Publication - Independent report

Public energy company: strategic outline case

Published: 16 Apr 2019
Directorate:
Energy and Climate Change Directorate
Part of:
Economy, Energy
ISBN:
9781787817357

Independent strategic outline case to consider how Scotland's public energy company could be developed suggests that a phased approach would work better.

Public energy company: strategic outline case
Appendix G – Detailed tax analysis

Appendix G – Detailed tax analysis

Introduction

This Appendix is designed to highlight the key tax VAT considerations that will need to be taken into account in terms of establishing and operating an Energy Co.

The high level comments are based on the information provided and should be refined as the project develops and the preferred structure and operating model for the Energy Co. is selected.

Short list of options

The following four options have been identified:

1. Do nothing

2. Existing socially minded supplier

3. Government Owned Company

4. Federal model.

Choice of legal entity

One of the key objectives of the Energy Co. is that whatever entity is selected it should be established as a not-for profit organisation (NFP). Setting up an entity with a NFP objective, directs how an organisation deals with any surplus that arises (i.e. by reinvestment in the business as opposed to distribution to shareholders), not that the organisation does not generate a profit.

There are many different legal forms that a NFP organisation can take, however for direct tax purposes the UK tax legislation only really recognises 2 different treatments, namely:

  • Those entities that are charitable in nature
  • Those that are non-charitable.

Entities that are established with charitable purpose, will have the ability to take advantage of charitable tax exemptions (as outlined below), including the ability to potentially shelter taxable profits in any non-charitable group entities.

Those that are not charitable, have no special tax treatment and are subject to tax in the same way as normal commercial entities, despite the NFP status. Where this is the case, further consideration should be given to the proposed operating model/transactions of any proposed entity to identify the profile of future profits or losses and the availability of tax reliefs.

Based on the short list of options for legal entity that has been selected through this process, we would make the following comments:

Do nothing

Where the Energy Co. project does not proceed, no UK tax consequences will arise.

Existing socially minded supplier

In this scenario the Energy Co. would utilise/invest in/take over an existing socially minded supplier as the future delivery structure. An existing socially minded supplier will be used as an example to comment on the possible tax implications of this delivery structure.

The existing supplier is structured as a Community Benefit Society (CBS) whose members comprise a number of social housing providers. The CBS is an asset-locked and non-profit distributing organisation.

The existing supplier is a wholly owned subsidiary company of a non-trading holding company, which is itself a wholly owned subsidiary of the CBS. The existing supplier is the main operating company of the group, being a fully licenced gas and electricity supply business regulated by Ofgem.

The existing supplier will not benefit from any tax exemptions or tax exempt status. It is liable to corporation tax on profits generated from the supply of energy. It has not, however, paid any tax to date due to it being loss making in its first period of operation. Based on forecast projections contained in the offer document for a recent bond issue, the group is not expected to make profits and pay tax until FY2020. Tax relief may be available to shelter profits arising which would potentially push back the date tax becomes payable. However, new loss relief provisions have been introduced which restrict the amount of losses that can be carried forward and utilised against future profits. A more detailed review of the group's historical tax loss position and forecast profit projections would be required to determine the exact date the group would become tax paying.

The holding company has no trading activity. It holds shares in the existing supplier as an investment. Funding has been provided by group undertakings (the CBS). For tax purposes it will likely be considered a company with investment business. Where intra-group loans are provided on an interest bearing basis, tax relief may be available for interest payable subject to provisions contained in the new corporate interest restrictions.

Where loans have been provided from a related party, tax relief can be restricted for the interest expense if the Company is considered to be thinly capitalised or where the terms of the debt are not considered to be arm's length. Compensating adjustments would be available in the lender where transfer pricing adjustments restrict relief in the borrower company, often making adjustments tax neutral across a UK group. However this may be relevant depending at which level SG would seek to invest in the group.

There is not sufficient publicly available information to determine the actual tax position of the holding company, however, based on the accounts for FY2016 it would appear that the company is not currently tax paying.

The CBS is a community benefit society registered under the Co-operative and Community Benefit Societies Act 2014. Again, based on publicly available information it is not possible to confirm its tax status or the actual activity taking place in this entity. A community benefit society will generally take one of 2 forms, these are described below.

Charitable community benefit society

A CBS will be charitable when it is established with an exclusively charitable purpose and is recognised as such by the OSCR. A charitable society benefits from a number of statutory tax exemptions, which can result in a charity not being liable to corporation tax on its profits or income.

