Post on 08-Dec-2021
Rep44-02
Intergovernmental Relations, and NaturalResources: the Case of Petroleum
Professor Alex KempSchlumberger Professor of Petroleum Economics
University of Aberdeen
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Intergovernmental Relations, and Natural Resources: theCase of Petroleum
Professor Alex KempSchlumberger Professor of Petroleum Economics
University of Aberdeen
Contents Page
1. Introduction – Uniqueness of Natural Resource Revenues...................... 1
2. Recipients of Economic Rents.................................................................. 2
a) The Efficacy of the Rent-Collecting Instruments..................................... 3b) Restricted Competition Among Supplies ................................................. 3c) Regulated Product Prices.......................................................................... 3d) Ownership of Mineral Rights ................................................................... 4e) Indirect Natural Resource Revenues ........................................................ 7
3. Types of Decentralised Schemes
a) Fixed and Flexible sharing with Specified Ceiling .................................. 7b) Independent Revenue Raising Powers ................................................... 10
4. Multi Tier Government Involvement in Natural Resource Taxation..... 12
a) Payment for Benefits Received .............................................................. 12b) External Costs of Natural Resource Exploitation – Pollution and
other Disruption ...................................................................................... 13c) Resource Exhaustibility .......................................................................... 14d) Rates of Time Preference........................................................................ 14e) Risk Bearing Capabilities ....................................................................... 15f) Redistribution/Poverty Alienation.......................................................... 16g) Alienation Reduction .............................................................................. 17h) Transparency........................................................................................... 18i) Promotion of Accountability .................................................................. 19j) Tax Compliance...................................................................................... 20
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5. Special Petroleum Tax Office................................................................. 24
6. Alignment of Taxation and Other Stakeholder Interests........................ 25
7. Conclusions............................................................................................. 26
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Intergovernmental Relations, and Natural Resources: theCase of Petroleum
Professor Alex KempSchlumberger Professor of Petroleum Economics
University of Aberdeen
1. Introduction – Uniqueness of Natural Resource Revenues
Revenues from natural resource exploitation have some unique features. Often
they emanate from the production of non-renewable resources. Conceptually
the reserves form part of the nation’s capital stock and reserves depletion is akin
to depreciation of the capital stock. Another feature of natural resource
revenues is their volatility. This is generally a reflection of fluctuations in oil
prices, but it also reflects production variations.
In the petroleum sector oil revenues can be very large. This depends on the size
of fields exploited as well as oil prices. Because of these characteristics oil
revenues have the potential to make a significant contribution to total state
revenues.
The size of these revenues depends not only on the extent of the economic rents
available, but also on the efficacy of the schemes employed by Governments in
collecting them to the state. Economic rents are defined as returns in excess of
the supply price of the investment. A large variety of schemes is available. A
full discussion is outside the scope of this paper. Some are more accurately
targeted on economic rents than others. A well-targeted scheme should allow
for the deduction of all legitimate costs plus a return on the investment
reflecting the risks involved. In developing countries Production Sharing
contracts (PSCs) are the most prevalent form of contract arrangement. Under
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these the petroleum is divided into cost oil and profit oil. Contracts
incorporating profit-oil sharing where the state’s share is based on the investor’s
rate of return or on an R-Factor schedule (ratio of contractor’s accumulated net
revenues to contractor’s accumulated costs) are potentially better targeted on
economic rents than contracts where the state’s share is based on royalties
and/or profit oil sharing based simply on production. Similarly, with
concession-type schemes, royalties and production-based taxes are not so well
targeted on economic rents as profit-related impositions such as the resource
rent tax and net cash flow tax.
The impact of the various instruments is such that, given the volatility of oil
prices profit-related schemes produce larger variations in state revenues through
time than those based on production. Profit-related schemes are less likely to
inhibit exploration and development, however, and, if the schemes are
reasonably well-specified, the size of the economic rents available should be
maximised.
