be at arm’s length prices
when compared with similar services provided by independent parties. Each company
charges different types of mark ups on services provided by their own staff and
therefore company should aim to have a transfer pricing dossier evidencing that the
mark up charge is within market range when compared to similar services hired from
independent parties.

e) Other types of intra company services include administration and commercial functions
like accounting, payroll, human resources, training, legal marketing and insurance
services. According to the OECD principles, these intra company services should be
directly charged (paragraph 7.23 of the OECD Transfer pricing guidelines). In some
examples, like Norway, the country may artificially fix what is the maximum mark-up
chargeable in intra group service transaction. This could lead to challenging situation
where the market price is above the maximum acceptable tax deduction. Also, given
the high risk of oil and gas operations, companies normally enter Joint Ventures with
other oil and gas companies. This will lead to service charges between JV partners
who need to be compared to charges between unrelated parties and are subject to
audit between partners.

f) Guarantees is another area where transfer pricing provisions are relevant. Because of
the high environmental risk of oil and gas operations, countries require oil and gas
companies to provide a financial and environmental guarantee. Where a parent
company is providing the guarantee in the name of one of its subsidiaries, fees charged
may come under scrutiny because of the relationship between parent company and its
subsidiary. Sometimes it could be argued that a comparable fee cannot be found as no
third party would incur such risk and sometime the fee maybe subject to reductions as

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implicit “free” support by the parent company is also expected in a group relationship.
In this regard the case The Queen vs. General electric capital Canada 2010 is the
relevant jurisprudence.

g) The financing of oil and gas projects is an area where transfer pricing rules and
guidelines may have a significant impact. It is very usual for oil and gas companies to
obtain centralized loan based on its proven reserves and then use a group company to
distribute those funds throughout the projects of the company. For oil and gas
companies the type of contract entered into may be of great relevance as PSC normally
do not allow for interest payments deductions to the cost oil.

h) The determination of an arm’s length interest rate takes into consideration several
factors. These factors include the repayment terms of the loans, the loan duration, any
loan covenants, what type of guarantees are offered, credit risk of the borrower and the
country where the company is operating, market conditions, foreign exchange risk and
risk of the investment itself.

i) Other tax aspects of the group loans are related to new exploration loans and whether
considering the very high risk and higher interest rate should be charged. One other
component of this problem is whether it can be supported that the loan should bear no
interest as no third party would lend the company funds for such a risky operation. The
grossing up of the withholding is also something that has been discussed with respect
to intra group loans. In a normal loan between unrelated parties any withholding tax
applicable in the host country would be expected to be grossed up. Thus, there is an
argument to allow the gross-up of withholding also for loans between related parties
which may be against the tax law in some countries.

j) Other transfer pricing relevant challenges for oil and gas include the use by some PSCs
or agreements of official sale prices for tax purposes which may be different from the
market price and use of group trading companies to trade oil where the trading
company does not have enough third party comparable on fees and margin charged.

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Part C

Question 5

Part 1

Ring Fence Corporation Tax (RFCT)

This is calculated in the same way as the standard corporation tax applicable to all companies
but with the addition of a “ring fence” and the availability of 100% first year allowances for
virtually all capital expenditure. The ring fence prevents taxable profits from oil and gas
extraction in the UK and UKCS being reduced by losses from other activities or by excessive
interest payments. The current main rate of tax on ring fence profits, which is set separately
from the rate of mainstream corporation tax, is 30%

Supplementary Charge (SC)

This is an additional charge on a company’s ring fence profits (but with no deduction for finance
costs). The supplementary charge was introduced from 17 April 2002. The supplementary
charge was increased to 20% from 1 January 2006 and to 32% from 24 March 2011. The
current rate is 10%. The charge to supplementary charge may be reduced to zero on a slice of
production income by the investment allowance, cluster area allowance or onshore allowance

Petroleum Revenue Tax (PRT)

PRT was introduced in the 1975 Oil Taxation Act. This was a field-based tax charged on profits
arising from oil and gas production from individual oil fields which were given development
consent before 16 March 1993.

The 1993 legislation reduced the rate of charge from 75% to 50% with effect from the
chargeable period ended 31 December 1993. Since 1 January 2016, the rate of PRT has been
permanently set to 0% but it has not been abolished so losses (for example incurred as a result
of decommissioning PRT-liable fields) can be carried back against past PRT payments. PRT
was deductible as an expense in computing profits chargeable to RFCT and SC; refunds of
PRT are chargeable to RFCT and SC.

