Petroleum sector: Fiscal regimes Ehtisham Ahmad June 2007 Based on joint work with Philip Daniel and Giorgio Brosio. The views in this presentation are personal and should not be attributed to the IMF, or to its management or Board of Directors. Petroleum sector: Fiscal regimes Ehtisham Ahmad June 2007 Based on joint work with Philip Daniel and Giorgio Brosio. The views in this presentation are personal and should not be attributed to the IMF, or to its management or Board of Directors.

Key issues  Why should countries adopt a fiscal regime specific to the petroleum sector?  What are the advantages and disadvantages of alternative fiscal instruments?  How to share revenue between central and regional governments (second lecture)?  How to achieve better governance (also second lecture)? Build on the IMF’s revised Code of Fiscal Transparency; and Guide on Resource Revenue Transparency

Why natural resource sector-specific fiscal regime? A valuable asset in the ground, that can be exploited only once A valuable asset in the ground, that can be exploited only once Leads to generation of economic rent: Leads to generation of economic rent: conflict between government and investor over the division of risk and reward conflict between government and investor over the division of risk and reward Aim for fair and rising government share of rent, without scaring off investors. Aim for fair and rising government share of rent, without scaring off investors.

How to achieve the government’s share? The government’s share can be achieved by different instruments :  Government share of equity of oil companies  Production sharing agreements  Fiscal instruments

Equity and production sharing

Preconditions for investment Large-scale direct foreign investment requires clear legal, regulatory and fiscal regime Large-scale direct foreign investment requires clear legal, regulatory and fiscal regime For exploration, investors need clear path to development and production after discovery For exploration, investors need clear path to development and production after discovery For development, investors require security for very large investments For development, investors require security for very large investments Need to settle which level of government grants title, value of rights and likely environmental liabilities. Need to settle which level of government grants title, value of rights and likely environmental liabilities.

Minimum Conditions for Investment Promising geolgy Promising geolgy Security of tenure Security of tenure Competitive fiscal regime Competitive fiscal regime Fiscal and regulatory stability Fiscal and regulatory stability Foreign exchange retention Foreign exchange retention Freedom to export investor’s share of petroleum Freedom to export investor’s share of petroleum Freedom of operation and commercial structure Freedom of operation and commercial structure Stability in environmental management Stability in environmental management Access to International arbitration Access to International arbitration Physical security Physical security

Establishing Petroleum Rights ResponsibilitiesLegislatureLegislatureMinisterial NOC / Regulatory Authority Legal Framework Constitution Constitution Petroleum Law Petroleum Law Fiscal Legislation Fiscal Legislation Regulations Regulations Contracts Contracts

Constitution Constitutions typically reserve rights to resources in the ground to the state Constitutions typically reserve rights to resources in the ground to the state National/federal or sub-national National/federal or sub-national exceptions with some private ownership in the USA and Canada exceptions with some private ownership in the USA and Canada Sometimes all oil and gas activity is reserved to a state company (Mexico) Sometimes all oil and gas activity is reserved to a state company (Mexico) Kuwait also establishes the right of the state to revenues and prohibits exploitation of resources by foreigners Kuwait also establishes the right of the state to revenues and prohibits exploitation of resources by foreigners Constitution usually requires that use of resources must be governed by law (Iran) Constitution usually requires that use of resources must be governed by law (Iran)

Petroleum Law Confirms right of the state to control over resources in the ground Confirms right of the state to control over resources in the ground Governs the grant of petroleum rights: Governs the grant of petroleum rights: to whom (restrictions?) to whom (restrictions?) for what (exploration, development, production, ancillary rights) for what (exploration, development, production, ancillary rights) and by what means (licenses, contracts) and by what means (licenses, contracts) Establishes regulatory authority (may be the Minister) Establishes regulatory authority (may be the Minister) Governs petroleum operations and sets power to make regulations Governs petroleum operations and sets power to make regulations May establish a national oil company, and define its powers May establish a national oil company, and define its powers May include scope of contracts, or provision for royalty May include scope of contracts, or provision for royalty Commonly includes fiscal provisions, though these may be better placed in the Tax Code Commonly includes fiscal provisions, though these may be better placed in the Tax Code

