UK oil and gas tax mechanism must balance fiscal stability with continued investment

The consultation (38 pages/336KB), announced by the Treasury, is part of the government’s broader strategy regarding the future of the North Sea. It follows the government’s commitment made during the Autumn Budget 2024 to end the energy profits levy (EPL) by 2030, or earlier if the energy security investment mechanism (ESIM) is triggered.

The EPL, introduced in response to the profits made by oil and gas companies during periods of high prices, is a temporary measure. The new proposed oil and gas price mechanism aims to replace the EPL, providing a permanent solution that will activate only during periods of unusually high oil and gas prices.

Jake Landman, tax law expert at Pinsent Masons, said: “The mechanism chosen must seek to balance the need for fiscal stability with continued investment in the sector, and alignment with environmental objectives. The industry may feel that the balance is not quite struck if their tax burden, which has historically been much higher than other companies in any event through the operation of ring fence taxation and related measures, remains even higher over the longer term. Indeed, there are genuine questions around whether the EPL has in fact been taxing a windfall or going beyond this.”

The primary objective of the consultation is to gather feedback from stakeholders, including the oil and gas sector, investors, and the public, to design a mechanism that balances the needs of the industry with the government’s fiscal requirements. The policy options are currently split between a revenue-based model (RBM), which targets the excess revenue a company receives for its oil and gas above threshold prices, and a profit-based model (PBM), which targets a proportion of profits arising from unusually high prices, with unusual being considered by reference to average market prices and thresholds.

The government emphasises the importance of creating a mechanism that is predictable, sustainable, and which minimises distortion in investment decisions when prices are not unusually high.

The RBM would have two thresholds, one for oil and one for gas. The tax would apply to revenue above that threshold, with revenue determined by realised prices rather than any market price, recognising that many oil and gas companies use forward contracts and hedging such that the market price at a given time does not necessarily reflect the realised price. Under the RBM, no deductions for costs would be allowed. However, the government suggests that the thresholds will be set at a high enough level that recognises the costs of doing business in the North Sea. Additionally, the tax point will be the first point of sale following the extraction to avoid double taxation.

Landman said: “If the government proceeds with a RBM model, setting the threshold at a sufficiently high rate to reflect necessary costs will be essential, however the government has also suggested that if a higher threshold is set then this may mean a higher rate is chosen.” The government says it does not envisage that the sector will face any exceptional costs exceeding those during times of normal prices but has provided no evidence of this.

The PBM would have a number of different features, including identifying a slice of profits that will be deemed to be attributable to price shocks. The PBM would only kick in when the average market price over the accounting period exceeds the threshold that applies at the end of that accounting period. When that has happened, the percentage of profits to which the tax applies would be determined by dividing the difference between the average market price and the threshold, by the average market price. This percentage would then be applied to the company’s profits, which will be an adjusted ring fence profit similar to the existing EPL calculation. The new tax rate would then apply to that slice of profits. The government is also exploring the possibility of conducting the PBM calculations separately for oil and gas and applying the tax to different percentages of the profits in each market, but recognises that this is difficult to achieve.

The consultation also covers how the thresholds will be set to determine what are “unusually high prices”. There are set to be different thresholds for oil and gas, and the government is also considering whether there might be further separate thresholds for different variants of oil or gas, such as for natural gas liquids. The expectation is that these thresholds will be set using similar indicators as for the existing ESIM, using a $/barrel of oil and pence/therm of gas. Factors such as historical price data, forecast price data, and costs of operating in the UK and on the UK continental shelf will be considered in setting the thresholds.

Landman said: “The government has expressed a clear preference for adopting a revenue-based model, while stating that it is open to feedback on both models. While RBM might be a simpler model to legislate and operate, it appears unfair that there’s the risk of a ‘dry’ tax charge for companies, where they must pay tax even if they have no profits. Indeed, the government’s comments on the alternative PBM model in the document do suggest that it considers it appropriate that the new levy will apply even to loss making entities.”

Consultation responses must be made by 28 May.