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Does the tax reimbursement for exploration costs constitute illegal state aid?

On 21 August 2017, the Bellona Foundation (“Bellona”) lodged a complaint with the EFTA Surveillance Authority (“ESA”) alleging that the cash reimbursement of the tax value of exploration costs constitutes illegal state aid under Article 61 of the EEA Agreement.

On 7 December 2017, ESA sent a letter to the Norwegian government, requesting additional information regarding the complaint. The Norwegian Ministry of Finance responded to this letter on 9 February 2018, maintaining the government's stance that the cash reimbursement does not constitute state aid. First, a brief overview of the legal question that ESA must consider.

The first section of Article 61 of the EEA agreement reads as follows:

Save as otherwise provided in this Agreement, any aid granted by EC Member States, EFTA States or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Contracting Parties, be incompatible with the functioning of this Agreement.

Thus, for a measure to constitute state aid, it must confer a selective advantage on an undertaking, entail the use of state resources and (potentially) distort competition and affect trade between EEA Member States. For all practical purposes, the provision corresponds to the state aid provision in the EU, Article 107(1) of the Treaty on the Functioning of the European Union ("TFEU").

The key issue in this case is whether the reimbursement rule pertaining to exploration costs gives petroleum companies benefitting from the rule a selective advantage. This rule, having its legal basis in the Petroleum Tax Act section 3, litra c, paragraph five, gives oil and gas companies a claim against the state for a reimbursement in cash of the tax value of all costs related to the exploration for petroleum on the Norwegian Continental Shelf.

According to case law from the European Court of Justice ("ECJ"), a three step test must normally be applied to consider whether measures that mitigate the normal charges of undertakings, typically advantages granted through exemptions to national tax provisions, are selective.

The first step is to identify the correct system of reference. The second step is to consider whether a given measure constitutes a derogation from the system of reference by differentiating between economic operators who are in a comparable factual and legal situation. If the measure is not a derogation from the reference system, it is not state aid. If the measure is a derogation from the reference system, the next step is to consider whether the derogation is justified by the nature or logic of the system. If it is consistent with the nature and logic of the system, it is justified and therefore not state aid in the meaning of Article 61 of the EEA Agreement.

The arguments in bellona's complaint

Bellona's main legal argument is that the reimbursement is not in fact a "real tax advantage", but is in its form and content a subsidy. Bellona argues that the state through the reimbursement scheme covers the operating expenses of the undertakings without any certainty of ever being able to recoup the expenses through subsequent taxation. The three step test described above should therefore, according to Bellona, not apply; the measure is according to Bellona not a "normal" tax measure.

If the three step test applies, Bellona does not question that the correct reference system may be the petroleum tax system. The reimbursement however only applies to companies that perform specific exploration activities, and not to other companies subject to petroleum tax, and is therefore a derogation from the reference system. Furthermore, the objective of the measure is to induce exploration for oil and gas to make sure more oil and gas reserves are discovered, and in turn to increase the tax revenue in the long run. Bellona argues that this objective is an external policy objective, and as such not consistent with the nature and logic of the system.

The response from the norwegian government

The Ministry of Finance commented on Bellona's complaint in a letter 22 September 2017. ESA subsequently requested more information, in particular with regard to the identification of the reference system for the measures in question. ESA further asked for clarifications with regard to the relationship between the regular corporate tax regime in Norway and the petroleum taxation regime. The Norwegian Ministry of Finance provided additional information to ESA in its letter 9 February 2018. In its responses to ESA, the Ministry argues that the petroleum tax regime is the correct reference system. The applicable tax rate of approx. 78% consists of the general corporate tax rate (23% in 2018) and a special tax on petroleum activities (55%). The petroleum tax regime is a resource rent tax, and is in its nature different from a regular business tax regime. A resource rent tax, according to the Ministry, should be neutral and symmetrical, to ensure that a project's profitability does not depend on the tax rules. This is especially important when the tax rate is high. A central objective of the tax rules is to not distort investment decisions, either by hindering profitable investments or encouraging unprofitable investments.

