The Taxation of Petroleum and Minerals

Philip Daniel, Michael Keen, Charles McPherson

• Publisher: Routledge
• Year: 2010
• ISBN:
  9781136966941
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

There are few areas of economic policy-making in which the returns to good decisions are so high—and the punishment of bad decisions so cruel—as in the management of natural resource wealth. Rich endowments of oil, gas and minerals have set some countries on courses of sustained and robust prosperity; but they have left others riddled with corruption and persistent poverty, with little of lasting value to show for squandered wealth. And amongst the most important of these decisions are those relating to the tax treatment of oil, gas and minerals.

This book will be of interest to Economics postgraduates and researchers working on resource issues, as well as professionals working on taxation of oil, gas and minerals/mining.

1
Introduction

Philip Daniel, Michael Keen, and Charles McPherson

What this book is about

There is big money in oil, gas, and minerals—big not only in absolute terms but also, and more importantly, relative to the overall size of many resourceendowed countries. Upfront investment costs are commonly huge, as are the potential rewards (and losses). How all this gets shared between the governments that control access to the resources and those who discover and exploit them that is, how these resources are taxed—can have a powerful impact on the economic and political fate of resource-rich countries.

But it is not only the sheer magnitude of the sums at stake that motivates this book: that in itself need not pose intellectual or practical challenges qualitatively different from those studied in the wider public finance literature. The principal motivation lies rather in distinct challenges for tax design and implementation that are posed by inherent characteristics of the sector: heavy sunk costs and long production periods (making the certainty and credibility of tax policies critical for investors), pervasive uncertainty (technological and economic), the volatility of commodity prices, the prospect of substantial earnings in excess of the minimum required by investors, and the ultimate exhaustibility of deposits. All but the last of these are present in other activities too. But in the resource sector they are center-stage rather than—as in most of the literature on business taxation—minor players. It is the conjunction of massive practical importance and distinctive conceptual and practical difficulty that is at the heart of this book.

Specifically, this book aims to provide an exhaustive account—accessible and useful to all those with more than a passing interest in the topic, whether practical or more academic—of core issues that arise in designing and implementing fiscal regimes for oil, gas, and mineral taxation, the focus being on taxation in the countries where the resources lie, not necessarily those in which they are ultimately used. The concept of a “fiscal regime” here includes not only literal taxes—compulsory unrequited payments to government—but also, for instance, production sharing, royalties, state participation, contract fees, output pricing constraints, and the like, together with tax administration. (Quite often, as in the title of the book, we use “taxation” as synonymous with fiscal regimes in this wider sense). Reflecting the focus of most the work of the IMF in resource tax issues, some but by no means all of the chapters give special attention to the particular circumstances of resource-rich lower-income countries (which face, for instance, quite different challenges in administering resource taxes).¹

As a guide to reading, this introduction provides a taster of each of the chapters.

What the chapters are about

The book is divided into five parts, though each chapter is intended to be self-contained: so they can be dipped into in any order.

Part I sets out key conceptual issues and ideas, providing a framework for many of the more applied contributions that follow.

Robin Boadway and Michael Keen review key concepts and issues in resource tax design, setting out a conceptual framework for many of the more applied contributions in this book. They bring to the central challenges of resource taxation a perspective drawn from the wider public finance tradition, pointing out that literatures on resource taxation, on the one hand, and on general business and commodity taxation, on the other, have evolved largely distinct from each other, with much for each strand to learn from the other. They examine various forms of potentially neutral rent tax—including not only the resource rent tax, familiar to resource practitioners, but also the “allowance for corporate equity” scheme that developed from analysis of distortions inherent in the conventional corporate income tax rather than from any special concern with natural resource issues.

Boadway and Keen also devote substantial attention to the issue of progressivity in resource taxation. They find that progressivity is likely to be unappealing for many low income countries in the presence of uncertainty. On the other hand, the strongest case for progressive resource tax arrangements in lower income countries may well be in dealing with the politics of time consistency, and determining the optimal degree of progressivity is likely to involve trading this off against the associated costs of risk-bearing.

