What are oil, gas, and mining fiscal terms?
In most countries, the extractive industries develop and operate through relationships between sovereign governments and private companies. The fiscal terms that govern the relationship between these parties determine how the financial benefits and risks of extractive projects will be divided. Terms can be written into a country’s laws and apply to all projects or they may be contained within the individual contracts that govern the rights and obligations for a specific site or project.
Fiscal terms in the oil, gas, or mining industries must be structured around four important characteristics of the extractive industries: 1) petroleum and mineral resources are not infinite, so governments must generate returns that are sufficient to compensate the country for the value of the asset being depleted; 2) extractive projects require significant upfront investments before revenues begin to flow; 3) project risks, including geological risks, price variations, technical uncertainties, and political risks, are often significant; and 4) extractive revenues have the potential to represent a dominant share of a country’s public revenues.
Why are fiscal terms important?
If managed successfully, petroleum and mining projects can generate large revenue streams for the state. The right set of fiscal terms enables a government to strike a balance between attracting the best investors and getting a good deal for the country. A fiscal regime that does not provide sufficient incentives for investors can result in production or revenue levels that fall short of government goals. But a fiscal regime that fails to distribute enough revenue to the host country can fail to effectively compensate the country for the value of its depleting resources, and can foster citizen dissatisfaction and national instability.
The fiscal terms influence not just theoretical assessments of expected national revenue under various scenarios, but also the enforcement of extractive agreements. The success or failure of a legal system to provide benefits for the country depends on the state’s ability to manage its commitments and ensure that all parties are adhering to the rules. Thus, an analysis of any system must consider how effectively it empowers the government to enforce the terms that capture benefit for the state. Good terms will enable governments to minimize the risk of corruption, non-compliance, and over-use of loopholes.
What are the main fiscal instruments?
Among the most common tools that states use in varying combinations are:
- Bonuses. A one-time payment made upon the finalization of a contract, the launch of activities on a project, or the achievement of certain goals laid out in the law or contracts. Sizes vary, ranging from tens of thousands to even hundreds of millions of dollars for a few large petroleum projects.
- Royalties. Payments made to the government to compensate it for the right to extract (and purchase) a non-renewable natural resource. Most royalties are either ad valorem (based on a percentage of the value of output, e.g., 5% of the value of the minerals produced) or per unit (based on a fixed amount, e.g., $10 per ton). When examining the likely financial impact of a royalty, it’s important to consider not just the percentage or per-unit value, but also the base against which that figure will be applied. The system in place for measuring the value or market price of the mineral plays an important role in determining the impact of royalty rules.
- Income Tax. In some cases, oil, gas and mining companies are subject to the general corporate income tax rate prevailing for all businesses in a country; in other cases, there is a special regime for these extractive sectors. Because petroleum and mining projects require heavy capital and operational investments, rules on how the tax system handles costs and deductions – the deductibility of interest payments, the depreciation of physical assets, the ability to count losses from one tax year to offset profits in a future tax year, etc. – play a major role in determining how governments and companies benefit.
- Windfall Profits Taxes. Some countries have set up special tax instruments designed to give the government a greater share of project surpluses, through additional tax payments, when prices or profits exceed the levels necessary to attract investment.
- Government Equity. In some cases, petroleum and mining projects are set up as locally-incorporated entities for which shares are divided between a private company and a state-owned company or another public body. Holding these equity stakes can give the state access to a portion of dividend payments.
- Other Taxes and Fees. Additional sources of fiscal revenues for the state include withholding tax on dividends and payments made overseas, excise taxes, customs duties, and land rental fees.
- Production Sharing. Many oil and gas contracts entitle the state to a share of the physical quantities of petroleum produced. These systems typically allocate such resources as reimbursements on production costs, then split control over the remaining “profit” oil or gas between the operating group of companies and the government. The government either sells its portion on its own, or takes cash payment from the operating companies in lieu of physical delivery of the commodity.
What are best practices for fiscal terms?
