September 13, 2018
On 25 June 2018, the Federal High Court (FHC) Lagos, in the case of the Federal Inland Revenue Service (FIRS) vs Shell Production Development Company (Shell) held that payments for gas flaring are not tax-deductible. The Court reached this decision on the grounds that such payments are not within the category of expenses incurred wholly, exclusively and necessarily for petroleum operations as envisaged by Section 10 of the Petroleum Profits Tax Act.
Shell made payments to the Department of Petroleum Resources (DPR) for gas flaring between 2006 to 2008 and treated the payments as allowable deductions for tax purposes. However, the FIRS disallowed the deductions on the grounds that the payments related to penalties and imposed additional liabilities on Shell.
Upon appeal to the Tax Appeal Tribunal (TAT), the TAT set aside the additional liabilities imposed by the FIRS and held that the said payments were “royalties” and not “penalties” thereby constituting allowable deductions.
However, the FIRS appealed to the FHC as it was dissatisfied with the TAT’s decision. The crux of the issues before the FHC was whether the TAT was right to have regarded such payments as royalties rather than penalties and hold that Shell could take tax deductions for the said payments.
The Court ruled in favour of the FIRS stating that payments made for gas flaring are non-deductible for tax purposes because such payments are not within the category of expenses incurred wholly, exclusively and necessarily for petroleum operations. The Court also held that the TAT acted ultra vires its powers by substituting the class of payments from “penalties” to “royalties”.
Based on this judgment, payments for gas flaring activities that carry the nature of penalties are not deductible for tax purposes.
This Judgment reinforces the decision of the FHC in an earlier case between the FIRS and Mobil Producing Nigeria Unlimited (Mobil) (please refer our tax alert on the Mobil case). Similar to this Shell judgment, the Mobil case was decided in the Lagos division of the FHC, albeit by different Judges. However, an interesting perspective to this case is the argument on the replacement of penalties with royalties.
Aside from the overriding importance of the nature of transactions as against their associated nomenclature, a literal interpretation of Section 3 of the AGRA simply suggests that the provision is focused on procedural and administrative treatments of payments for gas flaring and not their tax treatments. Thus, contemplating a substitution of flaring fees for royalties suggests that the issue was wrongly canvassed as payments for royalties and gas flaring are clearly separate and distinct.
Furthermore, there is no legal basis for the classification of payments for gas flaring as “penalties”. In fact, the penalty for flaring gas in an oil field without obtaining a prior Certificate/Permit from the Minister is a forfeiture of the concession granted by the minister with respect to such oil field and not a monetary sum in line with Section 4 of the AGRA. Thus, the strict interpretation of the law is that the Minister would withdraw any licence granted with respect to the affected oil field and not impose a monetary sum as penalty where there is a breach of Section 3 of the AGRA.
Given the typical delay in the issuance of Certificates/Permits for gas flaring, taxpayers may be reluctant to adhere to this judgment as delay or denial in issuance of Certificates/Permits puts them in a prejudicial state. It is important for the relevant government authorities to revisit the process for issuance of Certificates/Permits to foster voluntary and seamless compliance from taxpayers.