Liquefied Natural Gas (LNG) has been making the headlines for the past year as a result of significant interest in potential sales to energy-hungry Asian markets from the coast of British Columbia. There are at least 19 LNG proposals for British Columbia, but so far none of the proponents have commenced construction.

Against this backdrop of significant development interest the BC Government began a review of the LNG industry in early 2014 for the purpose of investigating an appropriate taxation regime. This review ultimately lead to the Liquefied Natural Gas Income Tax Act, which is scheduled to come into effect on January 1, 2017.

The initial BC government review was focussed on four principles: (1) achieving a fair return for British Columbians; (2) remaining competitive with other jurisdictions; (3) providing predictability to LNG proponents; and (4) integrating input of LNG proponents to ensure consistent treatment. The BC government was also concerned that its current tax regime might be insufficient to properly tax the LNG industry: The existing royalty structure might only apply to LNG produced from natural gas actually extracted in BC, and the BC corporate income tax would only apply to entities with a fixed place of business in the province. Accordingly foreign businesses concluding contracts outside of BC, and using liquefaction facilities belonging to other entities under tolling agreements might escape tax on a significant portion of the value-added associated with the LNG industry. This was viewed by the government as an intolerable situation relative to the perceived benefit that these companies would be reaping.

The initially announced tax regime proposed a tax at a maximum rate of 7% of the income derived from liquefaction of natural gas at LNG facilities in BC.  However, with the decline in the price of oil in late 2014 (and associated decline in the price for LNG), and suggested higher construction costs based on similar projects taking place in Australia, BC was pressured to re-jig the proposed tax rate, settling on a rate of 3.5% through the first 20 years, and 5% thereafter.

As currently proposed, the BC LNG income tax is somewhat unique in presenting a two tier tax system, meant to ease LNG facilities into the tax in stages, saving the bulk of the tax for when the facilities are fully operating and profitable, but also resulting in some up-front tax revenue for the province in the earlier years of the project.

The costs associated with the construction of an LNG facility will be accumulated in a capital investment account, or treated as an operating loss, as applicable. Once the facility begins commercial production, those costs are deductible, and a minimum tax of 1.5% applies (based on net operating income). Once the operating losses and investment capital investment costs are fully deducted, the 3.5% tax rate applies and any tax previously paid at the 1.5% rate is creditable against same. For example, an LNG facility that paid $150,000 in tax at the 1.5% rate can take a $150,000 credit against tax in future years calculated at the 3.5% rate.

From the BC government’s perspective, the Liquefied Natural Gas Income Tax Act is probably viewed as successfully ensuring that an LNG investment is suitably taxed without disadvantaging the province. The downside would appear to rest entirely with the LNG investors who would run the risk of construction cost over-runs, lower future LNG prices – and potential future government rate hikes. (The upcoming 100th anniversary of the Canadian federal income tax is a reminder that the 1917 tax rate was initially 4%).

In an effort to mitigate some of this risk, the proposed LNG Income Tax also includes a Natural Gas Tax Credit within the existing BC provincial income tax act to provide a discount for LNG taxpayers who have a permanent establishment in the province (defined in the federal regulations). More recently the federal government has agreed to changes in the federal CCA rules for BC LNG terminals which are expected to be in place for nearly 10 years.

We understand that the BC government currently expects that up to three LNG facilities will be operating in the province by 2020, and hopes that the new rules and competitive tax rates will entice LNG proponents to finally commit to the province and help ensure that British Columbians get their fair share of the LNG windfall.

On the other hand, LNG Proponents appear to be proceeding somewhat cautiously. Undoubtedly they want to avoid spending huge up-front costs for an as of yet unproven market. With uncertainty on the revenue side due to the fall in energy prices in late 2014, the BC tax proposals may look somewhat premature.

One wonders if BC is guilty of counting its eggs before they have hatched.