Regulatory and Legal Issues for Gas Sector: Gas Infrastrucutre in Kerala – Engine of Economic Growth S P Singh December 13, 2010

Contents Introduction Key foreign investment regulations relating to Petroleum & Natural Gas Sector Foreign Direct Investment (‘FDI’) Policy External Commercial Borrowings (‘ECB’) Policy Key tax regulations Direct Taxes Current tax regime Direct Taxes Code, 2010 Indirect Taxes Relevant provisions Goods & Service Tax (‘GST’) Budget 2011 – Time to ring the bells Conclusion

Introduction

Importance of Natural Gas Gas complements the oil industry to address the issue of energy security Gas can directly replace oil as a transport fuel – Compressed Natural Gas (‘CNG’)/Diesel (gas to liquid) Vis-a-vis oil, more diverse distribution of reserves Liquefied Natural Gas (‘LNG’) together with pipeline routes connect geographically diverse producing centres and consuming markets Eco-friendly Safer than Liquefied Petroleum Gas (‘LPG’), as it is lighter than air Source: BP Statistical Review 2010 Source: Integrated Energy Policy

Infrastructure and Consumption of Hydrocarbons in Kerala Growth of petroleum products in Kerala and India in 2009 Product % Growth in Kerala % Growth in India Gasoline (MS) 14.0 13.9 HSD 5.9 8.9 SKO 2.8 0.0 LPG 9.4 6.2 LPG-Domestic 7.6 Auto LPG 31.2 Key upcoming natural gas infrastructure: Petronet LNG’s 2.5 MMTPA regasification terminal at Kochi expandable to 5.0 MMTPA Assured long term supply for 20 years upto 1.44 mmtpa LNG from Exxon Mobil’s Gorgon Project, Australia GAIL’s 1114 km Kochi – Kanjikkod – Mangalore/ Bangalore pipeline with a capacity of 16 MMSCMD at an approx cost of Rs. 3263 Cr. Both of above gas infrastructure would be the catalyst for gas market growth in the southern India HSD, LPG and SKO would be main products to be replaced by gas in future in Kerala for industrial, transportation, commercial and domestic uses. MS stands for ‘Motor Severe Oil’ SKO stands for ‘Superior Kerosene Oil’ LDO stands for ‘Light Diesel Oil’ HSD stands for ‘High Speed Diesel’

Key foreign investment regulations relating to Petroleum and Natural Gas Sector

Foreign Direct Investment Policy Instruments covered under FDI: Equity shares, Preference shares, Convertible Debentures Sector FDI cap Conditions Other than Refining and including market study and formulation; investment/ financing; setting up infrastructure for marketing in Petroleum & Natural Gas sector 100% under automatic route Subject to sectoral Regulations issued by Ministry of Petroleum & Natural Gas (‘MoPNG’) Refining 49% in case of PSUs with FIPB approval, 100% in case of Private Companies under automatic route Subject to Sectoral policy and no divestment or dilution of domestic equity in the existing PSUs.

Foreign Direct Investment Policy (contd..) Automatic Route not available if existing Joint Venture (‘JV’) or technology transfer/ trademark agreement in 'same' field Exceptions: Investments by Venture Capital Funds registered with the Security and Exchange Board of India (‘SEBI’), investment by either of the parties is less than 3%, and existing venture/collaboration is defunct or sick ‘Conflict of interest‘ clause may be provided for in JV agreements to safeguard the interests if the foreign partner decides to set up another JV or a Wholly Owned Subsidiary ‘(WOS’) in the same field Payments for royalty / lumps sum fee for technology transfer are now covered under automatic route without any monetary ceiling – No threshold

External Commercial Borrowings Policy Companies engaged in mining, refining and exploration are eligible to avail ECB: Under Automatic Route: upto USD 500 million, Under Approval Route: additional amount of USD 250 million where average maturity period is more than 10 years Companies engaged in transportation and distribution not eligible Prohibited End Use: On-lending Investment in capital market Acquiring a company (or a part thereof) in India Real estate excluding development of Integrated townships Working capital requirements of the company General corporate purposes Repayment of existing Rupee loans