Where charities are engaging in commercial / non-charitable activities it is usual to have these conducted through a wholly owned trading subsidiary. Profits arising in trading subsidiaries can be paid up by way of gift aid to the parent (charitable) entity where the subsidiary has sufficient distributable reserves and cash balances. Paying gift aid in this manner, has the potential to remove any tax charge from arising in the subsidiary, whilst the charity is not subject to tax on the gift aid receipt. This can eliminate any tax charges across a charitable group and is a common structure used and accepted by Her Majesty's Revenue & Customs (HMRC).

In a charitable CBS, the asset-lock provides that if the society or charity is dissolved, any residual assets must be transferred to another charity with the same or similar charitable purpose, thereby reducing flexibility.

Non-Charitable

A non-charitable CBS would be one that does not have wholly charitable objectives. It will be subject to tax on any profits and gains earned similar to an ordinary trading company, unless HMRC accepts that the activity of the company does not amount to carrying on a trade (see comments below).

A non-charitable CBS will not be able to shelter any subsidiary entity profits by way of gift aid.

In the case of the existing supplier, given the forecast projections outline an anticipated tax charge in FY2020, it is considered likely that the CBS has not been established as a charitable CBS, although a more detailed review is recommended in order to confirm this position, should this option be retained going forward. .

Government owned company

Under this option, a new Limited company, 100% owned by SG (potentially by a Department, e.g. Energy Directorate) would be created. The company would be governed by the Companies Act and with an appointed Board of Directors.

As a separate legal entity, a government owned corporation has no special tax status and would be within the scope to corporation tax. If the Energy Co. is considered to be trading, and profits are generated from that trade, those profits would be subject to tax.

A 'trade' is considered to include 'any venture in the nature of trade'. Broadly, 'trade' is taken to refer to operations of a commercial kind by which a trader provides to customers some kind of goods or services for reward.

In this case, where the Energy Co. providing services (supply of energy) to customers for reward it would be considered trading in nature and taxable.

If the Company generated losses initially those losses would be available for carry forward. Losses carried forward can be offset against future profits arising, subject to an annual restriction where profits exceed £5m pa.

Federal model

Under this option a newly incorporated company could be established to could hold shares in various joint ventures operated by individual LAs. The potential for JVs with partial subsidiary ownership by respective LAs.

The top company would be controlled by SG (through Board representation as per a Government Company). Governance arrangements would be agreed for the regional subsidiaries, including delegated remit. Funding would be through SG (as shareholder) with the potential for third party funding.

The tax treatment of the top company would depend on what that entity is and what activities if any are being carried out in it. In principle the entity would be within the scope of tax. Further consideration would need to be given as to how the top company is funded (i.e. grant or SG loans) and the nature of funding being passed to the subsidiaries.

Where the JV subsidiaries are responsible for the supplies of energy, granting a shareholding of >25% to the individual LAs would break the group relationship for corporation tax purposes. The JV subsidiaries themselves would be trading companies that are subject to tax. However, breaking the group relationship could be tax disadvantageous if one JV subsidiary has losses whilst another is profitable.

Where the intention is for the LA to hold at least 5% of the ordinary share capital of the JV subsidiary, each entity is likely to be considered a consortium owned company, meaning consortium relief could be granted between the consortium owned company (the JV) and the members of the consortium and vice versa. This may be beneficial where there are losses or tax reliefs arising in the top company as a result of debt funding.

A detailed consideration of the structure / flows should be undertaken to ensure this structure does not create unnecessary tax charges as a result of stranded losses or tax.

VAT considerations

The choice of legal entity should not significantly impact the VAT position. The supply of power and electricity is a business activity for VAT purposes and this position is not altered or dependent on the delivery structure chosen to supply the power and electricity.

It will be important to clearly understand and define the VAT structure and VAT accounting obligations of the legal entity that is chosen to deliver the Energy Co.

The legal entity will need to be VAT registered and it will need to charge VAT at the appropriate rate on its sales. It will also need to be able to ensure it is entitled to recover the VAT it incurs on its purchases, subject to the normal rules.

VAT registration

Legal entities undertaking taxable business activities in excess of £85,000 per annum are mandatorily required to register for VAT.

The Energy Co. will be required to register for VAT and, where it is in a net VAT payment position to HMRC, it is likely that it will submit quarterly VAT returns to HMRC.

Based on the short list of options, we would make the following comments:

Do nothing

Where the Energy Co. project does not proceed, no VAT registration will be required.

Existing socially minded supplier

Where an existing socially minded supplier is used, it is likely that the entity is already registered for VAT.

