The IMF report on petroleum taxation and revenue management (Part II)

Last week, we began to highlight the key findings contained in the IMF report entitled “Guyana: A reform Agenda for Petroleum Taxation and Revenue Manage-ment” dated November 2017. The report was commissioned at the request of the Minister of Finance with a view to providing initial policy advice in relation to the fiscal management of future petroleum revenue. Today, we continue from where we left off last week.

Chapter II:  Fiscal regimes for extractive industries (cont’d)

Confidentiality

While government and industry stakeholders state that the agreement with ExxonMobil’s subsidiaries (Esso Exploration and Production Guyana Ltd., CNOOC Nexen Petroleum Guyana Ltd. and Hess Guyana Exploration Ltd.) is confidential, the related clause in the model Production Sharing Agreement (PSA) does not appear to apply to the agreement itself. Only petroleum data, information and reports obtained or prepared by the contractor in relation to the contract area covered by the PSA are confidential. It would be preferable therefore to make the agreement public for the following reasons:

(a)   Public disclosure will ensure coordinated and effective management of the sector;

(b)  Disclosure of fiscal terms provides a more informed public debate and accountability;

and

(c)   Contract transparency may allow governments to negotiate more effectively within       a level playing field.

Legal framework

Guyana’s laws relating to petroleum fiscal regime date back to the 1980s, mainly the Petroleum (Exploration and Production) Act 1986 and its related Regulations. They are very discretionary in nature as regards fiscal arrangements, and therefore such arrangements have to be considered and dealt within the PSAs. In addition, while the Act and its Regulations provide for the grant of petroleum prospecting and production licences, they are mostly silent on processing and refining of petroleum products and other associated activities. The IMF team believes that authorities should consider reforming and modernizing the legal and fiscal framework for new investments in the sector.

The Act provides for competitive bidding procedures to the followed in the grant of petroleum prospecting licences. However, the current practice is to grant such licences and to negotiate PSAs on a first-come-first-served basis.

Royalties

Royalties are the most relevant fiscal instrument provided for under the Petroleum Act. However, the rate and base are left to be determined in PSAs. In addition, the Act grants the Minister responsible for petroleum, in consultation with the Minister of Finance, to remit, in whole or in part, any royalty payable, upon application by a licence holder, or to defer payment. The Act also permits the Minister, subject to affirmative resolution of the National Assembly, to exempt the licensee from income tax, corporation tax and property taxes, among others.

The royalty rate applicable to the agreement with ExxonMobil’s subsidiaries is two percent on an ad-valorem basis, i.e. on gross revenue, up from one percent previously agreed on and to be paid out of government’s share of profit oil. This revised rate, however, appears to be well below what is observed internationally. In countries where ad-valorem rates are applicable, the rates vary from 8 percent to 20 percent. For example, in Trinidad and Tobago the royalty rates are between 10 percent and 12 percent while for the United States, the rate is 16.6 percent. Colombia’s royalty rates are between 8 percent and 25 percent while for Brazil and Peru, the rates are 10 percent and 5 to 20 percent respectively.

Profit-sharing and other fiscal arrangements

Currently, there is no published model PSA, but the Guyana Geology and Mines Commission’s website contains the following minimum fiscal terms:

(a)          Maximum cost recovery ceiling of 75 percent of the value of crude oil and natural            gas produced and sold from the contract area;

(b)          A minimum government share of profit oil of 50 percent on a per field basis. The              report defines ‘profit oil’ as the petroleum remaining after (royalty and) cost oil, including any surplus of cost oil over the amount needed for cost recovery;

(c)           Tax obligations of the contractor are to be satisfied through the Government’s share of profit oil. In this regard, the contractor’s corporate income tax liability is to be paid by the Minister responsible for petroleum on behalf of the contractor out of the government share of profit oil;

(d)          Contractors and subcontractors are to be allowed to import capital goods, materials and supplies used solely for petroleum operations free of duty and other taxes; and

(e)          Fuel is to attract a reduced Excise Tax of up to 10 percent.

PSAs include an annex detailing the rules for cost recovery, including rules for depreciating capital expenditure and the treatment of certain expenses such as services provided by affiliated third parties and financing costs. It is the understanding of the IMF team that in the case of Guyana’s PSAs, exploration and development costs can be fully expensed for cost recovery purposes. If cost oil is less than recoverable costs in any given period, unrecovered costs can be carried forward, without interest, to subsequent periods without any limitation.

