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Petroleum sector:Petroleum sector: Fiscal regimes Fiscal regimes
Ehtisham AhmadEhtisham Ahmad
June 2007June 2007
Based on joint work with Philip Daniel and Giorgio Brosio. The Based on joint work with Philip Daniel and Giorgio Brosio. The views in this presentation are personal and should not be views in this presentation are personal and should not be
attributed to the IMF, or to its management or Board of Directors.attributed to the IMF, or to its management or Board of Directors.
Key issuesKey issues Why should countries adopt a fiscal regime specific to Why should countries adopt a fiscal regime specific to
the petroleum sector?the petroleum sector? What are the advantages and disadvantages of What are the advantages and disadvantages of
alternative fiscal instruments?alternative fiscal instruments? How to share revenue between central and regional How to share revenue between central and regional
governments (second lecture)?governments (second lecture)? How to achieve better governance (also second How to achieve better governance (also second
lecture)?lecture)?
Build on the IMF’s revised Build on the IMF’s revised Code of Fiscal Transparency; Code of Fiscal Transparency; and Guide on Resource Revenue Transparency and Guide on Resource Revenue Transparency
http://www.imf.org/external/np/fad/trans/index.htmhttp://www.imf.org/external/np/fad/trans/index.htm
Why natural resource sector-Why natural resource sector-specific fiscal regime?specific fiscal regime?
• A valuable asset in the ground, that can A valuable asset in the ground, that can be exploited only oncebe exploited only once
• Leads to generation of economic rent:Leads to generation of economic rent:• conflict between government and investor conflict between government and investor
over the division of risk and rewardover the division of risk and reward• Aim for fair and rising government share Aim for fair and rising government share
of rent, without scaring off investors.of rent, without scaring off investors.
How to achieve the How to achieve the government’s share?government’s share?
The government’s share can be The government’s share can be achieved by different instrumentsachieved by different instruments:: Government share of equity of oil Government share of equity of oil
companiescompanies Production sharing agreementsProduction sharing agreements Fiscal instruments Fiscal instruments
Equity and production Equity and production sharingsharing
Preconditions for Preconditions for investmentinvestment
• Large-scale direct foreign investment Large-scale direct foreign investment requires clear legal, regulatory and fiscal requires clear legal, regulatory and fiscal regimeregime
• For exploration, investors need clear path to For exploration, investors need clear path to development and production after discoverydevelopment and production after discovery
• For development, investors require security For development, investors require security for very large investmentsfor very large investments
• Need to settle which level of government Need to settle which level of government grants title, value of rights and likely grants title, value of rights and likely environmental liabilities.environmental liabilities.
Minimum Conditions for Minimum Conditions for InvestmentInvestment
• Promising geolgyPromising geolgy
• Security of tenureSecurity of tenure
• Competitive fiscal regimeCompetitive fiscal regime
• Fiscal and regulatory stabilityFiscal and regulatory stability
• Foreign exchange retentionForeign exchange retention
• Freedom to export investor’s share of petroleumFreedom to export investor’s share of petroleum
• Freedom of operation and commercial structureFreedom of operation and commercial structure
• Stability in environmental managementStability in environmental management
• Access to International arbitrationAccess to International arbitration
• Physical securityPhysical security
Establishing Petroleum RightsEstablishing Petroleum Rights
ResponsibilitiesResponsibilities
LegislatureLegislature
LegislatureLegislature
MinisterialMinisterialNOC /NOC /Regulatory Regulatory
AuthorityAuthority
Legal FrameworkLegal Framework ConstitutionConstitution Petroleum LawPetroleum Law Fiscal LegislationFiscal Legislation RegulationsRegulations ContractsContracts
ConstitutionConstitution
• Constitutions typically reserve rights to resources in the Constitutions typically reserve rights to resources in the ground to the state ground to the state
• National/federal or sub-nationalNational/federal or sub-national
• exceptions with some private ownership in the USA and Canadaexceptions with some private ownership in the USA and Canada
• Sometimes all oil and gas activity is reserved to a state Sometimes all oil and gas activity is reserved to a state company (Mexico)company (Mexico)
• Kuwait also establishes the right of the state to revenues and Kuwait also establishes the right of the state to revenues and prohibits exploitation of resources by foreignersprohibits exploitation of resources by foreigners
• Constitution usually requires that use of resources must Constitution usually requires that use of resources must be governed by law (Iran)be governed by law (Iran)
Petroleum LawPetroleum Law
