The petroleum taxation regime is a crucial element of the regulatory regime employed by governments to manage petroleum exploration and production to the maximum advantage of the country. Successful petroleum fiscal regimes tend to simultaneously reconcile the critical requirements of both government and investors.
Government interests normally revolve around attracting and sustaining an acceptable level of exploration, development and production activity whilst yielding a fair and equitable fiscal take. Investor interests revolve around achieving full and early cost recovery, earning a reasonably competitive level of profit, and having some assurance regarding the predictability and stability of the overall economic and taxation regime.
Oil companies carefully consider the petroleum taxation regime in their investment decision making process. Taxation regimes that are incapable of meeting the critical requirements of investors could deter investment in projects that would otherwise be justified on economic grounds.
The critical challenge for most developing countries that seek investment into their upstream petroleum sectors is to strike an optimal balance between pursuit of revenue through taxation regimes, and the sustenance of investment inflows into the petroleum sector. While a petroleum taxation regime must be internationally attractive to investors, it must also be capable of yielding to the host country a fair and equitable share of the economic value generated by the exploitation of any commercial discovery of petroleum. This paper analyses this challenge in the context of the key practical issues faced by Sub-Saharan African countries endowed with petroleum resources when designing and implementing petroleum taxation regimes.
Optimising the front-end tax burden
When evaluating an investment opportunity, the structure of the taxation regime in the context of the tax burden over the life of a project is critical to an oil company. A particular concern for oil companies is the imposition of taxes prior to the start of commercial production. Because of the high costs and long gestation periods associated with petroleum projects, any front-end taxes will increase the total investment put at risk and reduce investment returns.
Petroleum royalties are characteristically heavy at the front end, and the challenge for most taxation regimes is to ensure that the rates and structure are competitive. Some petroleum taxation regimes do not levy a production royalty. For Sub-Saharan African countries however, the royalty represents an assured source of tax revenue, especially considering weak regulatory and institutional capacity in many of these countries to sufficiently monitor and collect other tax revenues.
A legitimate concern for host country governments is the need to obtain a fair compensation for the depletion of their non-renewable petroleum resources. Traditionally governments have always sought to obtain their revenues so long as there is production mainly through imposition of a royalty on production. In order to guarantee such revenue flows to the governments, the tendency is to make the royalty obligation non-negotiable.
Assurance of fiscal stability and predictability
Company investment decisions are normally based on projected cash flow streams that are likely to be generated over project life of more than 10 years. Companies therefore expect to have predictable and stable petroleum tax terms during the life of their investment.
The main challenge for developing countries in this regard is the provision of either legislative or contractual guarantees of the stability in the taxation terms agreed by both government and company for the project. These are usually significant assurances of the type that would satisfy most international oil companies and, most importantly, any third party financiers. To this end, the insertion of stability clauses into petroleum agreements is usually sought by companies during negotiations.
It is a widely accepted principle of general fiscal policy that a taxation regime should, as far as possible, not distort investment decisions by providing incentives for actions that would not otherwise be taken. Governments are, in the main, interested in providing a neutral fiscal basis on which companies would base their investment decisions.
For the petroleum sector, tax holidays are sometimes used to attract investment. Tax holidays are increasingly recognised by governments as being, at best, of only short-term benefit in attracting investment, and over the longer term can cause significant economic distortion. Also, certain capital allowances and deductions can distort investment decisions. An example is if a company is able to claim in excess of 100 per cent of expenditures actually incurred, as a result of the provision in the taxation regime of uplift on capital to be deducted or recovered.
Preventing tax avoidance
Governments seek to limit the extent to which tax revenues are reduced through tax avoidance by taxpayers. To achieve this, there must be appropriate rules and procedures in place, backed up by adequate enforcement capacity, that minimise risks of misreporting and transfer pricing.
Some petroleum taxation regimes in Sub-Saharan Africa fail to incorporate these reporting requirements, accounting principles and rules to prevent transfer pricing and misreporting. For many that do, there is need for review to reflect consistency with international standards.
Fair and equitable government take
Governments of petroleum producing countries seek to obtain a fair and equitable share of profits generated from exploitation of their petroleum resources while allowing investors to earn an internationally competitive return on their investment. They therefore seek to introduce more flexibility into the petroleum fiscal regime, so that their fiscal take automatically adjusts to the underlying profitability of petroleum projects in a progressive manner.
