Based on the 2017 annual oil and gas report issued by the Department of Petroleum Resources (DPR), Nigeria has 285 fields. 184 of these fields are producing while 101 are shut in due to operational reasons. Many of these fields are approaching the end of their expected lifetime. This, therefore, means that some of the related facilities will need to be shut down and decommissioned in a responsible manner and in compliance with the applicable legislation and regulations. However, the life cycles of these fields can be extended due to factors such as discovery of new satellite fields and improved recovery initiatives. It is also possible to extend the lifetime of oil facilities, which are no longer producing, if they can be used as host installations for other developments in the same area.
Paragraph 36 (1) of the Petroleum (Drilling & Production) Regulations provides that ‘no borehole or existing well shall be redrilled, plugged or abandoned and no cemented casing or other permanent form of casing shall be withdrawn from any borehole or existing well which it is proposed to abandon, without the written permission of the Director of Petroleum Resources.’ Paragraph 36 (2) furthers adds that ‘every borehole or existing well, which the licensee intends to abandon, shall, unless the Director of Petroleum Resources otherwise permits in writing, be securely plugged ……….and shall be dealt with in strict accordance with an abandonment program approved or agreed to by the Director of Petroleum Resources.’
There are three major costs involved in plugging and abandoning of an oil field: shutdown, removal and clean up. Currently, there is no reliable estimate as to how much it will cost to decommission Nigeria’s oil and gas facilities. However, the general agreement is that it will be significant based on experience from other jurisdictions. In July 2019, the UK Oil & Gas Authority estimated that it would cost £49 billion to decommission the remaining UK’s oil and gas facilities.
There are several issues that usually arise with respect to returning an oil facility to its original condition at the end of its useful life. These issues include: estimating the actual work and time scale involved in the decommissioning process, making adequate provision in the financial statements or providing the funds that will be required to implement the abandonment programme and securing tax deductions for the cost involved, given that there will be little or no revenue when the abandonment programme itself commences.
However, this article will only focus on the tax implications of decommissioning costs.
The Petroleum Profits Tax Act (PPTA) is the enabling legislation for the taxation of oil producing companies. The provisions of the Companies Income Tax Act will also apply where the oil company produces gas. The general deduction formula for an expense to qualify for a tax deduction under both laws are similar. The PPTA specifically states, in Section 10 (1), that ‘in computing the adjusted profits of any company of any accounting period from its petroleum operations, there shall be deducted all outgoings and expenses wholly, exclusively and necessarily incurred (emphasis mine), whether within or without Nigeria, during that period by such company for the purpose of those operations.’ The key question, therefore, is what does it mean for an expense to be ‘incurred’? Does it mean when that expense has been paid for or when there is an obligation to pay?
In a bid to provide some clarity on the tax treatment of decommissioning cost, the then Minister of Finance issued the draft Regulations on Decommissioning in 2018. The major provision of the Regulations is that only cash-backed provision for decommissioning cost will qualify for tax deduction. In other words, the FIRS should not allow the annual provision for decommissioning for tax purposes. The issue is, therefore, whether this position is consistent with the provisions of the extant law.
The Courts have generally adopted the literal meaning in the interpretation of tax statutes. This simply means that one should look at what is clearly said. There should be no room for intendment. Nothing is to be read in, nothing is to be implied. On this basis, the issue is what does ‘incurred’ mean? The Legal Dictionary defines ‘incur’ as ‘to become subject to and liable for’ and ‘to have liabilities imposed by Act or operation of law’. This means that expenses are only incurred when the legal obligation to pay them has arisen and not when the expenses have been paid for. This position may also explain why the tax laws do not use the word ‘paid’ to qualify ‘wholly, exclusively and necessarily’ phrase.
In the 2004 case between Shell Norway v Ministry of Finance & Others, the Norwegian Supreme Court held that provisions made in the 1995 and 1996 financial statements in respect of decommissioning costs were incurred even though the decommission process itself had not commenced. The Supreme Court ruling was hinged on the basis that obligation to decommission was unconditional and linked to the right to produce. At the time of the ruling, the provision in the Norwegian Income Tax law for allowing tax deduction was that ‘a cost shall be deducted in the year in which the taxpayer becomes unconditionally obliged to cover or discharge such costs.’ As a result of the ruling, the Norwegian Government amended its tax laws by adding a proviso to the applicable section – ‘Obligations to carry out, refrain from, or accept something in future shall be disregarded.’ Based on this modification, companies can only claim tax relief for decommissioning cost only in the period in which the work is carried out. In other words, provisions set aside, whether cash-backed or not, will not qualify for tax deduction in Norway.
Every operator in the Nigerian upstream oil and gas industry has an obligation to plug and abandon a field in compliance with all applicable regulations and the cleaning of the oilfield site to the satisfaction of appropriate governmental bodies, such as the DPR and the Nigerian Environmental Protection Agency. This obligation arises when the DPR approves the plan for the development and operation of the field. At the time the operator obtains the licence, the obligation to decommission is conditional. The reason is that the operator may choose not to utilize the licence until its expiration or when it is withdrawn. However, the moment exploratory and development activities begin, the obligation becomes unconditional.
Simply put, the oil company becomes subject to and liable for decommissioning of the field at the time of receiving the approval to develop the field and not at the time when production is shut down. This illustrates the difference between provisions that are based on accounting practice and those based on legal requirements. Provisions based on accounting practice does not confer any legal obligations and should, therefore, not qualify for tax deduction unless its deductibility is specifically provided for in the Income Tax Law, for example specific provision for doubtful debts. However, to the extent that provisioning for decommissioning costs is based on both accounting and legal obligations, such provisions will qualify as incurred and therefore deductible for tax purposes.
Many jurisdictions, including the UK that changed its Income Tax law in 2009, have addressed the dispute by simply and explicitly providing in their income tax laws that decommissioning costs will only be available for tax relief when the work is carried out. To the extent that we do not have such provision in our income tax laws, provisions for decommissioning will continue to qualify for tax deduction. This means that industry operators can successfully challenge any disallowance of provisions that might have been made in respect of decommissioning costs even if it is not cash backed. To ensure a successful challenge, the operators may need to ensure that they do not reference the amortization of the capitalized decommissioning cost as ‘depreciation’, which is specifically disallowed for tax purposes.
The FIRS and the Ministry of Finance will, therefore, need to review the draft regulations on decommissioning to align with the provisions of the principal legislation. Otherwise, it will most likely be held to be inconsistent with the enabling legislation and therefore null and void. Of course, it is within the power of government to amend the Income Tax Acts to reflect the fact that decommissioning costs will only be allowed when the costs are realized as other countries have done. This may not be unexpected given the current yearnings by many Nigerian legislators to amend the Cabotage Act to include drilling rigs as cabotage vessels subsequent to the Transocean court ruling.
However, changing the law to simply recognize cash-backed decommissioning provisions as tax deductible will not encourage the desired investment in the industry unless government also implements the UK model of Decommissioning Relief Deed to ensure that the amount of relief achieved will not be less than the amount of relief that would have been available if there had been no change in tax law. In addition, the issue of carrying back of unrelieved decommissioning losses (not currently addressed in the draft Regulations) should be explored.
Ajayi is the Partner and Head Tax Energy Practice, KPMG Nigeria