• Confirms right of the state to control over resources in the groundConfirms 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 regulationsGoverns petroleum operations and sets power to make regulations• May establish a national oil company, and define its powersMay establish a national oil company, and define its powers• May include scope of contracts, or provision for royaltyMay include scope of contracts, or provision for royalty• Commonly includes fiscal provisions, though these may be better Commonly includes fiscal provisions, though these may be better
placed in the Tax Codeplaced in the Tax Code
Petroleum RegulationsPetroleum Regulations
• Power to make regulations governing Power to make regulations governing operations will be established in the operations will be established in the Petroleum Law, specific regulations may Petroleum Law, specific regulations may cover:cover:• Health, safety, and environment (HSE)Health, safety, and environment (HSE)• Licensing procedures, bidding rounds, and Licensing procedures, bidding rounds, and
awardsawards• Forms of contractForms of contract• Technical aspects of operationsTechnical aspects of operations
Legal and Fiscal IssuesLegal and Fiscal Issues
Contracts and License FormsContracts and License Forms
Forms of Petroleum Rights or Forms of Petroleum Rights or ContractsContracts
FORMFORM• License or concession, with or License or concession, with or
without an agreement (North without an agreement (North Sea,)Sea,)
• License or concession with joint License or concession with joint venture (Nigeria, Venezuela)venture (Nigeria, Venezuela)
• Production sharing agreements Production sharing agreements (Indonesia, Syria, Egypt, Angola)(Indonesia, Syria, Egypt, Angola)
• Service contracts (including risk Service contracts (including risk service contracts and buy-backs)service contracts and buy-backs)
• Combination or hybrid Combination or hybrid arrangementsarrangements
FISCAL SYSTEMFISCAL SYSTEM
• Tax and royaltyTax and royalty
• Tax and royalty, participation Tax and royalty, participation termsterms
• Production sharing, perhaps Production sharing, perhaps with tax and royaltywith tax and royalty
• Fees, perhaps with production Fees, perhaps with production sharingsharing
• VariousVarious
Types of Petroleum Rights & ContractsTypes of Petroleum Rights & Contracts
Type of Type of contractcontract
Cost and Cost and riskrisk
Exclusive Exclusive right to right to operateoperate
Right to Right to productionproduction
License / License / concessionconcession
Private Private companycompany
Private Private companycompany
Private Private companycompany
Joint Joint ventureventure
Private Private companycompany
SharedShared SharedShared
Production Production sharingsharing
Private Private companycompany
StateState SharedShared
Service Service contractcontract
Private Private companycompany
StateState StateState
The Production-Sharing The Production-Sharing Agreement Agreement
• PSAs could be a transitional phase or a PSAs could be a transitional phase or a permanent feature of the petroleum regime (as permanent feature of the petroleum regime (as for example in Syria and Egypt)for example in Syria and Egypt)
• PSA allows investor participation while retaining PSA allows investor participation while retaining national ownership of shares of petroleum national ownership of shares of petroleum produced-produced- Production sharesProduction shares Participating interests by NOCParticipating interests by NOC
• PSA passes risk to the investorPSA passes risk to the investor• PSA is familiar to petroleum industryPSA is familiar to petroleum industry
The Production-Sharing The Production-Sharing Agreement: Key Modern ElementsAgreement: Key Modern Elements
• Independent environmental impact studiesIndependent environmental impact studies• Development Plan for regulatory approvalDevelopment Plan for regulatory approval• Contractor incurs all exploration and development costsContractor incurs all exploration and development costs• Cost recovered from agreed percentage of gross productionCost recovered from agreed percentage of gross production• Profit oil/gas shared on some basis taking account of cost Profit oil/gas shared on some basis taking account of cost
and price changesand price changes• Contractor proceeds from PSA usually liable to income taxContractor proceeds from PSA usually liable to income tax• PSA provides for fiscal stabilityPSA provides for fiscal stability• State can participate in the Contract through subsidiary State can participate in the Contract through subsidiary
companycompany
Investor's portion Government's portion
Investor's after tax portion Profit tax
Production
Total investor's share Total government's share
Production Sharing
Cost oil Profit oil Royalty
Cost OilCost Oil
Permits investor to recover capital and Permits investor to recover capital and operating costs (but usually not interest operating costs (but usually not interest expense or financing charges) expense or financing charges)
Limit on Cost oil—40 to 70 percent of Limit on Cost oil—40 to 70 percent of productionproduction
Ensures early revenueEnsures early revenue Unrecovered costs carried forward and may Unrecovered costs carried forward and may
be uplifted by an interest factorbe uplifted by an interest factor Excess cost oil treated as profit oilExcess cost oil treated as profit oil
Profit OilProfit Oil
• Split between government and Split between government and investorinvestor
• Split may depend on:Split may depend on:• Level of daily production from each field Level of daily production from each field
(Sudan)(Sudan)• up to 25,000 bpd 61.5 % for up to 25,000 bpd 61.5 % for
governmentgovernment• 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)Profit Oil (Cont)