Key tax regulations

Direct Taxes Current Tax Regime Special tax regime under Production Sharing Contracts (PSCs) signed with the Government of India Each member to be assessed in respect of its own share of income in the same status in which it has entered into the agreement with the Central Government Special provisions for determination of taxable income for business of extraction, prospecting of mineral oil, Seven (consecutive) years tax holiday for "undertakings" engaged in production of “mineral oils” starting from the year in which it commences commercial production, Controversy created by Memorandum explaining the Finance Bill 2008 - whether mineral oil includes natural gas - still exists Tax holiday to be available to companies in respect of natural gas production where the oil and gas blocks have been awarded under New Exploration Licensing Policy (‘NELP’) VIII and Coal Bed Methane (‘CBM’) IV round of bidding Infructuous or abortive exploration expenses Expenditure incurred in respect of drilling or exploration activities or services Expenditure incurred or physical assets used in respect of drilling or exploration activities or services Depletion of mineral oil in the mining area Balance expenditure on transfer of interest including treatment of recoupment of expenditure Controversy created by Memorandum explaining the Finance Bill 2008 - whether mineral oil includes natural gas Position after Finance Bill, 2009 Proposed to be available to companies in respect of natural gas production where the oil and gas blocks have been awarded under NELP VIII round of bidding Undertaking - All blocks licensed under a single contract, which has been awarded under NELP announced by the Government or has been awarded in pursuance of any law for the time being in force or has been awarded by the Central or a state Government in any manner, shall be treated as a single undertaking.

Direct Taxes Current Tax Regime Shift from profit linked incentives to investment linked incentives Companies engaged in the business of laying and operating a cross-country natural gas or crude or petroleum oil pipeline network for distribution allowed an investment linked incentive, subject to fulfillment of the following prescribed conditions: Make available not less than one-third of total pipeline capacity available for use on common carrier basis by any person other than the Company or an Associated Enterprise Total pipeline capacity to be made available for use on common carrier basis will be as specified below ‘one-third’ for a natural gas pipeline network and ‘one-fourth’ for petroleum product pipeline network Minimum Alternate Tax (MAT) increased from 15% to 18% w.e.f. April 01, 2011 Surcharge for domestic companies reduced from 10% to 7.5%. w.e.f. April 01, 2011

Direct Taxes Direct Taxes Code, 2010 (Proposed to be applicable from April 1, 2012) Generic Income & Rate Proposals Corporate tax rates to be uniform for domestic as well as foreign companies at 30% Tax exemptions removed MAT MAT levied at the rate of 20% on book profits for companies Tax credit for a financial year to be allowed shall be the excess of tax on book profit over normal income tax Tax credit allowed to be carried forward till 15 Financial Years from the year immediately succeeding the Financial Year in which such tax credit becomes allowable

Direct Taxes Direct Taxes Code, 2010 (Proposed to be applicable from April 1, 2012) – specific reference to Petroleum & Natural Gas Sector Specific provisions relating to Oil and Gas Industry prescribed in Direct Tax Code: Companies engaged in laying and operating a cross country natural gas or crude or petroleum oil pipeline network for distribution (Thirteenth Schedule) Specified capacity of total pipeline to be made available for use on common carrier basis in accordance with the Petroleum and Natural Gas Regulatory Board (‘PNGRB’) Companies engaged in the business of prospecting or extraction or production of mineral oil or natural gas (Eleventh Schedule) Natural gas eligible No specific condition of having entered into agreement with Central Government Comprehensive new provisions and cover not only computation of deductions but also define rules for determining income Significant shift in allowability of deductions for tax purposes considering the special needs of the industry Expenditure on land allowed fully Capital expenditure allowed completely (as opposed to depreciation)