The Government’s share of profit oil is fixed and is not linked to the profitability of projects. Most PSAs around the world usually have a formula in which the government’s share increases as a function of production, a combination of production and prices, or an economic variable such as the ratio of cumulative revenue to cumulative costs, or the project’s internal rate of return. In many countries, the top tier government share of profit oil could be as high as 80 or 90 percent. Considering that the contractor’s tax liability has to be settled from the Government’s share of profit oil, the fixed 50 percent share is considered relatively low.

The treatment of interest expense appears to be generous since excessive or abuse of the use of debt can have a detrimental impact on the amount of profit oil to be shared between the government and the contractor. It is the understanding of the IMF team that in Guyana’s PSAs, interest expenses, regardless of the source of financing, are permitted to be recovered, provided that such expenses are consistent with market rates. In addition, interest payments are exempt from withholding tax, thereby providing a further incentive for contractors to finance their costs with debt. Some countries disallow interest expense or limit the amount of debt permitted for cost recovery purposes through caps on debt to equity ratios while others may prescribe that interest may be deductible only on borrowing to fund development costs or a maximum percentage of such costs. For example, Uganda allows interest on loans (from any source) to finance development operations only up to 50 percent of the total financing requirements.  However, interest on loans to finance exploration is not allowed.

Since the Petroleum Act allows the Minister of Finance to exempt the holder of a PSA from most taxes, it is unlikely that petroleum companies will be subject to other taxes. It is the understanding of the IMF team that most petroleum companies in Guyana are not subject to Value Added Tax, import duties, property tax, capital gains tax, and dividend and interest withholding taxes. In relation to capital gains tax, the transfer of interest in petroleum or mining projects can result in significant gains to the seller in times of high fuel prices. In many countries, there is a desire to tax these gains. Going forward, the IMF team believes that this policy should be carefully reviewed.

Ring-fencing

A ring-fencing arrangement in a PSA framework ensures that only costs attributable to a particular field are taken into account in the computation of profit oil for that field. Although Guyana’s PSA framework involves the sharing of profit oil between contractors and the government on a field by field basis, it also allows the contractor to allocate cost oil to any field within the contract area, thereby defeating the main purpose of ring-fencing. This arrangement is likely to benefit contractors with multiple fields within their contract area at the expense of delaying government revenue.

Given the size of the contract area awarded so far in Guyana, the IMF team is of the view that there is merit in applying a tighter ring-fencing arrangement as part of the general PSA framework.

Economic evaluation of Stabroek PSA

The IMF team’s assessment of the Liza 1 Phase 1, using ExxonMobil’s estimate of 100,000 barrels per day over a period of 22 years as well as “stylized data from Rystad Ucube oil and gas database”, is that the project will generate unit cost of production of around US$21 per barrel and a pre-tax internal rate of return of about 26%. However, the Stabroek PSA has the lowest Average Effective Tax Rate (AETR) or “government take”, compared with other petroleum producing countries in the region and elsewhere. This confirms that the terms offered in the agreement are generous to the investor, but were probably required to attract investment at a time when little was known about the geological prospects of the country. Some of the countries with the highest AETRs are mature and well-established producers that had the opportunity to fine tune their fiscal regimes over time.

The IMF team’s recommendations

Having regard to the above assessment of petroleum sector fiscal framework, the IMF team has made the following recommendations:

(a)          Make PSAs public within a framework providing a level playing field for disclosure            that protects commercially sensitive and propriety data;

(b)          Close fiscal loops in existing PSAs in consultation with existing contractors, that may be a source of base erosion and profit-shifting activities;

(c)           Undertake a policy review of fiscal terms contained in existing PSAs to ensure that they are implemented properly, and assess areas of improvement for future investment;

(d)          Design a new generally applicable fiscal regime for upstream petroleum projects that increases the government take and limits the scope for individual negotiations;

(e)          Ensure that royalties are paid directly by PSA holders and not included in the ‘pay-on-behalf’ system;

(f)           Introduce a revised production sharing mechanism for new PSAs that provides the government with a higher share of profit oil as the profitability of projects increases;

(g)          Publish a model PSA that includes the minimum fiscal terms for future contracts;

(h)          Going forward, apply a tighter ring-fencing arrangement at the field level, including for the allocation of cost oil;

(i)            Consider conducting competitive bidding rounds future allocation of petroleum rights; and

(j)           Continue to develop petroleum tax policy and fiscal modelling capacity at the Ministries of Finance and Natural Resources.

Comments  

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