On October 21, 2014, the Liquefied Natural Gas Income Tax Act (the “Bill”) was introduced into British Columbia’s Legislative Assembly. The Bill reflects the culmination of the Province’s goal to introduce an LNG tax framework which was initially unveiled in February 2014. The introduction of the Bill is the most significant step taken to date in the B.C. Government’s effort to create a tax framework for the province’s LNG sector.

The primary purpose of the Bill is to introduce a tax regime (the “LNG Tax”) with two fundamental components:

  1. A tier 1 tax of 1.5% of “net operating income” (as defined); and
  2. A tier 2 tax at an initial rate of 3.5% of “net income” (as defined).

As set out in the Bill, the LNG Tax will apply to the income from all liquefaction activities in British Columbia. The 3.5% “net income” tier 2 tax is effective for taxation years beginning on or after January 1, 2017. The 1.5% “net operating income” tier 1 tax (i) applies during the period when net operating income exceeds the sum of net operating losses and the capital investment deduction and (ii) is creditable against the 3.5% tier 2 tax. In 2037, the tier 2 tax will increase to 5% of net income. Note that the tier 2 tax has been significantly reduced from the “up to 7%” rate contemplated in the initial version of the framework that was announced in February 2014.

In this article, we discuss the LNG Tax Framework and identify a number of issues and uncertainties arising from the Bill. As any such discussion is necessarily limited in its scope and detail, it is important that readers seeking to understand the implications of the Bill for themselves or their businesses consult experienced counsel with knowledge of their particular situations.

The Framework

Who will pay the LNG Tax?

The LNG Tax applies to a “taxpayer” which is defined as “any person that engages in or has income derived from liquefaction activities” at an “LNG facility”. The Bill does not explicitly require the taxpayer to be a resident of Canada or to have a permanent establishment in the province of British Columbia to be liable to pay the LNG Tax.

The Bill defines “liquefaction activities” in an extremely broad fashion that includes, among other things:

  • operating all or part of an LNG facility,
  • acquiring, owning or disposing of LNG (or the right to own or dispose of LNG) that is at an LNG facility,
  • acquiring, owning or disposing of all or part of an LNG facility,  or
  • receiving a tolling or processing fee for liquefying natural gas at an LNG facility (regardless of ownership in the LNG facility).

The definition is also broad enough to include:

  • the disposition of electrical power generated at the LNG facility,
  • acquiring, owning or disposing of intangible personal property (or a right to acquire such property) that is used for the operation of the LNG facility or the activities described above, or
  • acquiring, owning or disposing of a right to receive income “derived” from one or more of the activities described above.

The LNG facility consists of the particular “LNG plant” and the land that underlies the LNG plant, as well as the land that is contiguous with such land (including improvements on such lands that are used to carry out liquefaction activities). The definition of “land” contained in the Bill also contemplates floating LNG facilities that are anchored within provincial waters. The term “LNG plant” is defined to include the tangible personal property and improvements “that are part of a series of systems used or intended to be used for liquefying natural gas”, but specifically excludes any feedstock pipeline and property upstream of the feedstock pipeline. The interpretation of the phrase “series of systems” will be important in determining what infrastructure will fall within the definition of “LNG plant”, thereby entitling it to be included in the taxpayer’s capital investment account.

The LNG Tax will apply to toll processors as well as integrated companies that own the LNG facility. In our view, it would be difficult to overstate the potential for broad application of the LNG Tax. This is especially true when considering its potential extra-territorial application (setting aside the difficult jurisdictional issues that may arise as a result of such extra-territorial reach). Take the case, for example of a non-resident third-party marketer of LNG. Such an entity could arguably be subject to the LNG Tax – even though it is a non-resident of British Columbia and does not carry on business or have a permanent establishment in the province – simply by virtue of having a “right to acquire” LNG that is at an “LNG facility”.