Cumulative production from the contract area Cumulative production from the contract area (Nigeria deep water off shore)(Nigeria deep water off shore)
Million barrelsMillion barrels % for government % for government 0 – 3500 – 350 20 20 351 – 750 35351 – 750 35 751 – 1,000 45751 – 1,000 45 1 001 – 1,500 501 001 – 1,500 50 1,500 – 2,000 601,500 – 2,000 60 Above 2,000 to be negotiated Above 2,000 to be negotiated
Profit Oil (Cont)Profit Oil (Cont)
• Level of daily production and price of Level of daily production and price of crude oil (Trinidad and Tobago)crude oil (Trinidad and Tobago)
• R-factor: ratio of cumulative revenue to R-factor: ratio of cumulative revenue to cumulative costs (Azerbaijan)cumulative costs (Azerbaijan)
• Internal rate of return (Russia and Internal rate of return (Russia and Azerbaijan)Azerbaijan)
Summary: The Production-Sharing Summary: The Production-Sharing AgreementAgreement
• Terms of PSAs can be Terms of PSAs can be replicated in tax and royalty regimesreplicated in tax and royalty regimes, but , but PSAs allow PSAs allow variation of economic terms for an areavariation of economic terms for an area without without amendment of fiscal legislationamendment of fiscal legislation
• State can retain and dispose of its shareState can retain and dispose of its share of petroleum or make of petroleum or make marketing arrangements with Contractormarketing arrangements with Contractor
• State not obliged to find budget fundsState not obliged to find budget funds for costs unless it elects for costs unless it elects to take working interest participationto take working interest participation
• PSAs can be “ring-fenced” or notPSAs can be “ring-fenced” or not, depending upon the state’s , depending upon the state’s preference for early revenue or maximum pace of developmentpreference for early revenue or maximum pace of development
• A “Model” PSA provides a standard framework A “Model” PSA provides a standard framework for competitive for competitive bidding over areas to be awardedbidding over areas to be awarded
• ““Pay on behalf” arrangements for Contractor’s income tax provide Pay on behalf” arrangements for Contractor’s income tax provide built-in fiscal stabilitybuilt-in fiscal stability
• Combination of PSA with taxCombination of PSA with tax permits investors to obtain tax permits investors to obtain tax credits at home; minimizes cost to host country revenues.credits at home; minimizes cost to host country revenues.
Fiscal IssuesFiscal Issues
Tax and Revenue InstrumentsTax and Revenue Instruments
Which fiscal instruments are typically Which fiscal instruments are typically used to tax oil and gas operations?used to tax oil and gas operations?
• The government’s share can be The government’s share can be obtained by different instruments.obtained by different instruments.
• Multiple objectives may require Multiple objectives may require multiple instruments:multiple instruments: Product based instrumentsProduct based instruments Profit based instruments Profit based instruments Bonus and rental paymentsBonus and rental payments
General Strategy for Fiscal RegimeGeneral Strategy for Fiscal Regime
Four principlesFour principles• Fiscal regime for petroleum cannot move far out Fiscal regime for petroleum cannot move far out
of line with countries competing for petroleum of line with countries competing for petroleum investmentinvestment
• Fiscal system that reduces investor risk will Fiscal system that reduces investor risk will maximize investment AND government take over maximize investment AND government take over the long termthe long term
• ““Tax neutrality”: fiscal system should take Tax neutrality”: fiscal system should take account of rent and the particular risks of account of rent and the particular risks of petroleum investmentpetroleum investment
• Simple design with minimum of distortionsSimple design with minimum of distortions
PSA StructuresPSA Structures• Volume-basedVolume-based
Cost oil limit plus profit-sharing by scale of cumulative productionCost oil limit plus profit-sharing by scale of cumulative production
Cost oil limit with profit-sharing by scale of daily rate of productionCost oil limit with profit-sharing by scale of daily rate of production
• Profit-basedProfit-based Rate of return systemsRate of return systems
““R-factor” or payback ratio systemsR-factor” or payback ratio systems
• Volume-based systems alone are insensitive Volume-based systems alone are insensitive to prices and costs; they do not avoid need to prices and costs; they do not avoid need for valuation of costs and outputfor valuation of costs and output
State EquityState Equity
• Working interest—paid up equity on Working interest—paid up equity on commercial terms; government on par with commercial terms; government on par with private investorprivate investor
• Concessional interest—e.g., option to invest Concessional interest—e.g., option to invest at cost once commercial discovery made at cost once commercial discovery made
• Carried interest—government pays for Carried interest—government pays for equity share (plus interest) out of equity share (plus interest) out of production proceeds (equivalent to production proceeds (equivalent to nonrecourse loan)nonrecourse loan)
• Free equity—government assumes no Free equity—government assumes no financial obligations nor have any financial obligations nor have any management involvementmanagement involvement
State Equity (Cont)State Equity (Cont)
• Secure higher government share in up-Secure higher government share in up-side.side.
