The IMF report on petroleum taxation and revenue management (Part I)

In last week’s article, we mentioned some of the key findings contained in the IMF report entitled “Guyana: A reform Agenda for Petroleum Taxation and Revenue Management”, dated November 2017. Those findings were gleaned from the various media reports. With the benefit of sight of a copy of the report, we now highlight, without comment, key aspects of the report which readers may find of interest as they reflect on the petroleum agreement between the Government of Guyana and ExxonMobil’s subsidiaries (Esso Exploration and Production Guyana Ltd., CNOOC Nexen Petroleum Guyana Ltd. and Hess Guyana Exploration Ltd.).

The report contains an Executive Summary and five chapters, namely: (i) Introduction (ii) Fiscal regimes for extractive industries; (iii) Extractive industries revenue management; (iv) A roadmap for petroleum sector reforms; and (v) Possible technical assistance and capacity building.

Executive Summary

The key findings are as follows:

1. The government faces significant challenges in preparing for the start of oil production, especially the need to manage public and political expectations in relation to providing information in clear and simple terms about the expected benefits from petroleum investments;
2. A comprehensive agenda of policy, regulatory and institutional changes is needed, which requires strong leadership in government to coordinate the reform process;
3. The immediate priority is to ensure that the fiscal terms agreed on contractually in the petroleum sharing agreement (PSA) and mineral agreements are made to work and diligently enforced;
4. The GRA should assess base erosion and profit shifting risks contained in petroleum or mineral agreements and consider ways to mitigate such risks. One example is the treatment of interest expense for the purpose of cost recovery. This, combined with the absence of limitations on the use of debt as well as no interest withholding tax, can lead to significant base erosion and profit shifting;
5. Going forward, fiscal regimes for extractive industries should be reviewed for future investments and operations to enable a reasonable sharing of risk and reward between investors and the Government. In this regard, the Government should consider issuing a temporary moratorium on new licensing until a new fiscal regime is in place;
6. The intention is for the GRA to be the single collection agency for the petroleum sector. However, the GRA needs to develop capacity in this area, given its limited experience in petroleum taxation, especially where the contractor’s income tax obligations are settled from the Government’s share of profit oil;
7. Plans to establish a petroleum industry taxpayer unit at the GRA should be prioritized, especially considering the need to commence verification and audits of exploration and development costs;
8. The revenue forecasting framework can be enhanced by developing project-specific cash flow models for the petroleum project and the two large gold mines;
9. Once oil revenue begins to flow, fiscal policy objectives should reflect a balance between the need to maintain macroeconomic stability, and providing additional resources for development spending;
10. The prospect of oil revenue should lead to renewed efforts at strengthening public financial management. This includes the strengthening of: (i) a medium-term budget framework incorporating revenue forecasts from extractive industries; and (ii) the annual budget process, including enhancing the presentation of the budget;
11. Given the intention to use oil revenue to scale up investment, it is imperative that the public investment management capacity is strengthened. This includes project appraisal and selection, procurement, implementation, and monitoring and evaluation;
12. In relation to the plans to establish a natural resource fund that is well underway, there is merit in considering whether to explicitly separate the short to medium run stabilization objective versus the long run saving objective by having separate investment portfolios with different investment policies. There should also be consistency between the fund deposit/withdrawal rules and a potential fiscal rule, which could be reinforced by an overarching fiscal responsibility legislation; and
13. A Public Investment Management Assessment planned for September 2017 with the assistance of the IMF could be extended to include: (i) policy advice of a general fiscal regime for new investments in extractive industries; (ii) developing a revenue forecasting model and fiscal regime analysis framework; (iii) providing policy guidance on the design and implementation of a macro-fiscal framework; and (iv) supporting accompanying public financial management reforms.