To continue with the issue of the potential broad application of the LNG Tax, it is worth considering that the term “derived”, in the context of tax legislation, has been interpreted by the Supreme Court of Canada as having a broader meaning than the term “received” i.e. as the equivalent of “arising or accruing” (and is not limited to income arising or accruing from the operation in question by a particular taxpayer). One consequence of this in the current context is that the LNG Tax may be payable at multiple points along the value chain or may apply to other ancillary sources of revenue. For example, if a third-party loans money to an LNG project, are the payments received by the lender from the operating income of the LNG facility subject to the LNG Tax on the basis that the lender is in receipt of “income derived from the operation of an LNG facility”? While such a broad interpretation seems unlikely (especially considering the interpretation of similar issues under the Income Tax Act(Canada) (the “Federal Act”)), the Bill’s drafters clearly intended a broad application of the LNG Tax – they have even indicated that it may apply to income derived from operating a parking lot at the LNG facility.

The Tax Base

Computation of Income

As discussed above, the LNG Tax is imposed for a taxation year on net income or net operating income derived from liquefaction activities at an LNG facility. The tier 2 tax of 3.5% (rising to 5% for taxation years beginning on or after January 1, 2037) applies to net income and the tier 1 tax of 1.5% applies to net operating income. The tier 2 tax will come into effect when a LNG facility’s capital account is depleted and the taxpayer does not have a net operating loss. The Bill provides that the tier 1 tax paid will be accumulated in a tax pool balance to be credited against the tier 2 tax rate once the tier 2 tax applies. Unlike Crown royalties under the British Columbia Mineral Tax Act, the LNG Tax is not deductible for federal and British Columbia income tax purposes. It is an open question as to whether the federal government will provide any incentives to taxpayers, including, remedying the current non-deductibility of the LNG Tax as they have with respect to “mining taxes” and providing for enhanced capital cost allowance deductions.

The computation of net income and net operating income under the Bill is modelled after the calculation of income under the Federal Act with certain adjustments. For example, in computing a taxpayer’s income for the purposes of the LNG Tax the Bill excludes gains from hedging transactions and foreign exchange gains. Furthermore, the Bill provides that no deductions are allowed for capital cost allowance (or amounts paid under the Federal Act or financing charges paid or payable in a taxation year), although the taxpayer is permitted to deduct the “investment allowance” that is discussed in the following subsection.

Investment Allowance

The investment allowance is based on the balance of the taxpayer’s “adjusted capital investment account” for the LNG facility. The Bill provides that the capital investment account equals (a) the capital cost of tangible capital investment property (i.e. property comprising the LNG plant), and (b) intangible personal property that is “used or exploited for liquefaction activities”, less the proceeds of disposition of tangible capital investment property which was included in the account. The amount of the investment allowance which can be applied in the computation of net operating income, in any given taxation year, is based on a formula contained in the Bill. The Bill provides that the investment allowance is calculated as follows:

investment allowance = “prescribed rate” x 0.75 x ((year-end balance of taxpayers adjusted capital investment  account + previous year-end balance of taxpayers adjusted capital investment  account)/2)

The amount of the investment allowance cannot yet be determined as the “prescribed rate” has not been specified in the Bill. In addition, as a result of the broad application of the LNG Tax (as discussed above), there will be taxpayers who are liable to pay the LNG Tax but who do not enjoy the corresponding benefit of the investment allowance deduction because they have not incurred capital costs that meet the definition of “tangible capital investment property” under the Bill. This is different from an integrated company that conducts all the liquefaction activities that constitute an LNG source. As a result of the potentially broad application of the LNG Tax, it is reasonable to expect that there will be other examples of the unequal application of the LNG Tax to differing business activities.

The Bill provides that net income is equal to net operating income plus any net proceeds of the disposition of capital investment property that results in a negative balance in the capital investment account (i.e., the negative balance results in recapture of excess investment allowance deductions) less permitted deductions which includes amounts from the taxpayers net operating loss account. The net operating loss account accumulates a taxpayer’s operating losses in years when revenues are less than the aggregate of expenses and the investment allowance.