The Ministry argues that the reimbursement must be viewed together with, inter alia, the rules on tax loss carryforward with interest and the rules on reimbursement of the tax value of losses upon terminating activities in Norway. Viewed in this light, the reimbursement is an integral part of the petroleum tax regime, or is at least consistent with the nature and logic of the regime.

Before the reimbursement rule was introduced, petroleum companies that were not in a tax paying position (i.e. did not have a taxable surplus) could have a liquidity disadvantage compared to companies with a tax surplus. Petroleum companies with a tax surplus could deduct exploration costs from their taxable income from petroleum production. The goal of the reimbursements rule was to ensure equal treatment for all petroleum companies in terms of tax deductions for exploration costs. The Ministry therefore argues that the reimbursement rules are not selective. Further, the Ministry argues that the rules do not confer an advantage on petroleum companies not in a tax paying position.

The Ministry does not comment on Bellona's argument that the reimbursement is not a "real tax advantage" in its letter and that the three step test described above therefore does not apply.

The process going forward

There are in essence two procedural options for ESA to deal with the complaint from Bellona. It can either make a decision that the reimbursement rule does not constitute aid, or it can open a so-called formal investigation procedure.

An opening decision does in no way prejudge the eventual outcome of a case. ESA would then have to make a (final) decision after the formal investigation procedure on whether the reimbursement rule constitutes state aid. Only in final decisions (after a formal investigation procedure) could ESA make a negative decision, and theoretically order Norway to recover potential aid inherent in the reimbursement rules from recipients. All types of decisions can be appealed before the EFTA Court provided the applicant has legal interest to bring the case.

In terms of timing, according to its own "best practices", ESA will make a "no-aid" decision or an opening decision at the latest approximately one year after the complaint has been lodged. It would therefore appear likely that a decision will be taken by ESA before of after the summer this year. Should ESA open a formal investigation procedure, this would typically last between 9 and 18 months.

As regards to the type of decision that ESA will presumably take around summer, it is noteworthy that ESA is legally obliged to open a formal investigation procedure if there are (objective) doubts whether the reimbursement rule entails state aid. Given the complexity of the issue at hand, there is therefore indeed a risk that ESA will open the formal investigation procedure.

Should it do so, this decision including its preliminary legal assessment will be published, and third parties will be invited to comment. Prior to the opening of a formal investigation procedure, third parties other than the complainant have no formal role in state aid proceedings. However, companies that could be affected by ESA's future decision are not barred from providing information or expressing their view to either ESA or the Norwegian authorities.

Kluge's view

In our opinion, the measure should not be regarded as state aid. However, as the matter is rather unique, it is difficult to predict the outcome of ESAs assessment.

In our opinion, the petroleum tax regime should be regarded as the correct system of reference, because of the fundamental differences between this regime and the regular tax regime.

The reimbursement rule would appear to be a non-selective part of a neutral tax system which treats all comparable undertakings alike. The reimbursement rule should either be considered as not being a derogation from the reference system, or as a derogation that is justified by that nature and logic of the regime. The measure should therefore not be regarded as conferring any selective advantage to petroleum companies.

Nonetheless, there is a risk that ESA will find it necessary to open a formal investigation after its initial assessment, because of the complexity of the question and the lack of any directly comparable precedent in administrative practice from the EU Commission or ESA, or in case law of the Court of Justice of the European Union or the EFTA Court.

As mentioned above, an opening of the formal investigation procedure does by no means prejudge the eventual outcome.

Media has reported that oil companies having received exploration cost reimbursements risk having to repay the full value of the reimbursements. Even if ESA should find that the tax reimbursements constitute state aid after a formal investigation procedure and order its recovery, the state aid element inherent in the reimbursements may be far lower than the face value of the reimbursements (at least as long as other elements of the petroleum taxation regime are not questioned).

This newsletter provides a brief overview of the case, and is not intended to be relied upon as legal advice. Please refer to your advisors or one of the authors of this newsletter if you require specific advice.