Petroleum Regulations Power to make regulations governing operations will be established in the Petroleum Law, specific regulations may cover: Power to make regulations governing operations will be established in the Petroleum Law, specific regulations may cover: Health, safety, and environment (HSE) Health, safety, and environment (HSE) Licensing procedures, bidding rounds, and awards Licensing procedures, bidding rounds, and awards Forms of contract Forms of contract Technical aspects of operations Technical aspects of operations

Legal and Fiscal Issues Contracts and License Forms

Forms of Petroleum Rights or Contracts FORM License or concession, with or without an agreement (North Sea,) License or concession, with or without an agreement (North Sea,) License or concession with joint venture (Nigeria, Venezuela) License or concession with joint venture (Nigeria, Venezuela) Production sharing agreements (Indonesia, Syria, Egypt, Angola) Production sharing agreements (Indonesia, Syria, Egypt, Angola) Service contracts (including risk service contracts and buy-backs) Service contracts (including risk service contracts and buy-backs) Combination or hybrid arrangements Combination or hybrid arrangements FISCAL SYSTEM Tax and royalty Tax and royalty Tax and royalty, participation terms Tax and royalty, participation terms Production sharing, perhaps with tax and royalty Production sharing, perhaps with tax and royalty Fees, perhaps with production sharing Fees, perhaps with production sharing Various Various

Types of Petroleum Rights & Contracts Types of Petroleum Rights & Contracts Type of contract Cost and risk Exclusive right to operate Right to production License / concession Private company Joint venture Private company SharedShared Production sharing Private company StateShared Service contract Private company StateState

The Production-Sharing Agreement PSAs could be a transitional phase or a permanent feature of the petroleum regime (as for example in Syria and Egypt) PSAs could be a transitional phase or a permanent feature of the petroleum regime (as for example in Syria and Egypt) PSA allows investor participation while retaining national ownership of shares of petroleum produced- PSA allows investor participation while retaining national ownership of shares of petroleum produced-  Production shares  Participating interests by NOC PSA passes risk to the investor PSA passes risk to the investor PSA is familiar to petroleum industry PSA is familiar to petroleum industry

The Production-Sharing Agreement: Key Modern Elements Independent environmental impact studies Independent environmental impact studies Development Plan for regulatory approval Development Plan for regulatory approval Contractor incurs all exploration and development costs Contractor incurs all exploration and development costs Cost recovered from agreed percentage of gross production Cost recovered from agreed percentage of gross production Profit oil/gas shared on some basis taking account of cost and price changes Profit oil/gas shared on some basis taking account of cost and price changes Contractor proceeds from PSA usually liable to income tax Contractor proceeds from PSA usually liable to income tax PSA provides for fiscal stability PSA provides for fiscal stability State can participate in the Contract through subsidiary company State can participate in the Contract through subsidiary company

Cost Oil Permits investor to recover capital and operating costs (but usually not interest expense or financing charges) Permits investor to recover capital and operating costs (but usually not interest expense or financing charges) Limit on Cost oil—40 to 70 percent of production Limit on Cost oil—40 to 70 percent of production Ensures early revenue Ensures early revenue Unrecovered costs carried forward and may be uplifted by an interest factor Unrecovered costs carried forward and may be uplifted by an interest factor Excess cost oil treated as profit oil Excess cost oil treated as profit oil

Profit Oil Split between government and investor Split between government and investor Split may depend on: Split may depend on: Level of daily production from each field (Sudan) Level of daily production from each field (Sudan) up to 25,000 bpd 61.5 % for government up to 25,000 bpd 61.5 % for government 25,000 – 50,000 bpd 71 % 25,000 – 50,000 bpd 71 % over 50,000 bpd 80% over 50,000 bpd 80%

Profit Oil (Cont) Cumulative production from the contract area (Nigeria deep water off shore) Million barrels % for government 0 – – – – – 1, – 1, – 1, – 1, ,500 – 2, ,500 – 2, Above 2,000 to be negotiated Above 2,000 to be negotiated

Profit Oil (Cont) Level of daily production and price of crude oil (Trinidad and Tobago) Level of daily production and price of crude oil (Trinidad and Tobago) R-factor: ratio of cumulative revenue to cumulative costs (Azerbaijan) R-factor: ratio of cumulative revenue to cumulative costs (Azerbaijan) Internal rate of return (Russia and Azerbaijan) Internal rate of return (Russia and Azerbaijan)

