FISICAL REGIMES AND PSAs

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FISCAL REGIMES FOR Hydrocarbons
Shirley B Mushi (PhD)
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Covered areas

• Context of fiscal regimes for hydrocarbons
• Ideal fiscal systems
• Considerations a country makes in determining
  which fiscal tools to use and how to use them
• The take
• Categories of fiscal tools
• Advantages and disadvantages of fiscal tools
  categories
• Common/ popular fiscal tools
• Key fiscal related aspects in international oil
  and gas contracts (focus on PSA)
• Loopholes and pitfalls in fiscal regimes

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FISCAL REGIMES FOR Hydrocarbons

• A fiscal regime is the set of instruments or
  tools (taxes, royalties, dividends, etc.) that
  determine how the revenues from Hydrocarbon and
  mining projects are shared between the state and
  companies. 
• The Hydrocarbon Legal framework (Laws,
  Regulations and Contracts) contain the details of
  what fiscal tools are used and how they are
  applied.
• Fiscal terms are usually agreed to early in the
  project before extraction is underway. Natural
  resource extraction is costly and represents a
  risk, as the investment may not equal future
  profits. At times projects are not successful.
  Fiscal terms are therefore essential in decision
  making. 

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Mutual interest An aligned Objectives

• In any extractive project, the host government
  and the investor have the common objective of
  ensuring that the venture generates elevated
  levels of revenue
• Though they share the objective, host government
  and investment companies have different aims

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Host Governments Aims

• Host governments aim to obtain the maximum value
  for their countries over time in terms of net
  receipts for treasury
• The goal is to maximize the wealth from their
  natural resources and, at the same time, attract
  foreign investment
• They also have development and socioeconomic
  objectives, such as job creation, transfer of
  technology, and development of local
  infrastructure

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Investors/ Companies Aims

• Oil companies aim to ensure that the return on
  capital is consistent with the risk associated
  with the project and with the strategic
  objectives of the corporation

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IDEAL FISCAL SYSTEMS

• Host governments

• Investors/ Companies

• A minimum number of front-end loaded
  non-profit-sensitive taxes.
• The ability to repatriate profits to shareholders
  in their home countries.
• An overall policy environment that is
  transparent, predictable, stable, and based on
  internationally recognized industry standards and
  the rule of law so that decisions can be made
  with reasonable confidence.

• Supports macroeconomic stability by providing
  predictable and stable tax revenue flows.
• Permits capturing a greater share of the revenue
  during periods of high profits.
• Avoids the introduction of distorting effects
  through the fiscal instruments.
• Maximizes the present value of revenue receipts
  by providing for appropriations during the early
  years of production.
• It is neutral and encourages economic efficiency
  as a yardstick.

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Considerations a country makes in determining
which fiscal tools to use and how to use them

• Attraction of investment respond to the needs of
  the companies.
• Timing of the revenues Some fiscal tools provide
  governments with more money early in the life
  cycle of an extractive project, while others do
  not deliver significant revenues until the
  project has already turned a profit, which can
  take years. 
• For example, signature bonuses represent revenues
  early in the extraction project, called front-end
  loaded, while profit-based taxes tend to be
  back-loaded
• Government preferences. Governments consider
  broad issues and then choose a combination of
  fiscal tools that meet their objectives. 
• Country and resource position competition,
  market, political stability etc.

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The Take
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Government Take

• The share of oil and gas revenues that
  governments capture. 
• The take statistics for a given country are a
  benchmark to determine the competitiveness of a
  countrys fiscal terms. 
• The type of mineral being extracted, the quality
  of the crude or ore, and the costs of developing
  a project vary greatly and have a considerable
  influence on government take. This necessitates
  government to use a variety of fiscal policy
  tools to maximize revenue capture.

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Categories of fiscal tools
These Categories may determine how government
revenue changes with a profitability change in
the project. As commodity prices, production
techniques and production rates change over time,
so does the profit margin for the project. 