Chapter I: Introduction

Given the capital intensive and export oriented nature of the petroleum sector, the main direct effect on the domestic economy will be through fiscal revenue. The terms of the production sharing agreements are relatively favourable to investors by international standards. However, this is not unusual in a country only starting to develop oil. The priority should therefore be to strengthen the capacity to effectively implement the terms and conditions of the fiscal regimes. For new investments, the focus should be on improving the general fiscal regime and any future contracts reflecting the now lower exploration risks.

The mining regime does not include any fiscal mechanism to increase the Government’s share of revenue in the case of highly profitable projects and therefore also warrants revision of future investments.

There is a need to strengthen the policy framework for managing revenues from the extractive industries. This will require reforms to the fiscal regime, the macro-fiscal policy framework, public financial management reforms, and possibly a natural resource fund. There is also a need to strengthen the authorities’ capacity to better manage fiscal regimes for extractive industries and revenue forecasting for the sector, and improving fiscal transparency. The report noted the efforts being made for Guyana to become a member of the Extractive Industries Transparency Initiative.

Chapter II: Fiscal regimes for extractive industries

The following principles need to be considered in designing a fiscal regime for extractive industries:

1. As the owner of the resources, the State should receive an appropriate share of the economic rent resulting from the extraction of non-renewable resources;
2. It is desirable to have a flexible and progressive regime that yields a larger government share in highly profitable projects but one that imposes a lower tax burden on lower profitability ones. Such flexibility will reduce the need for project specific negotiations in response to unforeseen developments;
3. There should be neutral and non-distortionary taxation. As far as possible, fiscal regimes should not distort investment decisions, especially in relation to the ranking of projects, the pace of extraction or the decision to abandon a field;
4. There must be early and dependable revenue as well as efforts at cost containment in order to increase the size of shared profits;
5. Fiscal provisions should prevent or discourage pricing or cost recovery provisions that encourage or permit the erosion of the tax base;
6. Tax regimes should be comparable with those of other countries, taking into account, country conditions, and the stage of exploration and discoveries, among others;
7. Fiscal instruments or regimes should be simple for taxpayers to comply with and for the revenue authority to administer;
8. Tax rules for extractive industries should be set out clearly in legislation. Negotiation of project-specific fiscal arrangements should be avoided, and any negotiation should focus on non-fiscal terms. This will help to ensure transparency and equity through consistent treatment of taxpayers;
9. Frequent changes in the tax treatment of investment should be avoided as this may cause investments to be delayed in the expectation of future incentives, or discouraged for fear that future competitors may receive more favourable treatment; and
10. The Ministry of Finance should be the lead agency in setting fiscal policy for the extractive industries, in consultation with the departments responsible for those sectors;

The report identified the principal instruments that are applied in resource taxation. These are: (i) royalty; (ii) income or profit-based taxes; (iii) resource specific taxes; and (iv) State participation. Royalty is based on a percentage of production or gross revenue. While it has the advantage of producing early, dependable revenue, and is easy to administer; beyond modest levels, it can distort investment and production levels.

Income or profit-based taxes should ensure that normal profits from an extractive industry business are treated in the same manner as other business. Perceived drawbacks include complexity of administration and deferral of revenue during initial investor cost recovery period, depending on the depreciation rules.  Resource specific taxes in excess of those generally required to attract investment, work more effectively when they respond directly to measures of profitability. These can be achieved through a multiple of instruments, including through the profit share contained in a PSA.

State participation, which is a fixed interest in the company or venture developing an extractive industry project, takes one of three forms, namely: (i) Free equity: government receives a percentage of dividends but bears no responsibility for project costs; (ii) Carried equity: government contributions are met by the investor during the exploration and development phases, which are then recovered from dividends with or without interest if the project goes ahead; and (iii) Paid equity: government pays for its share of costs like other equity investors, along with “a seat on the table”. It is often perceived as a vehicle to improve local knowledge and capacity. In all three cases, government revenue is subject to companies’ dividend distribution policy; and in the case of paid equity, governments are exposed to significant financial risks.

The overall “fiscal package” is more important than the individual fiscal instruments that comprise it.