On 12 October 2020, the OECD/G20 Inclusive Framework on base erosion and profit shifting (BEPS) released ‘blueprints’ on Pillar 1 and Pillar 2, which reflect the efforts made towards reaching a multilateral, consensus-based solution to the tax challenges arising from the digitalisation of the economy.
The updated blueprints provide detail on the technical design and features of each pillar, identify areas that require further technical work and highlight aspects where political agreement will be necessary. The OECD is targeting bringing the process to a successful conclusion by mid-2021.
BEPS 2.0 is primarily aimed at dealing with the tax challenges arising from the digitalisation of the economy but the proposals will impact all sectors. Our comments below consider what the proposals might mean for the oil and gas sector.
Pillar 1 – Observations
Amount A – new taxing right allocating high value profits based on a formula
- It is proposed that “natural resources” will be carved out. This is intended to cover activities related to non-renewable extractives (including petroleum as well as renewable energy products (such as biofuels, biogas and green hydrogen). As such, most upstream and midstream activities, including commodity trading, are proposed to be excluded. However, the OECD acknowledges that further work is required to provide greater clarity.
Amount B – standard arm’s length remuneration for routine marketing and distribution services
- Amount B will not be subject to the Amount A limitations. This would mean that related party baseline marketing and distribution activities in the oil and gas sector would be in scope (i.e., where there is resale and routine distribution). This would include related party wholesalers and retailers. However, the full scope of Amount B is still being debated within the Inclusive Framework, where some countries are pushing for a broader range of activities being covered (for example commissionaire structures and sales agents).
- The positive and negative lists set out the expected functional, risk and asset profile of entities that would be in scope for Amount B. For example, distribution entities that perform very limited sales and marketing support type services (not involving resale) may be out of scope. At the same time, entities that perform more entrepreneurial functions, take more risks or engage in the development, enhancement, maintenance, protection and exploitations functions related to intangible assets would also be out of scope. For example, a distributor owning valuable brand and marketing intangibles or carrying out research and development activities would be considered to be out of scope.
- There is therefore a risk that marketing and distribution entities in the oil and gas supply chain sector may fall within the scope of Amount B, but this would need to be considered on a case by case basis. This could lead to new transfer pricing policies being adopted for the impacted elements of the supply chain.
Pillar 2 – Observations
The oil and gas sector by its nature is generally subject to higher rates of taxation and as such Pillar 2, which aims to apply a minimum level of taxation is not specifically targeting the sector. However, depending on its final form there is a risk Pillar 2 may apply to the oil and gas sector and result in an increased ETR. We set out below the areas of potential complexity.
- Carve-outs: The blueprint proposes a formulaic carve out to exclude a fixed return for substantive activities from the income inclusion rule (IIR). Payroll and tangible assets are proposed to be indicators of substantive activities, with the tangible assets component including property, plant and equipment and natural resources (including oil and gas deposits and mineral deposits) in a jurisdiction. The carve-out for property, plant and equipment, and natural resources will be based on the depreciation and depletion of the relevant natural resource respectively. As the oil and gas sector often has high rates of return (reflecting the inherent risk) such activities may not benefit from the carve out of nature resources.
- Financial accounting standards: The use of the parent’s financial accounting standards as the starting point for calculating the tax base for a jurisdiction could result in the understatement or overstatement of the ETR in jurisdictions where the accounting standards vary from those in the parental jurisdiction. This is especially true for the oil and gas sector where specific accounting policies apply e.g. successful efforts or full cost methodologies or where production sharing contracts apply specific policies.
- Covered taxes: The blueprint considers that taxes on activities such as the exploration and production of oil and gas (irrespective of whether or not they apply in addition to a generally applicable income tax) would fall within the general definition of a covered tax. Resource levies closely linked to extractions (e.g. imposed on a fixed basis or on the quantity, volume or value of the resources extracted rather than on net income or profits) may not be treated as covered taxes. As such, there is a risk that certain taxes e.g. amounts payable under production sharing agreements such as cost oil, profit oil or royalty regimes may would not be a covered tax and thus the risk of additional taxes applying under Pillar 2 is increased.
- Permanent differences: It is proposed that certain adjustments will be made to the tax base for permanent differences, using an agreed set of principles. Jurisdictions often provide significant incentives to businesses in the oil and gas sector (e.g. providing an uplift for capital expenditure) that may be treated as permanent differences from an accounting perspective. The failure to take these into account under Pillar 2 may result in the ETR for a jurisdiction being understated and it would be helpful if extractives incentives could be white listed where they are deemed acceptable regimes.
- Timing differences: Timing differences for businesses operating in the oil and gas sector are often substantial as it is capital intensive. Jurisdictions often offer incentives in the form of immediate expensing of capital expenditure or accelerated depreciation. The proposal discusses options for potentially addressing common timing differences (e.g. adjusting for certain deferred tax liabilities) and highlights the need to avoid creating additional complexities. However, it is not currently clear what approach will ultimately be adopted and this will be critical to clarify in order to understand the impact on the oil and gas sector.
- Transitional rules and carry-forwards: Oil and gas businesses often have significant upfront exploration and development costs and volatility in commodity prices can result in significant fluctuations in returns. As such, how losses are carried forward and the recognition for excess taxes paid in prior years (including prior to the start date of Pillar 2) will be particularly important, especially in the context of repayments of tax (e.g. decommissioning losses carried back). This may also create additional complexities arising from the need to track carry-forward losses and excess taxes for each jurisdiction.
As noted above there are a number of complexities in applying BEPS 2.0 principles to the oil and gas sector. We recommend that companies in the sector keep a watchful eye as matters progress in order to understand how the rules will be implemented in practice to upstream activities and the resultant impact on ETRs.