Part 2

On a profit of 100, lucky company is subject to 30% corporation tax

RFCT = 100 X 30% = £30

The remaining of Lucky Company’s profit is then subject to SC at 10%

[100 – 30 CT] X 10% = £7

PRT is currently at 0%

Therefore, the marginal tax rate Lucky Company is subject to is [(30 + 7) / 100] X 100 = 37%

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Question 6

a) Essential tax applying to the proposed investment, including rules for recovery of
exploration expenses, treatment of capital expenditure, carry-forward losses,
repatriation of profits, capital gains, transfer taxes, and indirect taxes such as VAT.
b) Hydrocarbon tax ring fence issues, such as restriction on interest deductions against
ring fence income.
c) Determination of the holding structure, including election of a branch, single company
or double company holding structure, consideration of taxation on income flows,
withholding taxes, potential capital gains taxes on exit, and the funding structure of the
investment.
d) The holding structure used if there are local or foreign partners.
e) Whether an intermediate holding country should be used for dividends, capital gains
tax and related tax treaties.
f) Preparing a tax leakage calculation for the preferred structure, eg calculation from
100% of oil and gas income, reduction for taxes including any profit oil sharing under
PSC regimes, calculating back to the net after tax cash to be received in the parent
country.
g) Determining whether the seller is taxable in its own country of residence or the country
where its assets are located, and estimating the amount of tax.
h) Reviewing transfer taxes or stamp duty applying to the sale and related asset or share
transfers, including the estimated amount, and whether these amounts are payable by
the seller, the buyer, or are shared.
i) Determining any carry-forward tax losses under a tax and concession regime, or
allowable costs under a PSC regime, in the transferred company or licence asset, and
reviewing whether these amounts are preserved by the transfer, and whether there is
any group relief, tax consolidation, or tax loss contribution available in the new holding
structure.
j) Reviewing what related party and external funding requirements apply for the
acquisition and anticipated future expenses.
k) Reviewing whether any interest payments on funds to acquire the company or asset is
deductible under local country rules. Some countries limit deductions based on purpose
of the loan, or if related party. Reviewing whether the debt and interest deductions have
been pushed down to the profitable company.
l) Consideration whether required loans are within this capitalisation rules in the
borrowing country. These rules can generally disallow interest deductions on related
party loans where a company’s debt exceeds certain levels.
m) Reviewing whether there is an opportunity to increase the value of transferred assets
to their market values to allow increased future depreciation deductions as an asset
step up for tax purposes, for example by using an asset transfer rather than acquiring
the company, or an asset transfer after the acquisition.
n) Consideration of any Goodwill in the transferred company, or asset such as a licence,
and whether any tax relief available for the goodwill such as goodwill tax amortisation.
o) Consideration of transfer pricing issues in the new structure, particularly whether any
intra group asset transfers or payments will be at arm’s length prices.

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Question 7

Part 1

Ref: Abrahamson 2014 13.1 to 13.34

a) In the oil and gas industry, lease operations are used mainly as a source of financing
by company to avoid having to advance the funds to acquire expensive equipment or
vessels.
b) Leases may be broadly qualified as finance leases or operational leases depending on
the several factors where one of the most important one is whether the lessee gains
ownership of the asset at the end of the lease.
c) Accounting and tax qualification of a lease may not be similar. For tax purposes, the
qualification of a lease will normally depend on factors such as ownership of the asset,
lease term when compared to the economic life of the asset (normally percentage
based, e.g. the Netherlands) and the existence of purchase options. As to the
accounting qualification, guidance is in the International Accounting Standard 17.
d) As a general rule, a finance lease will lead to the recognition of a debt on the balance
sheet of the company, similarly to a loan for acquisition of a tangible asset and for tax
purposes only the interest portion of the lease payment is tax deductible. The company
will get a depreciation deduction on the value of the asset.
e) On an operating lease, for accounting and tax purposes the transaction is qualified as
a rental operation, meaning that the company will get a full deduction for the total
amount of the lease payment.
f) From a tax perspective the qualification as an operating lease is usually more beneficial
as the full deduction of the rental payments leads to a faster deduction of the total cost
that a combination of the immediate deduction of the interest payments combined with
the depreciation deduction of the asset over its useful life. Exceptions to this rule may
be when the depreciation rate and interest rates on the lease are very high.
g) The operating lease also has the advantage of not leading to the recognition of
additional debt elements in the balance sheet of the oil and gas company which may
be seen as a weakness for investors and financial strength,
h) In oil and gas leasing operations, we normally see cross border leasing operations and
payments due to the fact that the equipment is needed in the jurisdiction where the
company holds the Licence/PSC. Therefore, attention must be paid to withholding rates
applicable to the lease payments, the qualification, as royalty or interest, given under
domestic law and the possible application of a double tax treaty to minimize withholding
tax impact.
i) Detailed attention should also be paid to VAT impacts of the transaction on whether
VAT may apply and not benefit from an exemption on the selling price of the asset or
the rental payment and in that case whether a credit or refund is available.
j) Other tax impacts on leases include possible stamp tax on the documentation (e.g.
mortgage/guarantee) or customs fees for importation as well as thin capitalization
limitations from the additional debt.

Part 2

A Sale and leaseback agreement is where an oil and gas company sells an asset to another
group company or independent lessor and then leases the asset back from the buyer. Sale
leaseback operations are normally qualified as an operating lease. This structure applies to
immovable property or equipment. This operation is an alternative to a normal financing
operation and allows the seller to access funds for its investment operations without losing the
use of the equipment or the property. The intervention of the lessor is reward through the
payment of rental payments throughout the life of the leaseback. So, the oil and gas company
is able to access value that would otherwise be tied in the property or asset.