This is normally done through the application of such tax instruments as the variable rate income tax, or the imposition of a resource rent tax, commonly called an additional profits tax, on post corporate income tax profits.
The entire premise of such additional tax instruments is hinged on the determination of economic rent from the project. It is generally accepted that oil and gas production generates economic rent, and there is wide debate concerning the extent to which taxation schemes can seek to tax this economic rent without eating into marginal profitability.
Companies, and in particular their financiers, seek protection on the downside and believe they are entitled to capture any bonanza that could arise from such factors as a significant increase in oil prices. Governments on the other hand believe they have an entitlement to some minimum return on the exploitation of their non-renewable resources and cannot be seen to miss out on any upside.
Many Sub-Saharan African petroleum taxation regimes are regressive, ie they do not possess such levels of flexibility that can capture economic rent from projects which become highly profitable. The key challenge in this regard lies in the practicality of amending existing legislative and regulatory structures to incorporate more progressive elements such as the additional profits tax or the variable rate income tax.
For the progressive petroleum taxation regimes, rates of additional profits tax to be levied are usually based on profitability thresholds indicated by project internal rate of return. A key challenge for such regimes is determining optimal thresholds and rates that would encourage the companies to keep costs down.
Uncertainty of fiscal terms
Potential investors looking for investment opportunities will consider the fiscal burden they will face in deciding where to invest and would therefore like to base their assessment on a predictable set of tax terms. A lack of certainty under the existing regime as to whether legislated or negotiated taxes would apply sends unclear signals to potential investors. The challenge is to ensure clarity of reference for the various taxation instruments relating to petroleum exploration and production. Leaving all the elements open to negotiation increases the level of uncertainty in the application of the petroleum taxation regime.
High transaction cost
A petroleum taxation regime should be designed to be as simple as is necessary to achieve the fiscal policy objectives for which it is intended. If the number of elements and/or the complexity of the fiscal regime can be reduced without putting the Government’s fiscal interests at risk, this should be done.
It is not uncommon for many petroleum producing countries in Sub-Saharan Africa to suffer weakness in administrative capacity for the implementation of taxation regimes. The challenge is therefore to ensure that the taxation regime is designed in a manner that imposes as little administrative burden as possible on the institutional capacity of the government.
This can be done through a number of means, chief amongst which is minimising the number of negotiable items and fixing them in the law.
For many Sub-Saharan African petroleum producing countries, deciding whether to open up to resource extraction before a well-structured and well-staffed system is available, or whether to wait until everything is in place before seeking foreign investment can be difficult. A possible solution may be to subject oil companies to as simple a taxation system as possible, at least initially.
To avoid the risk of this initially simple regime becoming permanent, this approach should be accompanied with a clear roadmap for the strengthening the system and building implementation capacity over time.
Limiting the scope for negotiation ensures simplicity, greater transparency and a reduced pressure on the government’s existing administrative capacity. It is therefore not bad practice for developing petroleum producing countries to consider fixing such elements of the taxation regime as will provide a satisfactory minimum level of fiscal take and rely upon other elements of the regime to negotiate levels of fiscal take above the minimum level.
Where possible, fixing royalty obligations either in the principal legislation or by periodic prescription in the regulations is recommended. The latter approach would provide for the royalty rate to be varied from time to time (on a prospective basis) in line with developments in the petroleum sector over time and, in particular, success in finding oil.
The power to alter royalty rates by regulation, however, brings in its wake a possible perception of uncertainty.
The lack of fiscal progressivity is one of the weaknesses of taxation regimes in many developing petroleum producing countries. The incorporation of resource rent capture fiscal mechanisms in the form of resource rent tax is recommended. Such an instrument is a feature of petroleum taxation regimes in a number of countries, such as Ghana’s additional oil entitlement (AOE), and Angola’s additional profit tax (APT).
Depreciation provisions should be simplified as much as possible. Some regimes include more than one depreciation rate for development expenditures. It is generally acceptable to provide for a rapid rate of capital deduction for exploration expenditure albeit with a slightly reduced rate for development and other capital expenditures.
Overall, the fundamental success factors in the design and implementation of petroleum taxation regimes revolve around simplicity, enforceability and administrative ease of management.
It is also useful for the taxation regimes to be benchmarked against international practice in other jurisdictions offering similar geological, economic and political investment potential.