Government owned company

The Government Owned Company would need to be registered for VAT in its own right.

Federal model

This option is potentially more complicated from a VAT perspective, as, hypothetically, the Energy Co. will sit above joint venture companies with each of the individual LAs in Scotland.

This approach is likely to require the Energy Co. to register for VAT and similarly each of the LA joint venture companies would need to register for VAT. This could require up to 33 VAT registrations to be obtained and 33 separate VAT returns would need to be submitted.

It is unlikely, that the Energy Co. and the LA joint venture companies would be able to form a VAT group, unless there is a single controlling entity. In principle, this could potentially be achieved if the Energy Co.'s shareholding in each of the LA joint venture companies is 51% or more.

The benefit of VAT grouping in this instance is that a single VAT group registration would be required and a single VAT return would be submitted covering the activities of all the members of the VAT group. The disadvantages of VAT grouping are that each of the members of the VAT group would be jointly and severally liable for the VAT debts of the other members of the VAT group.

VAT treatment of supplies of power and electricity

The VAT liability of supplies of power and electricity depends on the nature of customer and the levels of power and electricity used by that customer.

Two potential VAT rates apply to retail supplies of power and electricity, the:

  • Reduced rate of 5%
  • Standard rate of 20%.

The reduced rate of VAT applies to supplies of fuel and power for 'qualifying use'. Qualifying use is defined as domestic use and charitable non-business use.

In principle there are four potential types of customer for VAT purposes:

Domestic supplies

Domestic use is defined as supplies of power and electricity for genuine domestic use. The supply must be made to a dwelling or certain other types of residential accommodation.

The examples of residential accommodation include:

  • Houses, flats or other dwellings (including armed forces residential accommodation, caravans, houseboats, student accommodation etc.)
  • Children's homes and homes providing care for the elderly/disabled/people with alcohol, drugs or mental disorders
  • Institutions that are the sole or main residence of at least 90% of their residents
  • Monasteries, nunneries and similar religious communities
  • Hospitals, prisons (or similar) and hotels, inns etc. are not considered to be residential accommodation for the purposes of applying the reduced rate of VAT.

Charitable non-business use

Charities qualify for the reduced rate of VAT where power and electricity is used for:

  • A dwelling or certain other types of residential accommodation, such as a children's home, hospice or care home for the elderly or disabled
  • Charitable non-business activities, such as free day care for the disabled.

Where the charity does not make a charge for the services it provides, its activities are likely to be non-business. Care is needed in this area as many Charities do undertake business activities for VAT purposes and where this is the case, power and electricity used to support the Charities' business activities is unlikely to qualify for the reduced rate of VAT.

In order to apply the reduced rate of VAT, the Energy Co. will need to undertake reasonable steps to ensure that the supplies of power and electricity are being used for a qualifying charitable use. Typically part of this process should involve the Charities providing a certificate to the Energy Co. confirming that they are using the power and electricity for a qualifying charitable use.

Commercial de minimis supplies

Where the Energy Co. makes small de minimis supplies of power and electricity to customers, the supplies are treated as being for domestic use, regardless of whether the customers are domestic, charitable or commercial customers.

  • Supplies of electricity qualify as de minimis, where the quantity of electricity provided does not exceed 33 kilowatt hours per day, or 1000 kilowatt hours per month;
  • Supplies of gas qualify as de minimis, where the quantity of piped gas provided does not exceed an average of 145 kilowatt hours per day, or 4,397 kilowatt hours per month.

The de minimis limits apply to any one customer at any one of the customer's premises.

Industrial and commercial customers

Supplies to industrial and commercial customers which exceed the de minimis limits are subject to VAT at the standard rate.

Partly qualifying use

Where power and electricity is supplied to premises partly for qualifying use and partly for non-qualifying use, the VAT should be charged at the appropriate rate on each element of the supply made. However, where 60% or more of the power and electricity is supplied for qualifying use, the whole supply can be charged at the reduced rate.

A certificate should be obtained from the customer that states what percentage of the power and electricity supplied is being put to a qualifying use.

Ancillary supplies

The reduced rate of VAT can also be applied to ancillary supplies related to the principle supply of power and electricity, provided:

  • The Energy Co. makes the supply and provides the power and electricity to the consumer
  • The supplies are charged to that consumer
  • They are inseparable from a supply of fuel or power to that consumer.