From a tax perspective, given the usual qualification as an operating lease, the oil and gas
company will be able to expense the total amount of the rental payments which, as a general
rule, would be higher than the depreciation deductible as owner of the asset. It may also be the
case where the asset would already be fully depreciated and therefore would be no depreciation

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deduction left. However, it is important to analyse the tax impact of the initial sale of the asset
to check whether any capital gains or other types of tax on exit could apply which would diminish
the attractiveness of the operation. The existence of previous tax losses carried forwarded that
would otherwise expire can be relevant for the analysis of the tax optimization of the transaction.

A sale and leaseback operation may also be entered into between two related parties (e.g.
companies from the same group). Normally this is done through the incorporation of a leasing
company in a tax effective jurisdiction for holding of assets (e.g. Singapore). This leasing
company would hold all the main high value assets of the group paying less property tax and
would lease the assets to the operating companies in need of said asset shifting profits to this
lower tax jurisdiction and keeping the expenses in jurisdiction where the tax rate is higher. This
normally occurs with vessels or FPSO that have a very high value. In these structure attention
must be paid to possible anti-abuse provisions requiring the leasing company to have economic
substance and the existence of a full leasing business with directors, staff and capital.

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Question 8

Ref: Abrahamson 2014 - 6.1 to 6.8

In fact, the long lead time and upfront investment of oil and gas project may create a substantial
amount of losses in a jurisdiction where an oil and gas company has a specific project or
licence. As a general rule, these losses are recoverable, either through a cost recovery regime
or as accumulated tax losses in a corporate tax system, if the project reaches production phase
and can generate enough profits to offset the investment made by the oil and gas company.
However, reaching a production phase may take several years to materialize (normally between
5-10 years), meaning the recovery of the accumulated costs may take a long period of time to
recover fully. The impacts of the big temporary differences between investment and recovery
could also lead to significant cash flow impacts to the company.

A possible structure that may be used to overcome this limitation is the utilization of a branch
structure, where possible, where the head office, or a tax group to which the company is part
of, generates enough profit against which these initial losses can be deducted.

This is only possible in situations where tax laws of the head office’s jurisdiction company allows
for the consideration of branch expenses to be considered in the tax calculation of the company
based on the fact that the company and its branch are the same legal entity. This will not be
possible where the head office jurisdiction tax laws treat the branch income and losses as
exempt in the origin country. Some countries allow each taxpayer to elect which system they
prefer for the treatment of their branches’ income and costs, an exemption or taxation of
income.

It is important to note that, where the head office jurisdiction allows for the utilization the losses
under the head office company tax assessment, future income and profits obtained by the
branch will also be subject to tax, even if it has already been subject to tax in the host country
jurisdiction. This may create double tax situations if a foreign tax credit is not available at the
head office’s jurisdiction under the domestic tax law or double tax treaty entered into between
the two States.

The use early utilization of the losses accumulated in the host country under this circumstances
may constitute a major cash flow advantage by lowering the taxation of profits obtained in the
head office’s jurisdiction in which will only be subject to tax when the oil and gas project
generates income. Also, should the project never reach a production phase, this structure will
allow a definitive tax efficiency for the losses.

The Marks & Spencer EU case jurisprudence and its subsequent analysis by the European
Court of Justice on the recognition of final losses of foreign subsidiaries may also be relevant
for oil and gas companies resident in the EU, particularly in situation where the foreign branch
is wound up after unsuccessful exploration, even in a case where the head office jurisdiction
applies an exemption system for branch income and losses. The “check the box” system
applicable in the US may also be relevant for oil and gas company resident in the US.

Example jurisdictions:

a) The Netherlands: This jurisdiction initially allowed for the consideration of branch
losses in the head office tax calculation with claw back of subsequent profits. However,
in 2012 it changed that system to an object exemption where losses are no longer
deductible and profits will be fully exempt. However, the Dutch regime allows under
certain scenarios the deduction of branch losses where the activity of the branch has
been discontinued or sold, treating it as loss on the cessation of business.

b) United Kingdom: As a general rule, in the UK the branch income and losses will be
considered in the tax assessment of the head office corporate income tax calculation.
However, in 2009, the UK introduced the possibility of companies to make an election
to exempt all branch profits and losses from the head office taxation. This election once
made is irreversible and can be made on a company by company basis, meaning that

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in a tax group of companies there maybe companies with different treatment of branch
income and losses.

c) United States: In this country, the branch income and losses are considered for the
United States taxation of the head office with no possibility of an exemption applicable
to the branch. The domestic tax rules also foresee the possibility of clawing back any
foreign branch losses deducted in the United States, in case the branch is sold or
transferred after in starts turning a profit. In case of foreign branch profits taxable in the
US, a foreign tax credit is available but with limitations, particularly where the tax rate
is very high in the host country. This is normally the case for oil and gas taxation. The
US also has a “check the box” system that allows for the taxpayer to elect to have a
foreign subsidiary treated as a transparent entity for tax purposes. In this case, a
subsidiary is treated similarly to a branch for tax purposes in the US.

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