Benefits from an Oil and Gas Industry

Apr 09, 2017 News

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By Kiana Wilburg

Oil and gas can be of significant benefit to a country, particularly with regard to taxation and other

revenue. This is providing that the various contracts and agreements are appropriately designed. Guyana has this very valuable asset (crude oil and natural gas) which can only be exploited once; no second chance to get it right.
As important as the much talked about Sovereign Wealth Fund (SWF) is, ensuring that a country with this resource receives a just and reasonable return from the industry is equally important. While the SWF is intended to protect against the possible mismanagement of income earned from the oil industry, the Production Sharing Agreement (PSA) is one instrument used to ensure that the country receives a fair return from the industry.
Kaieteur News recently conducted an interview with Chartered Accountant, Shawn Naughton, who provided interesting insight into some of the more important potential benefits and associated risks to countries with this precious resource, and the importance of paying attention to partnerships with foreign companies.
According to Naughton, some important potential benefits to a country, which usually flows from the oil and gas industry include: signature bonus, production bonus, rentals, royalty, the country’s equity share, corporate tax, export duty, withholding tax, value added tax, and income tax.
Naughton then explained each of the listed potential benefits and associated risks.

SIGNATURE BONUSES
According to the Chartered Accountant, a signature bonus may be agreed as payable on the signing of a PSA or exploration and development licence with a specific oil company. He explained that obtaining the licence/agreement indicates to the oil company that it has won the right to benefit from any oil produced under the specific licence/agreement.
Naughton said that the bonus is especially useful where more than one oil company competes for this right/licence. Revenue from this source could be used to off-set the country’s administrative costs relating to the oil & gas fields, whether or not oil is found on exploration.

PRODUCTION BONUS
With regard to a production bonus, the tax expert said that this may be agreed as payable, for example, for each well found to be containing commercial quantities of oil. Since with each new find the overall project becomes more profitable to the oil company, Naughton said that including a provision in the PSA for these milestone bonuses is logical and common place with oil deals.

RENTAL
In this respect, Naughton explained that the oil company will need to use property belonging to the country to set-up operations. He opined that it is normal commercial practice to pay rent when occupying property which does not belong to you. He said that rents agreed as payable during the production period are typically significantly more than during the exploration phase.
The Tax expert asserted that an upfront refundable security deposit may also be agreed under the relevant PSA.
While it should be agreed that the oil company ‘clean up’ spills etc after and during its operations, Naughton said that the security deposit offers added assurance. He said that careful note should be taken that some of the rents are usually used as compensation to residents in close proximity to exploration and production areas.

ROYALTY
Naughton explained that royalty payments relate to the production of oil and gas. Unlike the bonuses and rent mentioned above, he said that royalty is not earned until production of oil and gas commences. Royalty payments receivable usually represent a percentage of the ‘value’ of the oil produced. He said that the ‘value’ given to production is therefore significant in calculating royalty payments, and should therefore have an unambiguous definition in the context of the PSA.

REVENUE RISK AND ROYALTY PAYMENTS
Since the oil produced has not actually been sold, the valuation of the oil at this stage can be somewhat subjective. Naughton said that agreeing on an unambiguous valuation method for oil produced is critical, if both parties are to be happy with the actual royalty payable/receivable during the course of oil production. He said that note should be taken that the oil, based on which royalty is payable, is the raw crude pulled/pumped to the surface.
“The simplest way of being unambiguous as it relates to valuing oil production is to agree to a fixed value per barrel produced (say US$80/barrel). Since different oil sources have different characteristics, including viscosity, sulfur content and other components however, the valuation of a barrel of crude oil can be very complex. Most crude oil pricing is determined by supply and demand in the marketplace and can fluctuate on a daily basis.”

THE COUNTRY’S EQUITY SHARE
Naughton explained that under PSAs, the ‘equity return’ (profit) is shared between the country and the company as agreed in the PSA. Since profit is defined as ‘income’ minus ‘expenses’, he said that it would again be important to clearly define relevant income and expenses in the context of the PSA. Naughton said that expenses relating to the activities covered by the PSA should be the only expenses allowed.
Furthermore, the Chartered Accountant explained that PSAs usually cover exploration and production activities only (known as upstream oil and gas activities). He said that the relevant activities for which costs should be allowed in this context are: Geological and geophysical research; Seismic surveys; Exploration drilling; Production drilling; and Production to the surface.
Naughton said that storage, refining, marketing and transporting of the oil produced (downstream activities) are not upstream activities so the associated expenses should not be allowable expenses in this context. Expenses may also have to be valued, in addition to being clearly identified as allowable.
He added, “While when doing business with third parties there is usually no reason for looking at the prices set between those parties, transactions between related entities (related parties) can pose a valuation problem. Many oil companies outsource aspects of their work to related companies, which means that it is possible that transactions between them are not reasonably priced.”
He continued, “By artificially inflating prices charged by related entities to the oil company the allowable expenses of the oil company increase, with a corresponding decrease in profits and the country’s profit share. This is a major risk, especially where the oil-producing country is without effective transfer pricing rules (a method of valuing transactions between related parties).”
The Chartered Accountant added, “Where the country is with no or with ineffective general transfer pricing rules, the PSA itself would need to include unambiguous rules on valuation of transactions between related parties. This can be achieved through the use of advanced pricing agreement (an upfront agreement between the country and the company on acceptable approaches to pricing).”
Once the valuation of oil produced is clearly agreed and the value and type of allowable expenses are also settled, Naughton said that associated revenue risk to the country is minimized. Clearly, having a general transfer pricing regime written into law would be preferred.

CAPPING EXPENSES
According to Naughton, some PSAs include a clause that limits the annual allowable expenses to a certain percentage of the value of oil produced. He said that this ensures that for each year of oil production, starting with the very first, there are profits to share. The Chartered Accountant stressed that this is a very useful clause for developing countries which depend heavily on the oil industry, since annual revenue from oil production is certain.
Furthermore, Naughton related that capping of expenses is logical, since the cap is usually set based on available and reliable estimates of unit cost of production. He noted that the country should not have to pay for the company’s inefficiency, which results in the actual production costs rising above the agreed cap.

CORPORATE TAX
Naughton expressed that the oil company’s share of profits is usually taxable. He noted that there are some PSAs where the country’s share of the profit is set high enough to avoid the need for separate corporate taxing measures applying to the oil company.
He said that allowing for the separation of the corporate tax charge makes it easy for the oil company to claim (double) tax relief, under international tax rules. He also pointed out that charging the tax separately under the terms of the PSA is therefore common place.
(To be continued)

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