Anastasia Nourescu * Stewarts
Guy Bud * Stewarts
In the UK, oil and gas contractors are subject to a special corporation tax regime. Given that almost all UK oil comes from offshore fields, the rules are relevant to many oil and gas operators. However, the law is not always clear, and the limited guidance and court decisions do not cover every scenario that comes up in practice.
Dolphin Drilling had to grapple with the complexity of these rules in a recent case involving the deductibility of vessel hiring costs for the purposes of calculating corporation tax on its profits. Having won in the Tax Tribunal, it has now suffered a loss before the Court of Appeal. The decision raises important issues around the statutory interpretation of the oil contractor activities regime and its application to the offshore oil industry.
UK taxation of oil contractor activities
The rules on the taxation of oil contractor activities apply to the provision, operation or use by contractors of a “relevant asset” as part of the offshore exploration or exploitation of oil in the UK territorial sea or the UK Continental Shelf. Corporation tax is calculated separately on profits from oil contractor activities, and the amount allowable as a deduction for the payment under a lease of a “relevant asset” is restricted in computing profits for corporation tax purposes.
An asset qualifies as a “relevant asset” if it is movable or if it “can be used” to drill for oil or to provide accommodation for offshore workers. However, there is an exception to this provision: if the asset can be used for accommodating offshore workers, it is deemed to fall outside the definition of a relevant asset “if it is reasonable to suppose that its use to provide accommodation for offshore workers is unlikely to be more than incidental to another use, or other uses, to which the asset is likely to be put.” The word “incidental” is not defined in the legislation, but according to guidance published by the UK tax authority, HM Revenue and Customs (HMRC), it “takes its natural meaning.” It is easy to see how the lack of clarity in the wording of these rules opens the door to different definitions.
Dolphin Drilling tax case
In 2011, Dolphin chartered a former drilling rig called the Borgsten Dolphin. It entered into a series of agreements with Total E&P (UK) Limited (Total) governing the Borgsten’s conversion into a tender support vessel (TSV) and tender-assisted drilling (TAD) services subsequently to be provided to assist a Total-owned minimum facility platform (MFP).
Before its conversion, the Borgsten had accommodation for 102 workers. This was retained during the conversion, although only around half were needed to accommodate the Borgsten’s own workers. Although the MFP had its own accommodation, Total wanted to use the remainder of the accommodation on the Borgsten to accommodate workers from the MFP. Dolphin even agreed to increase the number of berths to 120 as part of the conversion process.
Following an enquiry into Dolphin Drilling’s tax affairs, HMRC decided that the amount of the deduction claimed in respect of amounts paid for the hire of the Borgsten should be restricted. This was on the basis that the Borgsten was a “relevant asset” because the exception relating to the accommodation of offshore workers did not apply.
The only point in dispute was whether the Borgsten’s use for accommodating offshore workers was likely to be more than “incidental” to the primary TAD services. Although the Borgsten was not a classic example of a mobile offshore hotel (also known as a “flotel”) used to accommodate offshore workers, HMRC considered that its accommodation function was sufficiently important in the relationship between Dolphin and Total that it could not be described as “incidental.”
Dolphin Drilling successfully appealed the decision before the first two tiers of the Tax Tribunal. HMRC brought a further appeal. The Court of Appeal issued its decision on 11 January 2024, finding in favour of HMRC and overturning the Tax Tribunal’s previous decisions.
Court of Appeal decision
The Court of Appeal’s decision turned entirely on a point of statutory interpretation. The court noted the purpose of the oil contractor activities rules, namely that it “was designed to combat what was perceived to be a practice of moving profits in fact derived from the UK offshore oil sector outside the UK tax net.” While this was useful background, it provided little assistance in gleaning the meaning of the word “incidental,” and there was little to go on in terms of case law.
The court considered the ordinary use of the language. It held that in considering whether the use of the Borgsten as accommodation for offshore workers was incidental to its other uses, it had to decide whether its use as accommodation:
- Was an independent end in itself,
- Was unconnected with its other uses, or
- Was something that arose out of its other uses.
The court found that the use of the Borgsten as accommodation was an independent end in itself. It was not simply something that arose from its use as a TSV supplying TAD services to the MFP; it was also used as an accommodation vessel. Even if this was a “secondary” use, it was still a “significant and independent use and not incidental to its other uses.” Although both the accommodation and other services enabled the drilling campaign to take place, this did not mean that one use was incidental to the other.
The court concluded that it was not reasonable to suppose that using the Borgsten as accommodation was likely to be no more than incidental to its other uses. Therefore, the exception did not apply, and the Borgsten was a relevant asset subject to the oil contractor activities regime.
Wider impact
The case will be of interest to UK oil and gas operators. MFPs are attractive alternatives to conventional drilling platforms due to their low cost, and MFPs cannot operate without receiving TAD services, which TSVs provide. In practice, offshore operators may face this scenario and wish to benefit from the exception to the hire cap in the oil contractor activities rules relatively frequently. The case will also be of wider interest due to the Court of Appeal’s consideration of the meaning of an “incidental” use or purpose, wording that comes up in various contexts in the UK tax code.
Dolphin Drilling has already announced its intention to appeal the Court of Appeal decision to the Supreme Court. This is unsurprising given Dolphin’s success before the Tax Tribunal on this finely balanced point of statutory construction, which leaves room for further argument. The wider impact the Court of Appeal’s findings would have on Dolphin’s operations has no doubt also informed this decision.
Finally, the UK government is keeping the oil and gas fiscal regime under review as the energy transition progresses. The current law may well be reformed and potentially simplified in the future. However, any such reform is not imminent, and the oil contractor activities rules will be around for some time to come.
The authors
Anastasia Nourescu is a senior associate and Guy Bud is an associate barrister in the tax litigation department at UK dispute resolution specialist law firm Stewarts.