Summary: The Production-Sharing Agreement Terms of PSAs can be replicated in tax and royalty regimes, but PSAs allow variation of economic terms for an area without amendment of fiscal legislation Terms of PSAs can be replicated in tax and royalty regimes, but PSAs allow variation of economic terms for an area without amendment of fiscal legislation State can retain and dispose of its share of petroleum or make marketing arrangements with Contractor State can retain and dispose of its share of petroleum or make marketing arrangements with Contractor State not obliged to find budget funds for costs unless it elects to take working interest participation State not obliged to find budget funds for costs unless it elects to take working interest participation PSAs can be “ring-fenced” or not, depending upon the state’s preference for early revenue or maximum pace of development PSAs can be “ring-fenced” or not, depending upon the state’s preference for early revenue or maximum pace of development A “Model” PSA provides a standard framework for competitive bidding over areas to be awarded A “Model” PSA provides a standard framework for competitive bidding over areas to be awarded “Pay on behalf” arrangements for Contractor’s income tax provide built-in fiscal stability “Pay on behalf” arrangements for Contractor’s income tax provide built-in fiscal stability Combination of PSA with tax permits investors to obtain tax credits at home; minimizes cost to host country revenues. Combination of PSA with tax permits investors to obtain tax credits at home; minimizes cost to host country revenues.

Fiscal Issues Tax and Revenue Instruments

Which fiscal instruments are typically used to tax oil and gas operations? The government’s share can be obtained by different instruments. The government’s share can be obtained by different instruments. Multiple objectives may require multiple instruments: Multiple objectives may require multiple instruments:  Product based instruments  Profit based instruments  Bonus and rental payments

General Strategy for Fiscal Regime Four principles Fiscal regime for petroleum cannot move far out of line with countries competing for petroleum investment Fiscal regime for petroleum cannot move far out of line with countries competing for petroleum investment Fiscal system that reduces investor risk will maximize investment AND government take over the long term Fiscal system that reduces investor risk will maximize investment AND government take over the long term “Tax neutrality”: fiscal system should take account of rent and the particular risks of petroleum investment “Tax neutrality”: fiscal system should take account of rent and the particular risks of petroleum investment Simple design with minimum of distortions Simple design with minimum of distortions

PSA Structures Volume-based Volume-based  Cost oil limit plus profit-sharing by scale of cumulative production  Cost oil limit with profit-sharing by scale of daily rate of production Profit-based Profit-based  Rate of return systems  “R-factor” or payback ratio systems Volume-based systems alone are insensitive to prices and costs; they do not avoid need for valuation of costs and output Volume-based systems alone are insensitive to prices and costs; they do not avoid need for valuation of costs and output

State Equity Working interest—paid up equity on commercial terms; government on par with private investor Working interest—paid up equity on commercial terms; government on par with private investor Concessional interest—e.g., option to invest at cost once commercial discovery made Concessional interest—e.g., option to invest at cost once commercial discovery made Carried interest—government pays for equity share (plus interest) out of production proceeds (equivalent to nonrecourse loan) Carried interest—government pays for equity share (plus interest) out of production proceeds (equivalent to nonrecourse loan) Free equity—government assumes no financial obligations nor have any management involvement Free equity—government assumes no financial obligations nor have any management involvement

State Equity (Cont) Secure higher government share in up- side. Secure higher government share in up- side. “Ownership”, technology transfer, know- how, control over development. “Ownership”, technology transfer, know- how, control over development. Often large cash-calls for working interest. Often large cash-calls for working interest. Conflict of interest: role of regulator vs. shareholder. Conflict of interest: role of regulator vs. shareholder.

Tax/royalty regime  Royalty—secures minimum payment;  Regular corporate income tax/with higher than normal, or progressive tax rate;  Resource rent tax—captures a larger share of the most profitable projects.

Royalties  Up-front revenue stream; regular minimum payment;  Assessed on volume or value of oil and gas;  Often considered disincentive to investment and a source of distortions;  Typically only deductible in home jurisdiction.