Non-arm’s length transactions

Since the valuation of revenues, expenses and the cost of capital investment are central to the calculation of the LNG Tax, the Bill provides a special set of rules for non-arm’s length transactions. In circumstances where parties are related or are not dealing at arm’s length,  a transfer price is relevant for the computation of the LNG Tax. In addition, the Bill will deem self-dealings by a single taxpayer to be a non-arm’s length transaction between separate persons and therefore, subject to the non-arm’s length transfer pricing rules. The Bill provides that the rules in the Federal Act for determining whether persons are related and whether they are dealing at arm’s length apply equally to the Bill.

Purchase of Natural Gas at the LNG Facility Inlet Meter

The Bill has a separate set of rules that apply to valuing the non-arm’s length acquisition of natural gas at the inlet to an LNG facility. The Bill provides that if a taxpayer owns natural gas immediately before and after the natural gas passes through an LNG facility inlet meter, the taxpayer is deemed, for the purposes of the Bill, to purchase that natural gas at the LNG facility inlet meter for a notional amount.

For each month in a taxpayer’s taxation year, the taxpayer must calculate the cost of all natural gas notionally acquired by the taxpayer in that month at the LNG facility. Calculation of the notional cost of gas is based on the following formula contained in the Bill (and adjusted to account for transportation costs to the LNG facility).

Notional cost = energy content x fuel and losses adjustment x reference price + differential amount

Aside from the energy content variable contained in the formula, all of the remaining components have yet to be prescribed by regulation. Due to the liquid market for natural gas in North America, it seems reasonable to assume that the notional cost of gas computed under the Bill should be a close estimate of a taxpayer’s actual cost, however, this cannot yet be confirmed and may not be the case with respect to integrated projects.

Deemed Sale of Natural Gas at the LNG Facility Outlet

The Bill also provides a separate set of transfer pricing rules for the valuation of the sale of LNG at the LNG facility outlet that apply to non-arm’s length parties (which includes parties deemed not to deal at arm’s length under the self-dealing rules).  These transfer pricing provisions are unlike the Federal Act which only apply to transactions with non-residents.

For example, the Bill deems sales of LNG, natural gas liquids, or natural gas if a taxpayer owns the commodity immediately before and after it leaves the LNG facility. The sale is deemed to occur between separate persons that do not deal at arm’s length, with the result that the transfer pricing rules are applicable as are any penalties for non-compliance with such rules. The deemed sale amount will be adjusted to the amount that would be determined “had the transaction been entered into between persons dealing at arm’s length”.

The difficulty with the transfer pricing adjustment is that it mistakenly presupposes a liquid market for LNG. Currently, there exists a wide variance in the commercial terms of offtake arrangements between arm’s length parties, ranging from short term Henry Hub based pricing to long term (20 year) oil indexed pricing arrangements. The Bill does not provide any indication as to how these differences in LNG prices will be reconciled, which could result in lengthy and costly disputes. The determination of the appropriate transfer price will have a significant impact on the total amount of the LNG Tax that is ultimately paid by the taxpayer. Unfortunately, the Bill provides little certainty as to its application.

The deemed sales at the inlet and outlet of the LNG facility described above also create the potential to tax third parties that have only a remote nexus to British Columbia. For example, if a third party non-resident marketer purchases natural gas in British Columbia and enters into an LNG liquefaction tolling agreement with an LNG facility, with the ultimate intention of selling the LNG in international waters, the provisions described above create taxable income based on the deemed purchase and sale at the LNG facility inlet and outlet. The LNG Tax would therefore be payable notwithstanding that the taxpayer does not have a permanent establishment in the Province (which is counter to principles contained in many international income tax treaties). In addition, the taxpayer would be fully taxable under the Bill as it would not have the ability to shield income through the investment allowance deduction, with the amount of tax being based on a price for LNG that potentially bears no resemblance to what the taxpayer ultimately receives for the same.