For example, the reduced rate can be applied to:

  • Disconnection and re-connection of the supply and special meter readings at the instigation of the supplier
  • Installation by a supplier of liquefied petroleum gas of a bulk gas tank regarded as essential to the supply of liquefied petroleum gas
  • Installation of check meters
  • Installation or replacement of lines and switchgear belonging to the electricity supplier
  • Installation tests and re-tests where required by the supplier to protect their equipment
  • Maximum demand and minimum guarantee charges
  • Removal of damaged coins/tokens from meters
  • Rental charges for meters, including secondary meters used by landlords to apportion charges between their tenants
  • Rental of a bulk gas tank in conjunction with the supply of liquid petroleum gas to that tank
  • Repair, maintenance or replacement of equipment and gas pipes or electric cables - belonging to the supplier - up to and including the consumer's meter
  • Replacing a credit meter with a pre-payment meter under the supplier's Code of Practice, or replacing or re-siting by a supplier of their meter at their instigation
  • Replacement of mains fuses and provisions of earthing terminals
  • Standing charges.

Wholesale purchases of power and electricity

The Energy Co.'s wholesale purchases of gas and electricity from counterparties established in the UK are likely to be subject to UK domestic reverse charge.

UK Domestic Reverse Charge

The domestic reverse charge procedure is an anti-fraud measure that is designed to counter criminal attacks on the UK VAT system by means of sophisticated fraud.

Subject to certain exceptions, the domestic reverse charge applies to all wholesale supplies between UK counterparties under trading contracts (for example European Federation of Energy Traders contracts, Grid Trade Master Agreements and National Balancing Point contracts) and over the counter or spot contracts of:

  • Gas, where it is gas supplied through a natural gas system situated within the territory of a Member State or any network connected to such a system, or
  • Electricity.

The domestic reverse charge also applies to emissions allowances, where compliance markets credits can be used to meet obligations under the EU ETS. These currently comprise EU Allowances, some certified Emission Reductions and some Emission Reduction Units.

Power Purchase Agreements

Sales of electricity made under a PPA or similar agreement may or may not be subject to the reverse charge depending on their wholesale features.

Electricity sold under a PPA agreement will not be regarded as wholesale supplies, which are subject to the reverse charge where the:

  • Seller of electricity is a generator who is exempted from holding a generating licence
  • The generation capacity by asset is 100 megawatt (MW) or less
  • The generated volume is not allocated to the generator's production account with Elexon.

Exceptions to the UK Domestic Reverse Charge

The domestic reverse charge does not apply to supplies of gas and electricity made under supply license or metered arrangements to domestic and business premises. For example, supplies made to commercial customers that are used and consumed within that business, rather than being resoled or traded are not subject to the reverse charge.

Further examples of supplies or charges not covered by the domestic reverse charge include:

  • Distribution use of system charges
  • Transmission network use of system charges
  • Metering rental charges
  • Data collection charges
  • Balancing system use of system charges
  • Interconnector capacity charges
  • Gas storage charges
  • Gas network system charges
  • Payments made in respect of constraint contracts with National Grid
  • Balancing and settlement code charges (Elexon market operator charges)
  • Levy Exemption Certificates (LECs) and/or Renewable Obligation Certificates (ROCs) traded separately from the underlying electricity
  • Fees for exchange related settlement for example N2Ex fees
  • Option premiums.

The above list is not exhaustive.

Application of the domestic reverse charge

Where the Energy Co. receives wholesale supplies of electricity from a supplier established in the UK, the domestic reverse charge is likely to apply. This means that the Energy Co.'s suppliers will not charge VAT on their sales invoices to the Energy Co.

Where VAT is not charged by the supplier, the Energy Co. will be required to self-account for the VAT through its VAT return. The Energy Co. will be required to:

  • Charge itself notional output tax based on the net value of the purchase invoice received. This notional output VAT should be included into box 1 of the VAT return
  • Reclaim a corresponding amount of notional input tax in Box 4 of the VAT return
  • The net amount of the purchase should be included in Box 6 and Box 7 of the VAT return.

As a result of the above, the net VAT impact of the domestic reverse charge for the Energy Co. should be zero. The notional output VAT charged should be directly offset by the corresponding input VAT credit claimed.

Renewable Energy Implications

Where the Energy Co. intends to undertake renewable energy projects, which could include, for example, placing solar panels on customers' homes and buildings, the VAT treatment of the arrangements should be considered in detail.

Taking a solar panel project as the indicative example, the following VAT treatments would apply to the related transactions:

Feed in tariffs

Where the Energy Co. receives feed in tariffs in relation to the electricity generated by the solar panels, the feed in tariffs should be treated as outside the scope of VAT.