Royalty (with PSA) In PSA regimes, royalties In PSA regimes, royalties May be explicit (and deducted from cost oil), or May be explicit (and deducted from cost oil), or May be implicit—limit on cost oil ensures that there is revenue for the State as soon as production commences May be implicit—limit on cost oil ensures that there is revenue for the State as soon as production commences

Corporate income tax Issues peculiar to oil sector: Issues peculiar to oil sector: Sometimes profits from oil are taxed at a higher rate; Sometimes profits from oil are taxed at a higher rate; Tax incentives : immediate recovery of exploration costs, accelerated depreciation, investment credits, and tax holidays; Tax incentives : immediate recovery of exploration costs, accelerated depreciation, investment credits, and tax holidays; Problems can originate from transfer pricing, “earning stripping”, and inflated expenditure deductions. Problems can originate from transfer pricing, “earning stripping”, and inflated expenditure deductions.

Corporation Income Tax (with PSA)  Under PSAs, investor is subject to income tax on investor’s share of production;  Cost recovery rules for income tax will differ from cost recovery rules for purposes of cost oil;  Important to have CIT qualify for foreign tax credit in investors’ home country.

Resource rent tax  Rate of return based  the tax is assessed when accumulated real cash flow turns positive;  Rate of Return (RoR):  investor’s opportunity cost of capital;  country-specific mark-up on risk-free asset;  If discount rate and RoR are close, investment distortions will be reduced;  Problems: setting RoR and tax rate.

Timing of Revenue under Alternative Fiscal Regimes

Choice Between Tax/Royalty Regime and Production Sharing Risk/Remuneration Trade-off and immediate availability of revenue Tax/Royalty Regime Production Sharing Agreements Low risk to government and immediate revenue Royalty Explicit royalty; or limit on cost oil Medium risk and possible delays of revenue Corporation Income tax Income tax, may be paid out of government’s share of production High risk and substantial delays of revenue Resource rent tax The determination of profit oil can mimic a resource rent tax

Equivalence of tax instruments with non-tax instruments

Additional Issues  Fiscal stability  Ring fencing  Subcontractors  Indirect taxes  Fixed fees and bonuses For details see IMF, Guide on Resource Revenue Transparency, 2007

Fiscal Stability Fiscal stability clauses are wide-spread in petroleum contracts to solve problems deriving from: Fiscal stability clauses are wide-spread in petroleum contracts to solve problems deriving from:  the large size and the sunken nature of the initial investment;  long payback and profitability period;  a lack of credibility that the host country will not change the fiscal rules (“Sovereign risk”).

Approach to Fiscal Stability Frozen law: fiscal stability guaranteed by reference to laws in force on the effective date of the agreement;  May bestow unintended benefits to contractor;  Agree to negotiate to maintain economic equilibrium if there are any adverse changes; equilibrium if there are any adverse changes;  Should fiscal stability be a one-way street?  Appropriate offsetting change will depend on assumptions regarding future revenue and costs.

Ring Fencing limitation on consolidation of income and deductions for tax purposes across different contracts, fields, or activities.  Absence of ring fencing can seriously postpone government revenue;  Ring fencing may discriminate against new investors;  Lack of ring fencing may be an incentive for investment in the petroleum sector.

Subcontractors  May want to subject (nonresident) subcontractors (in the petroleum sector) to a simple final withholding tax of 5 to 10 percent;  Discrimination against domestic subcontractors.

Issues with indirect taxes  Gas and oil projects often receive special treatment  Specialized equipment for exploration and development often exempt from customs duty  Problems with providing VAT exemptions

Auctioning and payment of rights of exploration and exploitation These are ex ante instruments for the collection of oil rent. These are ex ante instruments for the collection of oil rent.  Upfront payments attractive to government;  Negative impact on investment, if too large;  High administrative administrative requirements for auctions, low for fees (but can generate small revenue).

Conclusions  Broad range of fiscal instruments available to secure an appropriate share of economic rent;  Most countries have both profit-based and production-based levies;  Tax/royalty regimes and production-sharing regimes can lead to similar sharing of risks and rewards;  Market test for each country’s fiscal regime  Issues of revenue-sharing, political economy and transparency in the next lecture.