2. Recipients of Economic Rents
It is widely agreed that the state should receive the economic rents from the
exploitation of natural resources. In most parts of the world the state is the
owner of the mineral resources. If only economic rents are collected no
distortions to the allocation of resources, such as inhibitions to exploration,
development and production below pre-tax levels, should occur. The extent to
which efficient rent collection occurs depends on several factors as follows:
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a) The Efficacy of the Rent-Collecting Instruments
As noted above it is clear that production-related instruments are not
efficient collectors of economic rents. They do not allow exploration,
development and operating costs as deductions nor the required rate of
return of the investor. There is a danger that, when oil prices are
relatively low, exploration development and thus production will be
inhibited by instruments based on production or gross revenues. Pre-tax
economic rents will be less than they otherwise would be. This may be
termed dissipation of the economic rent. Conversely, when oil prices are
high a scheme based on production may leave a large share of the
economic rents with the investors. This may be termed diversion of the
economic rents.
b) Restricted Competition Among Supplies
Such diversion can also take place for other reasons. There may be
restricted competition in the supply of inputs into the production of the
renewable resource. Elements of monopoly could well result in prices of
inputs being higher than in a competitive market.
c) Regulated Product Prices
A further and relatively common cause of diversion of economic rents
emanates from the intervention of Government authorities who stipulate
that the natural resource product be sold at a price lower than would
apply in a competitive market. This sometimes applies to oil. It is not
uncommon in Production Sharing Contracts that there is a domestic
market obligation provision to sell some oil at a price below the market
value. It is also quite common that the price of natural gas is held down
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below the free market level in contractual arrangements, especially in
developing countries.
d) Ownership of Mineral Rights
The ownership of mineral rights is always raised in the context of who
should constitute the recipient of mineral rights. The legal ownership is
generally specified in the laws of every country. There is normally little
doubt about the ownership within a country’s land boundaries and
territorial waters. Doubts sometimes arise outside a country’s territorial
waters. The extent of a country’s continental shelf may well be subject to
dispute.
The legal ownership of mineral rights has traditionally given the natural
resource owner the right to a share of the revenues from its exploitation.
Historically the royalty was the share of the output accruing to the
landlord. The ownership issue has become important in countries where
there is more than one tier of government. The tier which has the
ownership rights generally feels that it should receive at least a
substantial share of the economic rents. In some jurisdictions the tier
which has the rights is not the central or federal government but a
provincial or other lower tier. Sometimes in such cases the central or
federal government feels that it also has the right to a share in the
economic rents. Canada has been a well-known example of this
phenomenon. In the 1970’s this resulted in a major dispute between the
federal government and the Alberta government in particular. In this case
the independent attempts by both tiers of government to collect a high
share of economic rents resulted in the overall Government take causing
investment disincentives.
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There are other cases where the mineral rights are jointly held by
different tiers of government. Russia is an example. The core legislation
establishes rights to a share of the economic rents, but the question of
how the shares are to be determined is answered separately. Central or
federal governments generally have the unfettered right to levy taxation
and this can readily produce conflict with the lower tier of government.
Mineral rights to the Continental Shelf of a country are generally vested
in the central or federal government. Sometimes the legislation indicates
that a second tier of government should obtain a prescribed share of the
revenues accruing to the owner of the mineral rights. When Australia had
a conventional royalty and tax system applicable to its Continental Shelf
the royalty revenues were shared with the adjacent state government in
the ratio 60:40 in favour of the Commonwealth Government.
In some jurisdictions (such as some parts of Canada and onshore USA)
there is private ownership of the mineral rights. In such circumstances
the private owner has the right to levy impositions such as royalties and
thus receive a share of the economic rents. Some would regard such a
situation as diversion of economic rents, but this view remains
controversial.
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The bigger question relates to the issue of who should have the mineral
rights. This raises many issues some of which are beyond the scope of
this paper. From an economic viewpoint the following general
propositions can be made:
i) Where the rights are vested in the state rather than in private hands
there is a greater revenue potential to the state without endangering
investment incentives.
ii) Where the rights are with the central or federal government priority
is likely to be given to national considerations with respect to the
raising and use of revenues. Also, with respect to other objectives,
such as development and depletion policy, procurement, and
environmental policy, it is arguable that a national government will
give primary attention to national objectives. Sometimes these
may conflict with regional priorities.
iii) From the discussion in (ii) above it follows that when the mineral
rights are vested in a devolved or provincial government the
considerations with respect to revenue raising, use of revenues, and
development, depletion, procurement, and environmental policies
are likely to be primarily regional rather than national.
iv) When the mineral rights are jointly held the outcome in terms of
priorities depends on (a) the relative extent of the rights given to
the respective parties and (b) the negotiating abilities of the
respective parties. There is clearly greater potential for ensuring
that the interests of both tiers of government are taken into account.
Equally, scope remains for conflict between the two rightholders.