Based on these uncertainties, it remains to be seen how differences in commercial and corporate structures between project proponents will be treated under the Bill. Furthermore, since the Bill contains no regulations prescribing the rules of administration and enforcement it is unclear how these rules will be administered and enforced in the international context.

Tax Credits

The Bill also creates a closure tax credit of 5% of “eligible expenditures”, which can be claimed by a taxpayer in its last taxation year. Eligible expenditures include costs related to the restoration, reclamation and remediation of an LNG facility.  It remains to be seen how the Bill will deal with the classification of costs incurred as part of remediation operations, similar to the issues that arise under the Federal Act with respect to the classification of costs incurred to remediate as opposed to improving the property.

In conjunction with the Bill, the province introduced a new natural gas income tax credit under the

Income Tax Act

(British Columbia). The natural gas corporate income tax credit will apply to a taxpayer that has a permanent establishment in British Columbia. The credit is equal to 0.5% of the cost of natural gas acquired (including natural gas notionally acquired under the terms of the Bill) by the taxpayer at the inlet to the LNG facility. The maximum credit that can be used in a taxation year is equal to the lesser of (a) the taxpayer’s income tax payable after all other British Columbia income tax credits have been deducted; or (b) the amount that would reduce the taxpayers British Columbia corporate income tax to an amount equivalent to the amount that would be payable if the British Columbia general corporate income tax rate were 8%. The credit will have the effect of reducing the provincial corporate income tax rate from 11% to as low as 8%. For taxpayers that continue to have a permanent establishment in British Columbia, unused credits can be carried forward for use in future years (however, such carry forward credits can only be used in a taxation year in which the taxpayer is an taxpayer). At this point, it is unclear which taxpayers will qualify for the natural gas income tax credit, as the provisions of the credit contemplate exclusion of corporations that are “of a type and class prescribed by regulation”.

Greenhouse Gas Regulations

In conjunction with the release of the Bill, on October 20, 2014, the British Columbia government introduced theGreenhouse Gas Industrial Reporting and Control Act, which sets a greenhouse gas intensity benchmark for LNG facilities of 0.16 tonnes of carbon dioxide (CO2e) for each tonne of LNG produced. LNG export facilities will have the flexibility to meet the benchmark either through improving energy efficiency, purchasing carbon offsets or by investing in a technology fund at a rate of $25 per tonne of CO2e. An LNG Environmental Incentive Program will also be introduced that will provide escalating incentives to help mitigate compliance costs for facilities emitting anywhere between 0.16 and 0.23 CO2e. If the LNG facility achieves the 0.16 CO2e benchmark, the facility will achieve “performance credits” which can be sold to other facilities (such credits are excluded in computing a taxpayer’s income under the Bill).


As is evident from the foregoing discussion, considerable uncertainty remains with respect to the ultimate application of the Bill, if for no other reason than details of many of its key components remain outstanding. Adding to this uncertainty is the fact that the Bill may be amended as it passes through the legislature.

As stated in previous publications, it is our opinion that the legislation described above will have the effect of providing a reasonable basis to allow discussion and analysis of the various LNG projects to proceed, at least to the next phase. However, even to the extent that it succeeds in doing so, it does not solve or deal with other significant issues confronting the LNG industry in British Columbia, including the pricing and availability of off-take arrangements, the paucity of skilled labor and the resulting potential for escalating capital costs. In addition, LNG projects must deal with the timing and costs of obtaining all required regulatory approvals, negotiating final deals with First Nations and ongoing lobbying efforts aimed at convincing the Government of Canada to consider enhancing the existing capital cost allowance deductions. Adding difficulty to the decisions of project proponents is the fact that they must address these issues in the face of vigorous competition from potential U.S. Gulf Coast suppliers. We believe it is these issues, and not just the terms of the LNG Tax, that will ultimately determine the size, scale and pace of development in British Columbia’s LNG industry.