Supreme Court decision on eligibility for Capital Allowances for offshore windfarm surveys and studies
Overview
In a unanimous decision, the Supreme Court has allowed HMRC’s appeal and significantly narrowed the circumstances in which expenditure on pre‑construction surveys and studies qualifies for plant and machinery capital allowances under section 11(4) of the Capital Allowances Act 2001 (“CAA 2001”).
This decision is of particular significance for: (i) developers of large-scale energy and infrastructure projects (as the net of tax cost of developing such projects has increased); and (ii) buyers and sellers in M&A transactions involving energy and infrastructure projects (where the allocation and treatment of such pre-construction costs may affect the value of capital allowance pools and, consequently, the tax attributes assumed to be available for valuation purposes).
The decision also highlights the considerable cost pressures that developers of major offshore projects face prior to a project’s final investment decision, including the significant expenditure required on essential preparatory surveys and studies such as subsea surveys before planning permission is granted. As we discuss further below, these cost pressures, compounded by the inability to claim capital allowances on such expenditure, raise broader questions about project economics and the adequacy of existing support mechanisms during the development phase, including whether alternative models such as the Regulated Asset Base model should be explored.
In this article we provide an overview of the decision, and the practical implications for industry participants arising from this decision.
Background
The case concerned four offshore windfarm projects (the Gunfleet Sands Offshore Wind Farm I, the Gunfleet Sands Offshore Wind Farm II, the Walney Offshore Wind Farm and the West of Duddon Sands Offshore Windfarm), each developed by Ørsted. Substantial expenditure was incurred on a wide range of surveys and investigating many different aspects of the environment in which the projects would be constructed; this included landscape and seascape assessments, ornithology and collision risk studies, marine mammal studies, noise assessment studies and geophysical and geotechnical studies. The majority of the surveys and studies in question were required to support an environmental impact assessment needed before planning consent could be obtained for the construction of the relevant project.
Ørsted claimed capital allowances on the cost of the relevant surveys and studies on the basis that they were capital expenditure “on the provision of plant” within section 11(4)(a) of CAA 2001 and therefore qualified for plant and machinery allowances.
The First-tier Tribunal held that most of the expenditure on the surveys and studies in dispute did qualify for capital allowances but the Upper Tribunal allowed HMRC’s appeal and held that none of the expenditure qualified. The Court of Appeal subsequently allowed Ørsted’s appeal and held that all the expenditure qualified, which resulted in HMRC appealing to the Supreme Court.
The Supreme Court’s Decision
The core question before the Supreme Court was whether the costs of the pre-construction surveys and studies constituted “capital expenditure on the provision of plant” within section 11(4)(a) of CAA 2001.
The Supreme Court held that the phrase “on the provision of” within section 11(4)(a) of CAA 2001 demands a close connection between the expenditure and the plant itself. The Supreme Court distinguished the leading authorities — Barclay, Curle (concerning dry dock excavation) and Ben-Odeco (concerning loan interest) — and concluded that neither supported the broad interpretation of this phrase adopted by the Court of Appeal. The Supreme Court made the distinction between costs inherent in acquiring, transporting and installing the plant which can constitute qualifying expenditure and expenditure on studies and surveys which provide advice, information or data about how to choose, design or locate plant which was considered a too remote a connection. The Supreme Court found that the surveys and studies were not incorporated into the physical windfarm assets and did not become part of the plant itself. They were undertaken to assess environmental impact, risks and options, or to satisfy regulatory requirements, rather than to provide or install plant. The Supreme Court’s view was that capital allowances are designed to reflect the gradual deterioration of the asset through wear and tear and that this points to the narrowness of the concept of qualifying expenditure.
The Supreme Court allowed HMRC’s appeal which has resulted in none of the disputed survey and study costs qualifying for plant and machinery allowances. As it was accepted that the expenditure on the surveys and studies was capital in nature and not revenue expenditure, no corporation tax deduction is available for Ørsted in respect of the expenditure. This has the effect of increasing the overall net of tax costs associated with the construction of the projects.
Ørsted had argued that that the purpose of the capital allowances code is to ensure that a business is taxed on its true profits. However, the Supreme Court rejected this argument, noting that accounting principles are not determinative from a tax perspective.
The Supreme Court noted that renewable energy is certainly a sector which the Government has tried to incentivise. However, the Supreme Court concluded that, “One cannot rely on the broad purpose of a provision to define where the precise boundary lies between what is caught and what is not caught”. This perhaps underlines the limits upon the purposive approach to statutory interpretation.