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e) Indirect Natural Resource Revenues
Natural resource exploitation, particularly petroleum, can give rise to
significant revenues which are unrelated to the ownership of the mineral
rights. A prime example emanates from the property used for petroleum
exploitation. At the upstream stage this typically refers to the plant and
machinery employed in production, storage, and in processing at
terminals. If downstream is included refineries are also included.
Property taxes are typically levied by local governments. Because the
value of the property in petroleum exploitation is typically very high the
revenue from this tax can be quite substantial as far as the budget of the
local government is concerned. Where the production is located offshore
outside territorial waters the local government may not have powers to
levy the local property tax. Sometimes, however, it may have an
obligation to provide services relating to the offshore activity such as
police and health.
In this paper the issues raised in Sections 2 (d) and 2 (e) above are explored in
more detail. The various possible schemes for raising revenues involving more
than one tier of government are examined in more detail. They are assessed
against various criteria.
3. Types of Decentralised Schemes
a) Fixed and Flexible sharing with Specified Ceiling
Historically in Russia this concept was taken quite far reflecting the
acknowledged interests of the lower tiers of government. The details
have changed over the years, but a full picture of the arrangements at one
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time during the 1990’s is shown in Table 1. It is seen that sharing applied
not only to royalties but to other taxes as well.
Table 1
Sharing Arrangements for Revenues Generated in the Petroleum Sector(i) Export Tax:
100 per cent to Russian Federation(ii) Exploration Fee:
100 per cent to cities and rayons(iii) Mineral Replacement Tax:
20 per cent to Russia Federation40 per cent to oblast20 per cent for reinvestment
(iv) Petroleum Production Royalty:On production not in autonomous national region (okrug):
40 per cent to Russian Federation30 per cent to oblast or republic30 per cent to rayon or city
On production in autonomous national region (okrug):20 per cent to Russian Federation20 per cent to oblast or republic30 per cent to okrug30 per cent to rayon or city
On production from continental shelf:60 per cent to oblast, republic, or okrug40 per cent to Russian Federation
(v) Value Added Tax (VAT):As stated in VAT law:
100 per cent to Russian FederationAs implemented:
80 per cent to Russian Federation20 per cent to republic, oblast, or okrug
(vi) Excise (Production) Tax:100 per cent to Russian Federation
(vii) Enterprise Profits Tax:40.6 per cent (13/32) to Russian Federation59.4 per cent (19/32) to republic, oblast, or okrug
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The regional governments have had certain discretionary powers. With
respect to royalty they could reduce the rate which they effectively levied
as an incentive. They could not increase the rate above the total rate in
the primary legislation. Similarly, with respect to profits tax, the regional
governments have the right to reduce the rate they are prepared to levy as
an incentive.
Recently there have been significant changes to the sharing arrangements
in Russia. A new production tax has been introduced to replace the
royalty and the Mineral Replacement Tax. (The latter was introduced in
the 1990’s and shared between the federal and regional governments).
The production tax is entirely a federal government responsibility and
thus the regional governments have lost some fiscal autonomy. The new
system involves the federal government making budget payments to the
regional governments. When profits tax became a maximum of 30% the
federal rate became 11% and the range for the regional one 0%-19%.
Very recently the overall rate has been reduce to 24%.
In Nigeria historical the federal government has received all the main
royalty and tax payments from petroleum exploitation. Oil producing
states were then allocated a small share of these revenues. In 1999 the
federal government agreed to redistribute 13% of the total royalty and tax
revenues obtained from petroleum production to the producing states in
question. Thus 13% of the revenues generated by a particular state would
be returned to that state. The deviation principle has been employed to
justify this procedure.
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Recently the Nigerian Supreme Court ruled that all revenues from
offshore oil exploitation belong exclusively to the federal government,
rather than effectively be shared with the states whose location is adjacent
to the offshore exploitation.
In Malaysia the state government ceded all rights to petroleum to the
federal government. In compensation for this the oil producing states
have received 50% of the total royalty payments received by the federal
government. It should be stressed that the royalty (10% rate) constitutes
a very small proportion of the revenues received by the state from
petroleum exploitation.