Boadway and Keen accept that royalties will often have an important role in a resource tax regime, but emphasize that sole reliance on them risks creating costly distortions. Recognition that revenues may be easier for the tax authorities to monitor than costs suggests that royalties might be combined with rent taxes to exploit the advantages of both. They might also be combined with auctions in which the rate of rent taxation (and/or royalty) becomes a bid variable, not just an initial cash bonus bid. Ultimately, they conclude, it will seldom be optimal to rely on a single tax instrument, because of the range of challenges that governments face in designing their resource tax regimes: the preferred time path of revenues, problems of time consistency and asymmetric information, administrative capacity, and political economy pressures.

The chapter by Paul Collier, which developed from a lunchtime address given at the conference from which this book grew, aims to provoke debate over points sometimes taken as conventional wisdom in resource taxation and revenue management matters. His core theme is that economic principles for taxing resource extraction imply that the way in which natural resources are harnessed for society should differ considerably as between, say, Australia, Canada, and Norway on the one hand and Angola, Chad, and Timor-Leste on the other.

Collier stresses four distinctive features of the resource challenge in lowincome countries: (i) the discovery process is more important (Africa, for example, is relatively underexplored); (ii) institutions are less robust, so the credibility of government commitments is impaired; (iii) both consumption and capital are scarce, with the rate of return on scarce capital likely to be high; and (iv) governments are usually at a particularly severe informational disadvantage vis-à-vis resource companies. He deploys these features to challenge common prescriptions in favor of integrated budgets,² use of the permanent income hypothesis as a guideline for absorption, and the application of excess profits taxes. He argues for a wider separation of exploration from extraction, more frequent use of auctions, royalties geared to observable variables (such as prices), and adjustment of exploration to the pace of absorption of investment. He concludes by observing that earmarking of revenues, and assembly of infrastructure packages linked to resource development (common in China’s relations with Africa, for example) can serve as valuable “commitment technologies” to support positive development outcomes from resource wealth. Some of these are indeed quite radical departures from current recommendations, and are likely to receive closer attention in the coming years.

The second part of the book turns to the particularities of practice and experience in the three sectors with which it is concerned: oil, minerals, and gas,

One of the central issues in the oil sector, reviewed by Carole Nakhle, is the choice between tax and royalty (or “concessionary”) regimes and contractual regimes. She points out the possibility of deploying equivalent fiscal outcomes under either type, and then explores the evolution and characteristics of each, subdividing the contractual regimes into those of a production-sharing type (where produced oil and gas are shared) and those of a service contract type (where a cash fee is paid, even if geared to project results). Tax and royalty systems prevail in OECD countries, service contracts dominate where there are national restrictions on private participation in petroleum production, while production sharing has spread to much of the developing world—especially to Africa and south east Asia, but not to Latin America.

Nakhle finds that the choice between concessionary or contractual regimes has little impact on outcomes for core fiscal regime issues: the structure of the fiscal regime itself, the impact of price volatility, ownership and control, fiscal stability, or the sharing of risks. These issues remain equally difficult under either legal form—and equally capable of resolution. The choice of legal form comes down to factors of political economy and national institutions. In all cases, Nakhle sees potential for oil and gas producing countries to establish investment frameworks (including fiscal regimes) that respect their national sovereignty, and yet engage the finance and expertise which the international oil industry can provide.

Lindsay Hogan and Brenton Goldsworthy blend a survey of fiscal regimes for minerals with an approach to evaluating the component fiscal instruments. They find wide variation in fiscal systems among countries and over time. Mining fiscal regimes have tended to be unstable, and to respond sharply to price developments or to prevalent political trends (such as that towards state ownership of mines from the 1950s onwards, and privatizations after 1980). Production sharing and other contractual forms of fiscal regime have not taken hold in mining—the reason for this not being entirely clear, and perhaps meriting closer study—so Hogan and Goldsworthy focus on the key mineral taxation devices that prevail in most of the world: royalties, corporate income tax, and rent-based taxes.

Using the “certainty equivalent approach,”³ they evaluate the three main instruments, alone and in combination, in terms of their effects on neutrality, revenue yield, and investors’ assessment of risk under differing assumptions about attitude to risk. Rent or profit-based taxes tend to rank highly on neutrality, while output-based instruments (royalties) tend to rank highly in terms of moderating government risk, and administration and compliance criteria.