Export tariffs

Where the Energy Co. sells the electricity generated from the solar panels to other customers, the supplies of electricity will be subject to VAT at the appropriate rate.

Barter transactions

Where the customer receives 'free' electricity as part of the arrangement, it is likely that HMRC would view this a barter arrangement. The customer receives 'free' electricity in return for making a supply (for VAT purposes) of allowing the Energy Co. to place the solar panels on the customers building. The Energy Co. would then be required to account for VAT based on the cost of the 'free' electricity provided to the customer.

Capital investment

From a direct tax perspective capital investment in renewable energy projects would potentially qualify for tax relief, which would be available for offset against trading profits arising in the Energy Co.

For plant and machinery with an expected useful economic life of less than 25 years, capital allowances would typically available on qualifying expenditure at a rate of 18% per annum on a reducing balance basis. Allowances reduce the level of profits subject to tax.

Similarly, enhanced capital allowances (ECAs) are available for expenditure on energy-saving plant or machinery as specified on the Energy Technology List managed by the Carbon Trust. ECA's allow companies to write off the whole cost of the equipment against taxable profits in the year of purchase.

Non mainstream transactions

SG and the Energy Co. may need to give consideration to the VAT treatment of the related non-mainstream activities and transactions. We have outlined a number of potential areas that should be considered below:

Funding arrangements

The SG and the Energy Co. should give consideration to how the Energy Co. will fund its activities. We have envisaged that SG may provide loan funding to the Energy Co. The VAT liability of any interest income received by SG is likely to be exempt for VAT purposes.

Interest on loan funding provided will potentially be deductible for direct tax purposes. Special rules exist to restrict the amount of tax relief for interest expense in a group to the extent that the aggregate interest expense in any given year is in excess of £2m. The rules contain a number of elections that may increase the amount of tax relief available to a group, however the rules are complex and would require a more detailed consideration depending on the actual funding arrangements.

Where SG or third parties provide services to the Energy Co., it is likely that these charges will be subject to VAT at the standard rate. The Energy Co. should be entitled to reclaim any VAT charged, however it will need to be able to pay the VAT to its suppliers and to be able to cash flow the VAT until such time as the VAT can be reclaimed through its VAT return.

Where SG provides management charges or support services, the valuation of the management charges and support services charges should be considered and our recommendation would be that these charges are conducted on an arm's length basis.

Capital Expenditure and infrastructure charges

Where the Energy Co. incurs capital expenditure and infrastructure charges, it is likely that these charges will be subject to VAT at the standard rate. The Energy Co. should be entitled to reclaim any VAT charged, however it will need to be able to pay the VAT to its suppliers and to be able to cash flow the VAT until such time as the VAT can be reclaimed through its VAT return.

Where the Energy Co. makes onward supplies of the capital expenditure and infrastructure costs, for example in relation to property assets, it will be important to ensure that its onward supplies are taxable for VAT purposes. This may require consideration of the option to tax in order to protect the Energy Co.'s VAT recovery position.

Tax relief will be available for qualifying capital expenditure and infrastructure costs where these are used in the course of a trade carried on by the company.

Provision of energy savings materials

Where the Energy Co. provides and installs energy savings materials to its customers, it should be possible to apply the reduced rate of VAT to qualifying works and materials. Please note, the supply of energy-saving materials without installing them remains standard rated for VAT purposes.

Renewable Obligations Certificates and Levy Exemption Certificates

The Energy Co., as a licensed supplier should consider its obligations in relation to sourcing an increasing proportion of its electricity from renewable sources.

  • ROCs are issued as evidence that electricity from an eligible renewable source has been supplied to customers in the UK. ROCs are sold with the electricity to a supplier. The supplier is then able to use the certificate to demonstrate progress towards meeting its renewable energy obligations. ROCs can also be traded separately from electricity. As an alternative to supplying renewable energy, suppliers may discharge all or part of their obligations by buying ROCs from generators or another party and/or paying a "buyout" price to Ofgem.
  • Climate change levy (CCL) is a single-stage non-deductible tax with environmental objectives that is charged on supplies of electricity and gas to industrial and commercial users. VAT is chargeable on the CCL inclusive value of a supply. LECs allow commercial consumers to avoid paying CCL by acquiring LECs from renewable energy suppliers.

Conclusion

Further analysis will be undertaken at OBC to determine the specific tax implications of the preferred delivery vehicle and operating model.


Contact

Email: Alan.Clark@gov.scot