Indirect Taxes – Relevant provisions Concessional duty of Customs of 5% under Project Imports Scheme on machineries etc. required for Pipeline projects for transportation of natural gas Coal and crude oil enjoy ’declared good’ status for VAT purposes - VAT rate is 4% across States Natural gas does not enjoy the status of ‘declared goods’ and therefore, subject to varying VAT rates (as high as 12.5% and even more) Some states do not permit input credit in levy of VAT on gas thereby resulting in higher taxation Supply of gas by pipeline, whether inter-state sale or local sale – No clarification issued in this regard Service tax paid on services availed in relation to laying of pipeline and other related services is not available for set off and becomes the part of the cost of the project Concessional rate of Basic Customs Duty (BCD) 5% is applicable on the import of goods, machinery and equipment for oil and gas activities under project import scheme. Crude oil along with other products have been declared under the Central Sales Tax Act as being goods of ‘special importance’ in the inter-state trade or commerce, it cannot be sold at a VAT/ CST rate higher than 4%. Natural gas not accorded the same status VAT credit is not available in case of petroleum products in the State of Kerala - Service tax paid on input services used in laying down of pipeline becomes cost in the absence of output service tax/ excise duty liability.

Indirect Taxes - GST First Discussion Paper A final view as to whether Natural Gas would be covered under GST is yet to formulated and is subject to further deliberations Task Force Recommendations Natural gas should be subjected to GST with all the benefits of input credit as in the case of other normal goods. - Clarity is required regarding the inclusion of the petroleum sector including Natural Gas under the GST - since there are varied views within the Government on the same

Budget 2011 Time to Ring the Bells

Expectations from Budget 2011 Clarification as to availability of investment linked incentive for City Gas Distribution (‘CGD’) Deduction under section 80IB(9) of the Income-tax Act, 1961 (‘Act’) should also be made available for production of natural gas in blocks licensed under earlier NELP and CBM rounds of bidding Allowance of infructuous or abortive exploration expenses without the surrender of area Allow deduction under section 37 of the Act for the expenditure incurred on drilling and exploration activities in overseas blocks by Indian companies even where Indian companies do not enter into agreement with the Central Government Undertakings should be given option of claiming tax holiday under section 80IB(9) of the Act at any time during the first 15 years after commencement of commercial production since in actual terms, Companies do not earn profits in their initial years of operation Exemption of Oil and gas companies from paying taxes in terms of section 115JB of the Act (‘MAT’) to promote the Exploration and Production sector

Expectations from Budget 2011 (Contd.) ‘Farm-in-costs’ shall be recognized as an intangible assets eligible for depreciation under section 32 of the Act A provision of considering “each well” as undertaking in the Explanation to section 80IB(9) of the Act or the explanation applicable only prospectively Infrastructure status to be provided to companies engaged in transportation and distribution for the purposes of ECB regulations Zero customs duty on Liquefied natural gas (‘LNG’)/ Natural Gas and on LNG infrastructure facilities Clarity on inclusion of Natural Gas under GST regime

Conclusion

Need for help and support from the Government Clarity on policies, Infrastructure status to transportation and distribution companies for ECB, Clarity on investment linked incentives to CGD, Tax holiday for natural gas for pre- NELP VIII and CBM IV blocks, Zero customs duty on LNG/ Natural Gas and on LNG infrastructure facilities, Declared goods status to natural gas, Exemption from service tax to services used in upstream sector

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. This material and the information contained herein prepared by Deloitte Touche Tohmatsu India Private Limited (DTTIPL) is intended to provide general information on a particular subject or subjects and is not an exhaustive treatment of such subject(s). None of DTTIPL, Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively, the “Deloitte Network”)  is, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might affect your personal finances or business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this material.   ©2010 Deloitte Touche Tohmatsu India Private Limited. Member of Deloitte Touche Tohmatsu Limited