It is also worth noting that the Supreme Court left open the question of whether the cost of producing the final technical drawings and specifications as specified by the developer (i.e. before the plant is actually manufactured) — those which are then directly "made real" by the manufacturer — might qualify. By implication, costs which pre-date those incurred in connection with contracted design works (e.g. where the scope of work under an EPC contract includes general and detailed engineering design works) may not qualify. This means that a key point of concern moving forward will be the extent to which conceptual or front-end engineering design studies undertaken prior to the detailed design / detailed engineering phase can qualify for capital allowances. The judgment is silent on the distinction between final pre-fabrication drawings and red-line/as-built drawings, and the Supreme Court expressly declined to rule on the broader category of final technical drawings at all. The decision leaves open the possibility that red-line drawings produced during testing and commissioning — if they can be shown to be integral to the installation process — might also qualify. These remaining areas of uncertainty mean the position will need to be assessed carefully on a case-by-case basis.
Practical Implications
Practical implications – M&A transactions
This decision is particularly relevant in the context of M&A transactions involving infrastructure or energy assets, where the allocation and treatment of such pre-construction costs may affect the value of capital allowance pools and, consequently, the tax attributes being acquired and assumed to be available for modelling purposes. Purchasers conducting due tax diligence on target entities will need to scrutinise whether capital allowances pools include expenditure on such pre‑construction surveys and studies and therefore whether such claims may now be vulnerable to challenge by HMRC in light of the Supreme Court’s decision.
Practical implications – subsidy support in connection with costs incurred during the development phase of an offshore project?
The Supreme Court’s decision will impact all major infrastructure projects which undertake pre‑construction surveys and studies (e.g. pumped-storage hydro, onshore wind, nuclear and energy-from-waste projects). Offshore electricity projects (e.g. fixed and floating offshore windfarms, point-to-point subsea interconnectors, bootstraps/superhighways and offshore hybrid assets) will be particularly affected given the extensive (and costly) surveys and studies which are required for these projects as subsea cable routes become longer and longer.
Two of the most common types of pre-construction survey activities for offshore windfarms and subsea electricity interconnectors and cables are geophysical and geotechnical subsea surveys. By way of example, in the context of a fixed bottom offshore wind farm, the geotechnical studies will allow for the characterisation of the sub-seabed strata and support: (i) the design of the wind turbine generator and sub-station foundations; and (ii) the subsequent front-end engineering and design studies. For subsea point-to-point electricity interconnector projects (e.g. between the UK and continental European landfall points), hundreds of kilometres of the seabed will be surveyed.
These surveys often involve the use of smaller vessels for nearshore surveys through to dedicated large vessels for offshore surveys, and the costs associated with these surveys are considerable. The time at which the subsea surveys are undertaken (i.e. in advance of planning having been secured and well before the project is ready to build) means they represent one of the most “at-risk” major costs for projects.
The Supreme Court’s decision will not negate the need to undertake these studies — it is impossible to develop a major offshore project without undertaking these surveys. What the decision does do, however, is focus a spotlight on the economic pressures that developers of major offshore projects are under, including the considerable sums required to be expended on surveys and studies prior to the taking of the final investment decision. These costs pressures are affecting project delivery for European and UK offshore wind projects and subsea electricity interconnector projects, as has been seen with: (i) Ofgem’s decision to amend the Window 3 interconnector IPA Conditions; and (ii) the abandonment or suspension of a number of UK wind farms over the last 12 months.
As offshore projects become more complex (for example, offshore hybrid assets allowing offshore wind and interconnectors to work together as a “combined” project which allow clusters of offshore wind windfarms to connect to multiple countries), costs associated with pre-construction offshore surveys — alongside development expenditure straddling multiple jurisdictions — are likely to increase considerably.
Neither the Contracts for Difference scheme (which supports offshore wind projects in the UK by fixing a strike price to provide revenue stability) nor the Cap and Floor regime (which provides a regulated revenue framework for electricity interconnector (and soon long duration energy storage) projects in the UK by guaranteeing minimum revenues (floor)) provide point-in-time relief in respect of costs incurred during the development phase of a project. One alternative revenue approach which could provide significant cash flow relief for developers is the Regulated Asset Base (“RAB”) model, which is a form of economic regulation typically used in Great Britain for monopoly infrastructure assets such as water, gas and electricity networks (and is now being used for largescale projects in the new nuclear and CCUS sectors). It is also used extensively across Europe as the revenue model for interconnectors. One of the attractive features of the RAB model in the context of offshore projects with extended development timelines is that it can be used to provide revenue during the development phase, which allows for capital recycling during the development phase. Ofgem’s recent Call for Input on the “Future Strategic Approach to Interconnection” provides an insight into how a RAB scheme could operate to reduce the cost of capital during the development phase of a project, as further discussed in our recent update.
The Supreme Court’s decision represents the final appellate route for this matter. It remains to be seen how developers, investors and other industry participants will price these additional pre-construction costs into their project economics going forward, and whether this will prompt further consideration of alternative support mechanisms or legislative change to account for this decision.