• Neutral fiscal tools give the state the same
  share of revenue whether profitability increases
  or decreases
• Progressive fiscal tools give the government a
  larger share of the profit when profits increase
• Regressive fiscal tools give the government a
  lesser share as profits increase

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Advantages and disadvantages of fiscal tools
categories
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Common/ Popular Fiscal Tools
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Key fiscal related aspects in international oil
and gas contracts
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Bonus Payments

• Developing countries that tend to use PSAs are
  perennially short of money, and typically there
  is a signature bonus payable on signing. 
• First there is an exploration phase, with a
  minimum work programme and often also a minimum
  exploration expenditure level, with any shortfall
  in expenditure payable to the state in cash. 
• Further cash bonuses may be payable on moving to
  subsequent PSA phases, on the commencement of
  production, or on production reaching a certain
  specified level, or on the cumulative production
  of a certain volume of petroleum.

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Production Sharing

• The commercial heart of the agreement is the
  sharing of production between the contractor and
  state. 
• Contractors fund the operations as well as carry
  them out, although there is state control through
  some form of management committee. 
• The contractor recovers both its capital costs
  and its ongoing operating costs out of the share
  of production that is allocated for cost
  recovery. Oil allocated for cost recovery is
  known as cost recovery oil. The remainder of
  production is known as profit oil and is shared
  between the state and the contractor.
• The contractors cost can only be recovered out
  of production from the same PSA contract area.
  Its costs are not recovered at all unless
  operations result in a commercial discovery and
  development. 

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Production Sharing

• What happens if there is more than one
  development in a single PSA contract area? The
  best situation from the contractors viewpoint is
  to be able to recover the cost of the second (and
  subsequent development) out of production from
  the first. 
• Usually, the practice is that different
  developments are ring fenced so that the costs
  of a second development are recovered only out of
  production from that development. Some PSAs may
  provide for different profit splits on second and
  subsequent developments in the contract area.
• The share of production allocated to cost
  recovery, and the contractors share of profit
  oil, go to the heart of the contractors
  economies for the venture.
• In some established petroleum provinces, PSA
  terms are fixed contractors are invited to bid
  for PSAs simply based on et terms. 
• In less established regions, however, the whole
  PSA may be up for negotiation, and the
  negotiation of cost recovery and profit share is
  certainly to be highly contentious and
  protracted.

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Cost Recovery
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The contractors costs
Most PSAs provide for an order of priority in the
recovery of these costs, typically with operating
costs having priority and being recovered in the
year they are incurred.  Capital costs are
recovered over a period of years within the
proportion of production allocated for cost
recovery.

• capital cost
• operation cost a distinction familiar to those
  in the upstream business
• extraordinary operating costs, consisting of
  one-off items such as repairs

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Cost recovery complexities
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Profit Shares

• The early PSAs Divided on a percentage basis the
  production remaining after quantities allocated
  to cost recovery. 
• The actual percentages varied widely from country
  to country and from prospect to prospect. 
• With many IOCs seeking PSAs, the bargaining power
  shifted steadily in Favour of the state with
  proven petroleum reserves, so it became
  increasingly common for the contractors profit
  share to decline with cumulative production,
  although they were still expressed as simple
  percentages. 
• Through the 1980s and 1990s many states adopted
  mechanisms designed to restrict the contractors
  economic return. There are many different
  variations, but the contractors share of profit
  oil is tied to and declines not with production,
  but with the return it has achieved on its
  investment.

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The R factor

• A simple mechanism that reduces the contractors
  share of profit oil when it has fully recovered
  its initial capital investment
• This is the most used mechanism
• A sophisticated mechanism involves calculating
  the contractors actual rate of return, known as
  a ROR contract

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Taxation of Contractors Profit

• In its pure original form, the PSA expressly
  exempted the contractor from all local taxes and
  duties. Another common way of achieving the same
  end was to require the contractors local taxes
  to be paid out of the states share of
  production. 
• Tax exemptions for foreign companies were not
  easy to sell to local politicians and local
  public opinion. 
• Modern PSAs 
• The contractor does pay local taxes on its share
  of profit oil

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State participation

• The State wishes to be on both sides, that is to
  be part of the contractor group. 
• The IOC resists this proposal, although they are
  not always successful in doing so. State 
• Participation on the contractor side reduces the
  share of the project available to the IOC, but
  more significantly it gives the state direct
  access to the internal information, plans and
  finances of the contractor group.
• A state may propose to participate in the
  contractor group with a carried interest that is
  with its share of investment paid by the rest of
  the group.
• The IOC sometimes must accept this if their
  bargaining position is weak. Some states have
  seen this as another means of reducing the
  contractors share of the take. But it serves no
  such purpose.
• The IOCs calculation of their return from the
  project takes account of any carried interests,
  and they will not invest without an overall
  return that meets their internal criteria