Since each country is characterized by variations in economic priorities, administrative capacities, mineral/petroleum endowments, and levels of political risk, it is impossible to identify one type or mix of fiscal instrument as best for all countries across the board. But there are certain considerations that governments should include in the design of fiscal regimes:
- The fiscal regime for mining or petroleum should be clearly established by laws and regulations that should be readily accessible to the public. Minimizing parties' discretion to alter fiscal terms in individual contracts facilitates contract enforcement and the application of a coherent sector-wide fiscal strategy, and reduces the risk of corruption in negotiations.
- Fiscal regimes are most stable when they contain progressive elements that give the government an increasing share of revenues as profitability increases. This can be achieved using a variety of instruments, including progressive income taxes, windfall profits taxes, and variable-rate royalties.
- When developing a fiscal regime, it is important to consider not only the total value over the life of a project, but also the timing of the expected revenue flows. Some fiscal instruments – bonuses and royalties, for example – generate revenues to the state at an earlier stage than instruments such as profits-based taxes. Governments should develop their fiscal regimes so as to generate revenues on a timeframe that corresponds with national development plans.
When analyzing the impact of a country’s fiscal terms on revenue generation, there are several potential loopholes that bear close monitoring:
- Transfer Pricing. An integrated international company may use sales among various subsidiaries as a means to reduce its fiscal obligations within a particular country. A sale of mineral or petroleum output from one subsidiary to another at a price under the fair market value may serve to reduce the revenue the company reports to the government and thus limit the royalty or tax payments it owes. Similarly, by purchasing a good or service from a related company at an inflated price, a company can raise its reported costs, thereby increasing deductions and decreasing income tax liabilities. In order to limit transfer pricing abuse, a government should put in place a firm policy for the valuation of transactions between related parties, linking the prices utilized for revenue-collection assessments to objective market values wherever possible.
- Debt-to-Equity Ratios. Interest payments on loans are often deductible for income-tax purposes. Integrated international companies sometimes finance subsidiaries in extractive-rich countries with extremely high levels of debt in the form of related-party loans, which means that interest payments made from the subsidiary to its parent company are deducted, limiting the subsidiary’s tax liability. Governments can combat this problem by capping the level of debt that an extractive subsidiary can take on in relation to its total capitalization, or by mandating that interest payments made on debt exceeding a certain debt-to-equity ratio will not be deductible for tax purposes.
- Ring-Fencing. Companies that have multiple activities within one country sometimes use losses incurred in one project (say, exploration expenses from a new mine that has not yet begun production) to offset profits earned in another project, thereby reducing overall tax payments. Governments can overcome this situation through ring-fencing, the separate taxation of activities on a project-by-project basis, which facilitates the government collecting tax revenue on a project each year that it earns a profit.
- Loss Carry-forwards. Many tax systems allow a taxpayer to deduct losses generated in one year from income earned in a subsequent year. Such a system takes into account the heavy up-front costs necessary to get a project off the ground. But in an effort to prevent unfettered carry-forwards from overwhelmingly reducing long-term revenue generation, some governments have placed limits on them, restricting either the period of time that a loss can be kept on the books or the amount of income in any given year that can be offset by past losses.
- Stabilization Clauses. Petroleum and mineral contracts often have clauses that establish that the law that exists on the day that the contract is signed will govern the agreement, and that subsequent legal changes will not have any effect on the contract. These clauses offer investors some assurance that they will not be subjected by legislative action to a drastically different fiscal regime than the one on which they based their decision to invest. But in order to protect the interests of citizens, preserve state sovereignty, and remain flexible to changing economic and political circumstances, stabilization clauses should be narrowly drafted and limited to major revenue streams such as royalties, taxes, duties, and major fees. Stabilization clauses should not freeze environmental, labor or other similar rules.
Fiscal terms are only one aspect of the rights and obligations set out between companies and governments in contracts and legal frameworks. Other key terms include those related to the environment, local economic development, extractive work programs, community rights, rights to information and dispute processes. In order to evaluate whether or not the country is getting a "good" or "fair" deal it is necessary to weigh all of these terms together.