Title: FISICAL REGIMES
1FISCAL REGIMES FOR Hydrocarbons
Shirley B Mushi (PhD)
2Covered 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
3FISCAL 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.Â
4Mutual 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
5Host 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
6Investors/ 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
7IDEAL FISCAL SYSTEMS
- 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.
8Considerations 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.
9The Take
10Government 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.
11Categories 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.Â
- 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
12Advantages and disadvantages of fiscal tools
categories
13Common/ Popular Fiscal Tools
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19Key fiscal related aspects in international oil
and gas contracts
20Bonus 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.
21Production 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.Â
22Production 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.
23Cost Recovery
24The 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
25Cost recovery complexities
26Profit 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.
27The 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
28Taxation 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 PSAsÂ
- The contractor does pay local taxes on its share
of profit oil
29State 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
30Domestic 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.
31Stabilization
- 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.
32TYPICAL REVENUE FLOWS IN AÂ PRODUCTION SHARING
CONTRACT
33LOOPHOLES 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
34Common Loopholes exploited by companies
35- TRANSFER PRICINGÂ
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.Â
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.Â
36Thin 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.
37Production 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.
38Cash flow distribution and related fiscal aspects
to be covered tomorrow
- Negotiation context to follow.......