Solutions when jobs are on the line

The oil price slump in March caused uncertainty about future investments on the Norwegian continental shelf. The supply industry was suddenly facing dramatic investment cuts compared with pre-covid-19 levels. Something had to be done.

The market situation gave rise to considerable uncertainty regarding the development of new projects on the Norwegian continental shelf, since many of these would no longer meet oil companies’ required rate of return. This was especially dramatic for the Norwegian supply industry, which might rapidly find itself without work. In addition to the loss of a great many jobs, Norway risked losing key expertise needed to ensure proper management of oil and gas activities, including future decommissioning and removal. Besides, the Norwegian supply industry is a key factor in the development and construction of carbon capture, offshore wind and other green energy facilities. Norway could not afford to lose such a high-skill industry overnight.

– We were engaged to come up with a tax proposal for temporary petroleum taxation amendments to safeguard activity on the Norwegian continental shelf and thereby contribute to maintaining activity and expertise in the Norwegian supply industry, says Joachim M. Bjerke, BAHR Partner. However, the proposal needed to meet one key test: It was to entail no additional expenditure on the part of the State. This was not a matter of asking for tax reductions or any form of state aid package. The proposal had to be tax revenue neutral.

BAHR’s team comprised of Joachim M. Bjerke, Jan B. Jansen and Marius Pilgaard accepted the challenge.

– Over a few hectic days of working from home in close collaboration with Aker BP and other key persons, we came up with a proposal that eventually gained the support of the entire industry, as well as the Norwegian Confederation of Trade Unions and the Confederation of Norwegian Enterprise, says Bjerke. It was a great privilege to have the opportunity to work on such an exciting matter with so many high-calibre professionals.

Immediate deduction of investment costs was the basic pillar

The main challenge in explaining the proposal is that it needs to be understood in relation to how Norwegian petroleum taxation is structured, says Marius Pilgaard.

The team behind the proposal for temporary petroleum taxation amendments: (from left) Partner and Head of the BAHR Tax Group, Joachim M. Bjerke, Partner Jan B. Jansen and Specialist Partner Marius Pilgaard

Most people are struggling to get their head around Over a few hectic days ordinary tax rules and can hardly be expected to be of working from home, familiar with the special rules under the petroleum tax system. It is, however, these special rules that made it we came up with a possible to come up with a proposal that could proposal that gained both ensure implementation of planned projects and at the support of the entire the same time be tax revenue neutral, continues Pilgaard. industry, as well as the

Norwegian Confederation

The key element of the proposal was that companies may deduct their entire investment cost in the year in of Trade Unions and the which an investment is made. Under the current system, Confederation of the State covers about 90 percent of the investment Norwegian Enterprise costs, but it will at best be more than six years from the investment is made until the State has covered its portion of the investment cost (through the deduction of depreciation and uplift). If the company is running at a loss, it will take even longer. In contrast, the industry’s proposal meant that the State would have covered its portion of the investment cost within a year or two. Accelerated repayment of the State portion of the investment cost would make a major difference to project profitability from the perspective of the companies, while representing a very minor cost on the part of the State, observes Bjerke.

– The petroleum industry and the Ministry of Finance has for many years been discussing the net present value of such future deductions. A discount rate needs

to be applied to calculate the net present value of an amount, and the disagreement has concerned the choice of such rate. The industry has taken the view that the appropriate discount rate is the required rate of return applied by companies to their investment, for example 10 percent p.a., while the State has taken the view that a claim for repayment from the tax authorities is «like keeping money in the bank», thus implying that a risk-free interest rate shall be applied, says Bjerke. Although the current level of a risk-free interest rate is a matter for discussion, there is little doubt that it is significantly lower than companies’ required rate of return. The industry proposal is based on this difference, explains Pilgaard.

Could have been a win-win

The petroleum industry proposal did in actual fact represent a tax increase because the companies qualify for an interest deduction that depends on the depreciation base.

