By Mary Ongore
The discovery of natural resources in a country can have a significant impact on the revenues of a jurisdiction. These benefits can however only be realized where there is strong governance. The careful design of the fiscal regime is also imperative. This blog will review the types of fiscal regimes available, as well as the considerations developing countries, should make in designing them.
Types of regimes
The main fiscal regimes used to tax the extractive industry are contractual regimes or concessional regimes (also known as tax/royalty regimes).
Under concessional regimes, the natural resources belong to the investors who in exchange pay royalties on the volumes extracted. In addition, they will also pay some form of profit-based tax. The royalties will usually be based on the volume of products extracted products while the profit-based tax will usually be in the form of company income taxes, excess profits (or variable income) taxes, and resource rent taxes.
In the early years of extraction, revenues from profit-based taxes will generally be lower as cost recovery applies. Royalties on the other hand are calculated on the gross volume or value of production with no deduction permitted for costs and are payable once production commences. As a result, royalties are generally easier to predict and administer and ensure a steady income stream as they do not depend on the price of the product or revenues earned. The royalties are therefore favorable where governments want to raise revenue early in the project life. However, as they are not profit-based, they may deter exploration where margins are slim and where projects are only significantly profitable on a pre-tax basis. The profit-based taxes are however not progressive unless the tax rate scales are used. In addition, they are difficult to administer.
Bonuses are also commonly used under this regime and represent upfront payments made without full knowledge of the extent of production values. Although tax/royalty regimes are common in mining industries they are also used in the oil and gas industry.
Contractual regimes on the other hand can either be production sharing contracts or risk service contracts. These regimes are both are used in the oil and gas industry but are less common in the mining industry.
Under production sharing contracts, the revenues from extraction are shared between the host country and the international oil companies who work as a contractor. There may also be a royalty on gross production. A percentage of the remaining production known as cost oil is allocated to the investor to cover its cost of production. There are limits on the recoverable cost oil in a given year and costs exceeding the cost oil allocation for a particular year are generally carried forward. After the deduction of royalty amounts and cost oil, the remaining amount known as profit oil is further allocated based on pre-agreed formulas and percentages. This profit oil is also subject to regular profit-based taxes with deductions applying based on the tax law. The cost oil ceiling allows the government to recover early benefits.
On the other hand, under risk service contracts the government owns the oil and gas and the government pays a fee to the investor for exploration and production services. International Oil Company works as a service provider in different stages of the project. The fee paid to the investor may also be subject to profit-based taxes.
There can also be additional taxes in form of bonus payments, whether signature bonus or production bonus. Most tax regimes allow for bonuses to be tax-deductible since they are a cost of doing business; the larger the tax relief for the bonuses offered in the contract, the greater the magnitude of the upfront bonus is likely to be. However, they are typically not allowable for cost recovery under PSC, which ensures that the state receives more profit oil.
Other taxes on the extractive industry include VAT on domestic consumption which is often refundable on the export of the products. Sales or dispositions of assets are also taxable under ordinary income tax or in the form of capital gains tax. Taxes are also levied upon profit distribution whether done through the use of dividends, interest, royalties, and service fees to subcontractors.
Whilst there are differences between the two regimes, it should be noted that there is room for case-by-case negotiation under both. Tax and royalty schemes originated in the mid-1800s and generally prevailed historically. To date, they continue to dominate in OECD countries. In developing countries, however, contractual regimes which emerged in the 1950s are more common based on the desire to retain sovereign rights over a country’s resources. While it was generally argued that concessional regimes place oil companies in a much stronger position and allow them to exploit governments of oil-producing countries, it has been shown that such exploitation was not because of the fiscal regime, rather it was a combination of different political, economic, social and legal conditions, which have changed dramatically since then. In the early days, host governments often lacked expertise in the conclusion of concessional contracts, often giving sweeping powers and rights to extractive industry companies through one-sided agreements. Benefits to host governments were limited to royalties based on the volume of production at a flat rate rather than a percentage of the value of the oil produced. However, post the second world war, a new generation of concession agreements was developed which granted the host government more rights.
Although contractual regimes are preferred by developing countries, it has been shown that it is possible to design concessional regimes in a way that results in similar economic outcomes as contractual regimes.
In the design of a fiscal regime, countries should generally adopt a regime that best suits them. Whilst it is advisable to learn lessons from other countries, as there is no one-size-fits-all regime, countries should take the following considerations into account when designing their regime.
The fiscal regime adopted should result in a maximum return for the government while ensuring optimum economic efficiency. This can be done through the use of competitive tax rates and good use of deductions in the tax regime. Governments may, however, also design a fiscal regime that results in a lower effective tax rate because they would like to attract investment and compensate for high costs, high geological risk, and political risk. Where there is high volumetric potential a higher tax rate can be adopted.
Price volatility should also be considered particularly in the oil industry. Governments tend to favor high tax rates during an upswing in prices with conversant reduced tax rates during a downswing. It should however be noted that changing the fiscal regime is often a slow process. As a result, fiscal regimes should be flexible and responsive to these changes.
As it pertains to the control of the natural resources, although the government control is higher in contractual regimes, it has been shown that government control can be retained in concessional regimes through the legal and regulatory framework. Under concessional regimes, governments can still exploit the competitive instinct of international oil companies and build successful oil and gas regimes in a short time and benefit from the deployment of resources to the oil and gas industry. From an economic perspective, the government’s tax rate can ensure that there is commensurate compensation irrespective of the ownership of the underlying ownership.
Another consideration to be made in the design of the fiscal policy is stability. Investors prefer regimes that remain stable throughout the life cycle of exploration. Regimes that constantly change deter investment. Generally, a certain level of instability is acceptable where it is compensated for via a low tax-take. In addition, stability ensures that revenues are predictable for the host government.
Finally, the chosen fiscal regime should result in administrative efficiency. Tax administrators should be well appraised on how the regime works in order to prevent exploitation from the extractive industry operators.
As there is no fixed regime design that benefits developing countries, due care should be taken in the design of the regime in order to ensure that it is best suited to the individual circumstances of each country. The central fiscal issue is ensuring a ‘reasonable’ government share in the rents often arising from the extractive industry.
Although contractual regimes are perceived to be tougher and therefore the optimal regime for developing countries, concessionary regimes can also be designed to be similarly tough. Governments should ensure that they focus not just on the tax rate but also the way fiscal reliefs are granted. What is of utmost importance is the way the tax base is defined. Poorly designed fiscal regimes, however, can seriously undermine revenue potential. An optimal regime will consider the fluctuations in revenues during the cycle of exploration and ensure that their regimes can adapt to them. There are also various ways of ensuring fiscal flexibility through the linking of the tax/royalty/production share to proxies for profitability and it is encouraged to take these into account in developing the fiscal regime.
The evaluation criteria during the design of regimes can include an analysis on whether the regime is progressive, encourages efficient development, results in dependable revenues, and results in a favorable sharing of risk between investors and governments.
The IMF has developed a Fiscal Analysis of Resource Industries (FARI) tool which can be used to model cash flows for petroleum and mining projects. This is a useful tool that has successfully been used in many jurisdictions and assists with the optimal design of the fiscal regime.