Graham Kellas addresses the special case of fiscal regimes for natural gas projects. Although gas has many economic properties in common with oil, and is frequently produced in association with oil, the problems of bringing gas to market and of pricing it are significantly different. Commercialization of gas requires a chain of operations “from drill bit to burner tip” that includes upstream production, pipeline transportation, processing or liquefaction, transportation again (for example, on LNG (liquefied natural gas) tankers), distribution or regasification (if liquid), and final sale to end user as fuel, electric power, or an industrial input. At each stage there may be arm’s length prices or transfer prices, and rents may arise. Fiscal regime design for gas is therefore complex, and may have to be adapted to the commercial structure of individual projects. Kellas points out that individual project arrangements are common (outside the United States, where a spot market supported by a national pipeline system exists, and perhaps north-west Europe, similarly interconnected).

Kellas explores the commercial structure of different project types, making a key distinction between “segmented” projects where transfer prices must be established at each stage of the chain, and “integrated” projects where only the final price of gas (usually LNG) matters. Since petroleum fiscal regimes usually apply to upstream production in a segmented structure, and normal corporate income taxation will apply to other stages, the transfer price from the field delivery point is critical to the fiscal outcome. Kellas considers other complications too, including the higher costs of delivering gas and the historical tendency for markets to undervalue its calorific content (heating value) relative to that of oil. He argues that government policies on gas pricing, equity participation, and on fiscal terms must be developed simultaneously if governments are to extract a significant share of rents from the production of natural gas.

Part III of the book addresses a range of special topics whose importance spans the sectors of interest.

Philip Daniel, Brenton Goldsworthy, Wojciech Maliszewski, Diego Mesa Puyo, and Alistair Watson (Daniel et al) address the key question, critical for well-informed resource tax policy: How can one evaluate and compare alternative fiscal regimes for resource projects? In answering this, they present results from the Fiscal Analysis of Resource Industries (FARI) project undertaken in the Fiscal Affairs Department of the IMF. They use the example of an oil field development, but also show how the analysis can be extended to the exploration decision. After outlining criteria for evaluating resource taxation systems, they derive indicators that can be used in a practical project modeling framework to assess the regime against those criteria. Although much of their approach draws from standard procedures used by practitioners in the evaluation of petroleum projects and fiscal regimes for resources, following Boadway and Keen they try to relate these procedures to concepts employed in wider analysis of tax systems and their incentive effects.

Daniel et al. illustrate the application of the criteria and indicators using a simulation for “Mozambique.” They do not replicate any particular contract or field for that country, but use Mozambique’s model exploration and production concession contract with bid or negotiated parameters (which are not specified in that model) added by the authors. The circumstances of a country such as Mozambique recur elsewhere: one major petroleum project is already operating, there are further discoveries but, as yet, no further development decisions, and exploration interest is significant but possibly not sufficient to permit an auction process to work properly. After considering fiscal regime issues and impacts for their “Mozambique” case, Daniel et al. locate the possible outcome in international comparisons. As with all such exercises, they caution that these have limitations and need to be carefully interpreted, taking account of things they do not show. An investment decision in any country will be determined by much more than a mechanical comparison of the effect of a fiscal regime on investor returns, simulating an identical field across a number of different country regimes.

Bryan Land re-appraises the benefit of resource rent taxes to host governments in the light recent commodity price swings. His focus is on non-royalty devices for extracting resource rent, usually meaning a tax on net cash flows levied only after the project has generated a minimum acceptable return to capital. As Land notes, a resource rent tax (RRT) of this type has had both proponents, who regard it as an indispensable part of the resource tax armory, and detractors, who consider RRT inappropriate and/or unworkable.

After a survey of both design principles and experience in implementation of RRT, Land concludes that there is a place for such a tax device in making fiscal regimes more responsive to uncertain outcomes. In practice, RRT has only been used in combination with other devices (usually royalty and income tax). The RRT can be less distorting than other levies aimed at rent capture. RRT can, however, present administrative challenges in countries with poor tax administration capacity—though no more so than the regular corporate income tax. Land concludes that the benefits of RRT depend on the government’s discount rate and risk preference: a government will have to be willing to accept back-loading of fiscal take, and a procyclical pattern of resource tax revenues.

Charles McPherson considers state participation in resource industries, drawing on case studies from both mining and petroleum ju...

Table of contents

• Contents
• Figures
• Tables
• Contributors
• Preface
• 1 Introduction
• Part I Conceptual overview
• Part II Sectoral experiences and issues
• Part III Special topics
• Part IV Implementation
• Part V Stability and credibility
• Index