Fiscal analysis.pptx

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Introduction to Upstream Oil and Gas Training

I4TH – 16TH May 2013, Intercontinental Hotel, Nairobi

Fiscal analysis

Risk and financial analysis in Exploration and production

Philip M. Tsar

(Petroleum Engineer – National Oil Corporation - Kenya) 1



Scope

Fiscal analysis,

Structure of fiscal regimes,

Severity and efficiency of fiscal

regimes,

Incremental effects of fiscal regimes &

Revenue Sharing

2



Background & Introduction

Kenya has been exploring for oil since 1937

Current framework (Petroleum Act and Model

Production Sharing Contract (“PSC”)) was developed

prior to discoveries; Model PSC is oil-centric

2012 discoveries in Turkana and gas-prone offshore

highlighted need to modernize existing framework

GoK and World Bank engaged Hunton & Williams andChallenge Energy (“Consultant”) to review and provideguidance for updating the existing framework

Background of Legal and RegulatoryFramework

3



1. Fiscal Considerations – Progressive Fiscal Regimes

A progressive fiscal regime is one where the State‟s share of a project‟s

profits increases as the project‟s profits / rate of return increases.

S t a t e s

h a r e o

f t o t

a l b e n e f i t s

Project profitability

1

2

3

4



Fiscal Considerations – Fiscal Instruments

A range of fiscal instruments exist:

• Corporate Income Tax

• Windfall / Special Petroleum Taxes

• Royalties (although often not viewed as a tax)

• Bonuses (not a tax but can be used in combination

with above)• Production Sharing (consistent with existing PSC)

• Daily Rate of Production

• Rate of Return

• R-Factor

5



Fiscal Instruments

Benefits Drawbacks

CIT

• Familiar for both

parties

• Profit based

• Can be varied by theState so may

increase Investor risk

perception

• Requires additionalinstruments

WindfallSPT

• Progressive therefore

reduces impact on

Investor decisionmaking

• Flexible therefore

protects State

• Can be complex

increasing the

administrative burden

• Can be subsequently

modified by the State

so may increase

Investor risk

perception

6



Fiscal Instruments

Benefits Drawbacks

Royalties• Immediate income for the State

• Simple administration

• Regressive

• Does not factor in

Contractor‟s costs

• Delays cost recoveryfor Investor

• Potentially complicates

double taxation relief

administration

• Limited flexibility

7



Fiscal Instruments

Benefits Drawbacks

Bonuses• Guaranteed State

income

• Increases

Contractor‟s project

risk where exploration

uncertainty exists

Productio

n Sharing

• Progressive therefore

reduces impact onInvestor decision making

• Flexible therefore protects

State

• Immediate income for the

State

• Reduces the number of

fiscal instruments required

• Stable environment for

Investors

• Double taxation relief

administration

• In order to be stable,

must evaluate rates and

bands carefully before

PSC/PSA is signed

8



Sharing Mechanisms

Some specific benefits and costs of each method of production

sharing are outlined below (in addition to those listed on the

previous slide):

Benefits Drawbacks

DROP based

on profithydrocarbon

s

• Relatively simple tocalculate and

administer

• Not based on project

profitability

• Low volumes but highprices can limit State

share

• Requires accurate

volumes

9



Sharing Mechanisms

Benefits Drawbacks

Rate of Return

• Based on direct

measure of project

profitability

• Potentially no differenttreatment of oil and

gas Same rates can

be applied to onshore

and offshore projects

• Considers the timevalue of money

• Acceptable rates of return may vary

dramatically between

investors and concept

less simple than

volumes or R-Factor –

may complicatenegotiation

• Sensitive to timing of

costs

• Requires effective costaudits to be performed

regularly

10



Sharing Mechanisms

Benefits Drawbacks

R-Factor

• Based on directmeasure of project

profitability

• No different treatment

of oil and gas required

• Same rates can be

applied to onshore and

offshore projects

• Conceptually simple:

once revenues >costs, taxation

increases

• Does not directly

consider the time

value of money

(although this can be

factored in through the

cost recovery cap)

• Requires effective cost

audits to be performed

regularly

11



Wider Fiscal Issues Capital Gains Tax ensures where value is added by international

Investors, the Kenyan State will receive a share of the benefit.

• Transfer of interest via the sale of non-resident Companyshares does not appear to be directly addressed by the 9th

Schedule of the ITA.

• Clarity in relation to the „pay on behalf‟ scheme.

Withholding Tax protects against interest / dividend stripping by

non-resident companies.

• Interest stripping can result in income being paid to non-

resident companies via interest repayments (profits can be

removed by excessive repayments).

• Dividends paid to non-resident parent companies can help

owners realise an investments value whilst avoiding CGT.

VAT on sale to domestic end users reasonable (consistent with

HFO) but research required into VAT on LNG sales.

12



Fiscal Instruments – Best Practice

Best practice:

• A progressive fiscal regime, as this is a highly desirablefeature for the Investor, balancing taxation of profits against

the project‟s profitability.

• Use of production sharing (most progressive / flexible)

either the R-Factor or ROR methods would be broadly

appropriate.• An R-Factor approach – why?

13



Why R – Factor?

Under the R-Factor, profit hydrocarbons are allocated

using a measure of project profitability, therefore highlyprogressive and flexible (captures windfalls but also

reduces taxation for marginal investments).

The DROP method does not specifically include costs

when determining the profit hydrocarbon share so provides

limited relief for marginal projects. The DROP method requires additional instruments to

effectively capture windfall situations.

With the R-Factor it is possible to use only one method

of taxation reducing the administrative burden.

◦ Some form of windfall tax is required under the DROP

method.

14



Why R – Factor?

Stable as the State does not need to alter the terms

agreed with the Investor if the project turns out to bemore or less profitable than expected.

Including a windfall tax to support the DROP method may

increase uncertainty for investors / reduce stability if

possible that rate may be modified in subsequent periods

by future Governments. Can be tailored to specific situations if required (such

as extremely long project timelines which may require the

cost recovery cap to be increased) – the same is true for

DROP.

15



Why R – Factor?

Calculated using basic cash flows therefore simple to

calculate the R-Factor, but also relatively simple to audit costs incurred.

◦ DROP requires volumes to be measured accurately which can

be more complicated.

◦ DROP may under-tax profitable fields with low production

volumes Consistent terms for oil and gas, as well as onshore and

offshore developments may help to reduce the

administrative burden when implemented.

◦ DROP requires different terms or at least some form of

conversion of gas volumes into oil equivalents or vice versa.

16

Oth B t P ti



Other Best Practices

It is in good order that:

• The current VAT treatment is maintained for oil and gasdevelopments, however research is required into the

treatment of LNG exports.

• WHT should only be charged at generally applicable rates.

A specific study into the appropriate rate of WHT to be

levied on interest and dividend payments to non-residentsshould be performed.

• Revision of Schedule 9 of the Income Tax Act to remove any

uncertainty over how gains are taxed, and how these gains

interact with the PSC framework.

17



Thank you!!

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