– When the company is granted such depreciation already in the year of investment, there will be no interest deduction and the effective tax rate will thus increase. The proposal therefore implied increased tax revenues for the State. Companies covering a larger portion of the development costs also entails a lower risk that fields considered to be economically unprofitable will be developed. At the same time, the difference between companies’ required rate of return and the risk-free interest rate is so large that the proposal was nonetheless positive for the companies. It was, in other words, a win-win solution for everyone, says Bjerke. The Ministry of Finance and the Government may have felt that the proposal was too good to be true – not many industries were in the spring of 2020 asking for changes that would mean tax increases for themselves. This may have been why the Ministry misunderstood the proposal when it was first put forward for its consideration, and incorrectly concluded that it entailed a tax reduction. This may also have been the reason why the Government countered with a modified proposal that involved a significant tax increase for the industry compared to the existing rules.

– Fortunately, a broad consensus solution in the Norwegian Parliament – the Storting –compensated for the financial tightening represented by the Government’s proposal by increasing the uplift to 24 percent. However, it did regrettably retain the Government’s solution of only applying the new rules to the special tax component and not to the corporate tax component of the petroleum tax, says Pilgaard.

The Storting consensus does, according to the Ministry of Finance, represent a tax reduction of about NOK 8 billion in net present value terms. If the Storting had instead opted for the alternative solution (which the industry wanted), tax revenues would, according to the Ministry, have increased by NOK 7 billion in net present value terms. The difference between the two alternatives is, in other words, NOK 15 billion – which was the price one had to pay for barring the new rules from also applying to the corporate tax component of the petroleum tax system.

The petroleum tax system

The total rate of petroleum tax is 78 percent, comprised of 22 percent ordinary tax and 56 percent special tax. Because the overall tax burden is so high, it has been a key priority to make the petroleum tax as neutral as possible. By this is meant that the tax shall have the minimum possible impact on the investment decisions of companies.

The petroleum tax system involves a number of special rules to ensure such neutrality, including the guaranteed payment to companies of the tax value of any loss carry forward upon the cessation of their activities (discontinuation refund) and the right to carry any loss forward with interest in order to maintain the real value of such loss. Investment costs may also be depreciated (deducted) more rapidly than would normally be the case. In addition, companies are granted an extra deduction against the special tax to protect the ordinary return on their investments, which deduction is called uplift. The uplift is normally 20.8 percent of the investment cost and has a (nominal) value of 11.6 percent since it is only granted against the special tax of 56 percent. All in all, the rules mean that the State covers about 90 percent of the investment costs on the Norwegian continental shelf.

The Minister of Finance and the Prime Minister issued stern warnings against changing the corporate tax component of the petroleum tax system because this would violate one of the fundamental principles underpinning the 1992 tax reform, that of equal rules for all industries, and involve a risk of undesirable contagion effects. It might potentially undermine the entire corporate tax system, was their message, says Bjerke and makes the following point:

– This would have been a valid observation if corporate tax for oil companies had been a separate tax subject to the same terms as apply to other industries. However, such is not the case. And such has never been the case since the 1992 tax reform. There has throughout this period been special corporate tax rules for oil companies, partly to ensure increased neutrality.

Besides, a different attitude was adopted in connection with the exploration cost refund case pursued by the EFTA Surveillance Authority (ESA). The Ministry did in that context devote considerable time and energy to emphasising that the petroleum tax system is an integrated system, and that one cannot consider its corporate tax component in isolation. Moreover, it was highlighted that the corporate tax component of the petroleum tax has always had special characteristics that do not apply to other industries. However, that was two years ago. Now it was all of a sudden important to spend NOK 15 billion on defending a principle that has never been adhered to. – Instead of a win-win solution, one ended up with a solution that was NOK 15 billion more expensive, without offering oil companies or the supply industry better terms. It is not often that an industry ask for a NOK 7 billion tax increase and instead ends up with a NOK 8 billion tax reduction – against its own will, says Bjerke.

Admittedly, this is partly a numbers game. The calculations are based on a very high risk-free interest rate (the same rate as was applied in 2013, despite interest rates having declined steeply since then). If a more realistic interest rate had been applied, the tax reduction would have evaporated swiftly.

The Government and the Storting nonetheless deserve praise for having deliberated and enacted the temporary amendments within a short space of time. However, the petroleum tax amendments are temporary, and there is no doubt that the tax regime for oil companies will be a topic for considerable debate in coming years. The Ministry’s attitude to the temporary amendments signals that the industry must expect future amendments to the corporate tax element to bring this more into line with the corporate tax for other industries. Watch this space, says Bjerke.

– Instead of a win-win solution, one ended up with a solution that was NOK 15 billion more expensive, without offering oil companies or the supply industry better terms