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Domestic Supply Obligation

• Many PSAs allow the resource holder to require
  the contractor to deliver its share of production
  to meet domestic supply requirements. Domestic
  supply obligations invariably provide that the
  contractor will be paid for production supplied
  to local markets at an international market rate,
  so it may appear that the contract has little to
  lose from this provision.
• IOCs often resist the clause altogether, or at
  least try to narrow the circumstances in which
  the resource holder can exercise that power or
  limit the proportion of the contractors
  production to which it applies. 
• Often because many of the countries that use PSAs
  are potentially short of both fuel and money. The
  fear then is that the domestic supply obligation
  will be exercised on the basis that local markets
  are short of fuel, and that the production will
  not be paid for. This would leave the contractor
  in an unfortunate position with neither the
  production nor any sale proceeds, facing the
  unappealing prospect of pursuing legal action
  against the resource holder or some other state
  entity for the unpaid sums.

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Stabilization

• Stabilization is not only quite common in PSAs
  but is also regarded as an important provision by
  IOCs. 
• A stabilizing clause is short. It says that if
  the state makes legislative, fiscal or any other
  changes that reduce the economic benefit of the
  PSA to the contractor, then the parties will
  renegotiate the commercial terms of the PSA to
  put the contractor in the same economic position
  as it originally had. 
• Although this provision is an agreement to agree
  and is not binding, it does provide the
  contractor with the leverage to demand a
  renegotiation if its return is damaged by
  subsequent actions by the state.

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TYPICAL REVENUE FLOWS IN A PRODUCTION SHARING
CONTRACT
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LOOPHOLES AND PITFALLS IN FISICAL REGIMES

• Companies like any other taxpayer will try to
  minimize the amount they must pay for the
  government using various loopholes

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Common Loopholes exploited by companies
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1. TRANSFER PRICING 

Transfer pricing occurs when taxable income is
shifted from a high to a low tax jurisdiction.
Transfer pricing in the extractive industries
typically takes one of two forms.
The subsidiary in a resource-rich country may
sell its oil or minerals to a sister company at
an artificially low sales price to reduce its
declared revenues and thus the size of its
royalty or income tax obligations within that
country. 
The subsidiary within the resource-rich country
may purchase goods and services from a sister
company at an inflated price, thereby increasing
its declared costs and decreasing its declared
profits within the resource-rich country.

• A multi-national enterprise may seek to shift
  taxable income to its home country (if tax rates
  are lower there or the government provides
  special tax incentives) or to a tax haven
  country. 
• Governments can reduce the risk of transfer
  pricing on the revenue side by requiring
  commodity sales to be accounted for tax purposed
  using objective market prices rather than the
  sales value declared by companies. 

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Thin capitalization

• Thin capitalization frequently occurs when the
  interest payments that a company makes on loans
  are tax deductible. 
• This can encourage a company to finance a project
  with a large amount of debt (including debt from
  related companies), allowing the company to
  inflate its interest deductions and reduce
  taxable income. 
• States can adopt rules to limit interest
  deductions to a reasonable level to prevent the
  loss of tax revenues.

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Production costs

• Companies can decrease revenue to the government
  by increasing production costs. This can be done
  through gold plating, spending more on production
  than is necessary, or inaccurate accounting. 
• Countries can reduce this risk by developing
  rules that encourage efficient production and
  closely auditing the companys production costs. 
• Another way companies can decrease government
  revenues is by deducting costs incurred on a
  project from the taxable income of another
  project. A company may have legitimate reasons to
  do so, especially if it is engaged in several
  exploration or development efforts within the
  same country.
• Countries seek to prevent this practice by
  mandating ring fencing, which allows a company to
  apply the production costs only against the
  taxable income of the same project. 
• Other countries choose not to ring fence so that
  they can encourage investment in new mines.

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Cash flow distribution and related fiscal aspects
to be covered tomorrow

• Negotiation context to follow.......