• ““Ownership”, technology transfer, Ownership”, technology transfer, know-how, control over development.know-how, control over development.
• Often large cash-calls for working Often large cash-calls for working interest.interest.
• Conflict of interest: role of regulator vs. Conflict of interest: role of regulator vs. shareholder.shareholder.
Tax/royalty regimeTax/royalty regime
Royalty—secures minimum payment;Royalty—secures minimum payment; Regular corporate income tax/with Regular corporate income tax/with
higher than normal, or progressive higher than normal, or progressive tax rate;tax rate;
Resource rent tax—captures a larger Resource rent tax—captures a larger share of the most profitable projects.share of the most profitable projects.
RoyaltiesRoyalties Up-front revenue stream; regular Up-front revenue stream; regular
minimum payment;minimum payment; Assessed on volume or value of oil and Assessed on volume or value of oil and
gas;gas; Often considered disincentive to Often considered disincentive to
investment and a source of distortions;investment and a source of distortions; Typically only deductible in home Typically only deductible in home
jurisdiction.jurisdiction.
Royalty (with PSA)Royalty (with PSA)
In PSA regimes, royalties In PSA regimes, royalties May be explicit (and deducted from cost May be explicit (and deducted from cost
oil), oroil), or May be implicit—limit on cost oil ensures May be implicit—limit on cost oil ensures
that there is revenue for the State as that there is revenue for the State as soon as production commencessoon as production commences
Corporate income taxCorporate income tax
Issues peculiar to oil sectorIssues 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 Tax incentives : immediate recovery of exploration
costs, accelerated depreciation, investment credits, costs, accelerated depreciation, investment credits, and tax holidays;and tax holidays;
Problems can originate from transfer pricing, Problems can originate from transfer pricing, “earning stripping”, and inflated expenditure “earning stripping”, and inflated expenditure deductions.deductions.
Corporation Income Tax (with Corporation Income Tax (with PSA)PSA)
Under PSAs, investor is subject to Under PSAs, investor is subject to income tax on investor’s share of income tax on investor’s share of production;production;
Cost recovery rules for income tax will Cost recovery rules for income tax will differ from cost recovery rules for differ from cost recovery rules for purposes of cost oil;purposes of cost oil;
Important to have CIT qualify for foreign Important to have CIT qualify for foreign tax credit in investors’ home country.tax credit in investors’ home country.
Resource rent taxResource rent tax Rate of return basedRate of return based
the tax is assessed when accumulated the tax is assessed when accumulated real cash flow turns positive;real cash flow turns positive;
Rate of Return (RoR): Rate of Return (RoR): investor’s opportunity cost of capital; investor’s opportunity cost of capital; country-specific mark-up on risk-free country-specific mark-up on risk-free
asset;asset; If discount rate and RoR are close, If discount rate and RoR are close,
investment distortions will be reduced;investment distortions will be reduced; Problems: setting RoR and tax rate. Problems: setting RoR and tax rate.
