Petroleum taxation is a means by which the governments of petroleum producing countries earn revenues from investors whether such investors are international Oil Companies or National Oil companies, for a natural resource such as petroleum which is owned and controlled by the government. The main purposes of petroleum taxation as defined by Nakhle (2008) are: i) Financing government expenditures – taxation is important to every government as it is a source of revenue which can be used to meet their expenses. This is why taxes imposed on natural resources such as petroleum are a good source of revenue to the government.
ii) Rent extraction – the idea of economic rent is extremely important in petroleum taxation.
iii) Distribution of benefits – it is also used as a means to distribute wealth among other sectors of the economy.
Fiscal regimes are essential to every natural resource producing country because they can either attract investors or send the wrong signal to investors. Petroleum fiscal regimes comprise legislative issues, tax issues and contractual issues (Kjemperud, 2004). The objective of petroleum resource management is to maximise the value of the natural resource which in this case is petroleum (Kjemperud, 2004). In another perspective, the goal of a fiscal system from the government’s point of view is to attract investment and capture the maximum economic rent given the geologic endowment of their petroleum acreage (Blake and Roberts, 2006). In order to fully understand the goal of a fiscal system from the government’s point of view, it is essential that economic rent is defined. The concept of economic rent began in the initial studies of David Ricardo in his theory of “land rent” and has since then been applied to the natural resources development (Clark, 2001). According to David Ricardo (1772-1823) ‘Economic rent on land is the value of the difference in productivity between a given piece of land and the poorest [and/or more distant], most costly piece of land producing the same goods under the same conditions of labour, capital and technology’ (Ricardo, 1821). Nakhle (2008) also defines economic rent as the true value of a natural resource, which represents the surplus return above the value of capital, labour and other factors of production used to exploit the natural resource. From the two definitions of economic rent, we can now appreciate why it is an important goal of modern fiscal regimes to capture the maximum economic rent. Below is a graphical illustration of economic rent.
Fig 1: Economic Rent (Watkins, 2001).
What exactly constitutes Fiscal Regimes?
Fiscal arrangement is the government’s most important tool for the management of petroleum resources (Kjemperud, 2004). It is often said that there are more fiscal regimes in the world than the total number of countries in the world producing petroleum because many vintages of contracts may be in place at any given time and obviously contract terms often change as countries become more experienced in licensing and global economic conditions (Kaiser, 2007). In other words when it comes to petroleum contracts, experience with investors does count and more often helps shape future fiscal regimes. This is important as government decides whether natural resources are to be privately owned or owned by the state (Kaiser, 2007). The two major types of fiscal regimes are the Tax Royalty (T/R) system and the Contractual systems (Blake and Roberts, 2006). The Tax Royalty system is also known as the Concessionary system. The figure below is an illustration of the types of fiscal regimes.
Fig 2: Petroleum Fiscal Regimes (Johnston, 1994)
The Tax Royalty system (concessionary system) developed from the early concessions in the Middle East and the US (Blake and Roberts, 2006). I will discuss this type of fiscal regime in full detail-in my next article. As illustrated in the diagram above, contractual systems are of two types, the production sharing contracts and service agreements.
Production Sharing Contracts
Production sharing contracts (PSCs) give an International Oil Company (IOC) the right to explore for and produce hydrocarbons within the contract area or block for a specified time period (Johnston, Johnston and Rogers, 2008). Production sharing contracts stipulate the sharing of petroleum production called profit oil, between the host government and the contracting company also known as consortium (Blake and Roberts, 2006). According to Kjemperud (2004), below are the elements of a Production sharing contract:
i) Work Commitment
ii) Bonuses – signature bonus, discovery bonus and production bonus.
iii) Royalties – this is calculated from the gross revenue.
iv) Cost Recovery (Cost Oil) – normally includes unrecovered cost carried over from previous years, current year depreciation, depletion and amortisation.
v) Profit Oil – this is the residual petroleum production after the contracting company has been reimbursed of its expenses through the allocation of cost oil (Blake and Roberts, 2006). Profit Oil = Net Revenue – Cost Recovery.
vi) Government Participation
vii) Domestic Market Obligation
viii) Ring Fencing - The ring fence prevents taxable profits from oil and gas extraction in the UK and UKCS being reduced by losses from other activities or by excessive interest payments by treating ring fenced activities as a separate trade (Department of Energy and Climate Change, 2010).
Service Agreements
In a service agreement, the government gives the contractor the right to recover its cost and pays the contractor a fee based on a percentage of the revenue that is left (Nakhle, 2008). Service agreements are of two types, risk service agreements and pure service agreements.
i) Risk Service Agreement – in this kind of agreement, the International Oil Company takes all the risk and performs the exploration and/or production services for the Government within a given area for a fee, of which throughout the contract, the government maintains ownership of the petroleum produced (Johnston, Johnston and Rogers, 2008). The fee could be a fixed fee per barrel produces, a fixed fee as a percentage of costs, or a variable fee as a percentage of gross revenues (Johnston, 2007).
ii) Pure Service Agreement – the International Oil Company undertakes exploration and production on behalf of the government for a flat fee (Blake and Roberts, 2006). Pure service agreements are rare between International Oil Companies and the host Government but are mostly found to be between a service company and the International Oil Company (Johnston, Johnston and Rogers, 2008).
Having described the different types of contractual systems, it is important to point out what systems are being used around the world. Below is a table adapted from Kjemperud (2004) that shows the different fiscal systems around the world.
Fig. 3: Fiscal Regimes around the world (Kjemperud, 2004).
Below also is another table which illustrates the similarities and differences between the different fiscal systems:
NUTSHELL:
In this article Mabel has discussed the concept of Economic rent and the relationship with Fiscal Regimes; she then proceeds to analyse the contents of a fiscal regime. In her next article, Mabel will discuss what types of fiscal regimes apply in the UKCS & Nigeria; and then proceed to explain the nature of royalties and concessions, the historical framework of royalty and how beneficial royalty is to a government as a form of taxation. Mabel will also briefly discuss petroleum income taxes, weighing the options for different fiscal regimes. The objective of this analysis on Fiscal regimes is to give a better understanding of the topic and the various taxes involved, and also why it is important to tax natural resources.
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