Timing of Revenue under Alternative Timing of Revenue under Alternative Fiscal RegimesFiscal Regimes
1 2 3 4 5 6 7 8 9 10
11
12
13
14
15
16
17
-
10
20
30
40
50Income Tax Royalty
Years
Gov
ernm
ent's
Rev
enue
(mil
. $)
Choice Between Tax/Royalty Regime and Choice Between Tax/Royalty Regime and Production SharingProduction Sharing
Risk/Risk/Remuneration Remuneration Trade-offTrade-off
and immediate and immediate availability of availability of revenuerevenue
Tax/Royalty Tax/Royalty RegimeRegime
Production Sharing Production Sharing Agreements Agreements
Low risk to Low risk to governmentgovernment
and immediate and immediate revenuerevenue
RoyaltyRoyalty Explicit royalty; or limit on Explicit royalty; or limit on cost oilcost oil
Medium risk and Medium risk and possible delays possible delays of revenueof revenue
Corporation Corporation Income taxIncome tax
Income tax, may be paid out Income tax, may be paid out of government’s share of of government’s share of productionproduction
High risk and High risk and substantial substantial delays of delays of revenuerevenue
Resource rent Resource rent taxtax
The determination of profit The determination of profit oil can mimic a resource oil can mimic a resource rent taxrent tax
Equivalence of tax instruments with Equivalence of tax instruments with
non-tax instrumentsnon-tax instruments Production sharing
Tax Instruments Government Equity
Auctioning exploration/ exploitation rights
Share of physical output
Specific royalty
Share of value of production
Ad valorem royalty
Share of value of production after deduction of a proportion of operating and investment costs
Income/profit tax
Equity at a cost
Same as for previous line with a growing share f o r t h e government
Progressive income/profit tax
Resource rent tax/cash flow tax
Free and at a cost equity
Cash payment bids
Additional IssuesAdditional Issues
Fiscal stabilityFiscal stability Ring fencingRing fencing SubcontractorsSubcontractors Indirect taxesIndirect taxes Fixed fees and bonusesFixed fees and bonuses
For details see IMF, Guide on Resource Revenue Transparency, For details see IMF, Guide on Resource Revenue Transparency, 20072007
Fiscal StabilityFiscal Stability Fiscal stability clauses are wide-spread Fiscal stability clauses are wide-spread
in petroleum contracts to solve in petroleum contracts to solve problems deriving fromproblems deriving from::
the large size and the sunken nature of the the large size and the sunken nature of the initial investment;initial investment;
long payback and profitability period;long payback and profitability period; a lack of credibility that the host country a lack of credibility that the host country
will not change the fiscal rules (“Sovereign will not change the fiscal rules (“Sovereign risk”).risk”).
Approach to Fiscal StabilityApproach to Fiscal Stability
Frozen law: fiscal stability guaranteed by Frozen law: fiscal stability guaranteed by reference to laws in force on the effective reference to laws in force on the effective date of the agreement;date of the agreement;
May bestow unintended benefits to contractor;May bestow unintended benefits to contractor; Agree to negotiate to maintain economicAgree 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?Should fiscal stability be a one-way street?
Appropriate offsetting change will depend on Appropriate offsetting change will depend on assumptions regarding future revenue and costs.assumptions regarding future revenue and costs.
Ring FencingRing Fencinglimitation on consolidation of income and limitation on consolidation of income and
deductions for tax purposes across deductions for tax purposes across different contracts, fields, or activities.different contracts, fields, or activities.
Absence of ring fencing can seriously postpone Absence of ring fencing can seriously postpone government revenue;government revenue;
Ring fencing may discriminate against new Ring fencing may discriminate against new investors;investors;
Lack of ring fencing may be an incentive for Lack of ring fencing may be an incentive for investment in the petroleum sector.investment in the petroleum sector.
SubcontractorsSubcontractors
May want to subject (nonresident) May want to subject (nonresident) subcontractors (in the petroleum sector) to subcontractors (in the petroleum sector) to a simple final withholding tax of 5 to 10 a simple final withholding tax of 5 to 10 percent;percent;
Discrimination against domestic Discrimination against domestic subcontractorssubcontractors..
Issues with indirect taxesIssues with indirect taxes
Gas and oil projects often receive Gas and oil projects often receive special treatmentspecial treatment
Specialized equipment for exploration and Specialized equipment for exploration and development often exempt from customs development often exempt from customs dutyduty
Problems with providing VAT exemptionsProblems with providing VAT exemptions
Auctioning and payment of rights of Auctioning and payment of rights of exploration and exploitationexploration and exploitation
These are ex ante instruments for the These are ex ante instruments for the collection of oil rentcollection of oil rent..
Upfront payments attractive to government;Upfront payments attractive to government;
Negative impact on investment, if too large;Negative impact on investment, if too large;
High administrative administrative requirements High administrative administrative requirements for auctions, low for fees (but can generate small for auctions, low for fees (but can generate small revenue).revenue).
ConclusionsConclusions
Broad range of fiscal instruments available to Broad range of fiscal instruments available to secure an appropriate share of economic rent;secure an appropriate share of economic rent;
Most countries have both profit-based and Most countries have both profit-based and production-based levies;production-based levies;
Tax/royalty regimes and production-sharing Tax/royalty regimes and production-sharing regimes can lead to similar sharing of risks regimes can lead to similar sharing of risks and rewards;and rewards;
Market test for each country’s fiscal regimeMarket test for each country’s fiscal regime Issues of revenue-sharing, political economy Issues of revenue-sharing, political economy
and transparency in the next lecture.and transparency in the next lecture.