In Papua New Guinea the national government receives all the revenues
from petroleum exploitation. Oil producing provinces receive all the
royalty revenues from petroleum produced within their areas less the
costs of collection. It should be stressed that royalties are tiny in Papua
New Guinea with the main sources of petroleum revenues coming from
Additional Profits Tax and corporate profits tax.
b) Independent Revenue Raising Powers
In some jurisdictions the devolved tier of government has independent
royalty and/or tax powers. In Canada, where the mineral rights are vested
in the provincial governments, the government in question has
independent powers to levy royalties. There is a variety of royalty
schemes across the different provinces. Provincial governments also have
the powers to levy profits tax. In practice the detailed provisions
regarding allowable deductions are harmonised with the federal profits
tax.
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The Canadian federal government levies profits tax. It also has the power
to levy special taxes on the petroleum industry. For some years it levied
the Petroleum and Gas Revenue Tax (PGRT). This was essentially based
on gross revenues. Although the federal government is not the holder of
the mineral rights for onshore acreage it nevertheless felt that it was
entitled to a share of the economic rents from petroleum production.
The imposition of PGRT by the federal government as well as the
enhanced royalties by the Alberta government produced an extremely
high level of overall take which caused inhibitions to investment. To
enhance its share of the economic rents the federal government
disallowed royalties as a deduction for corporate profits tax. (A substitute
allowance termed resource allowance) was then introduced.
A further feature of the Canadian arrangements is the system of
equalisation payments. In essence, if for a particular revenue source
(such as from petroleum production), a province’s proportion of Canada’s
population exceeds its proportion of the aggregate revenue source base in
question, it is then entitled to an equalisation payment to produce parity
with the national average. The equalisation payments are calculated for
each of the revenue sources. A natural resource rich province would not
have a “fiscal capacity deficiency” and would not receive any
equalisation payment.
It is noteworthy that in Russia the federal government also has the right to
levy other special taxes on petroleum production, for many years there
has been an excise (production) tax. The effective rates have varied
enormously. They have been quite high. The entire proceeds of this tax
have gone to the federal government.
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4. Multi Tier Government Involvement in Natural Resource Taxation
a) Payment for Benefits Received
The first argument for allocating natural resource revenues to lower tiers
of governments stems from the notion that the devolved tier of
government has to provide infrastructure services to facilitate the natural
resource exploitation. Such services could include roads, water, airport,
housing, and miscellaneous other services.
This line of argument is consistent with the traditional benefit theory of
taxation. In principle the beneficiaries pay in accordance with the
benefits they receive from the provision of the public or social goods in
question. There is clearly a strong case for the application of this concept
under review in the situation under discussion. It should be noted,
however, that the unambiguous application of the concept does depend on
the decentralised government actually incurring the costs of providing the
infrastructure. Thus the central government may contribute to the
financing of the infrastructure costs. Sometimes the investors will
contribute as well. With this proviso, however, there is a strong case for
the application of the concept.
Given that the concept is applicable the practical issue arises of achieving
the appropriate correspondence between the expenditure on the
infrastructure and the payments by the petroleum companies.
Infrastructure is generally required well in advance of production. In fact
it may be required from the time of first exploration. Revenues can only
be received by the devolved government at this early stage if the
contractual arrangements involve signature of other early bonus
payments. Otherwise revenue receipts have to await the coming of
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production income. Royalty and production tax payments occur from the
beginning of field life. Profits tax payments, profit oil shares, and
particularly payments related to the project’s achieved rate of return, will
typically occur substantially later.
There will thus probably be a timing mismatch between the infrastructure
requirements and the revenue receipts. The exception is where the
signature or other early bonus payments are large. The total cost of the
infrastructure requirements should, of course be far less than the resource
revenues. This raises the question of the determination of the appropriate
amount of revenues which should be decentralised to the regional/local
government. It could be argued that the amount should be related only to
the costs of the infrastructure rather than a share of the economic rents
remaining after recovery of these costs.
b) External Costs of Natural Resource Exploitation – Pollution and otherDisruption
In practice natural resource exploitation has frequently brought with it
pollution and disruption to local communities. It is arguable that they
should be compensated for this, and that a share of the oil revenues
should be allocated to local/regional governments in recognition of these
costs. Local communities undoubtedly have to bear such costs. The
question of the appropriate amount of revenues necessary to compensate
them again arises. This formed the basis of a rather bitter dispute
between the oil companies and Shetland Islands Council in the UK in the
1970’s. It ended with the so called disruption payments being negotiated,
based on the throughput of oil landed in the islands.
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c) Resource Exhaustibility
As oil and gas are depleting natural resources the regions in which
exploitation is taking place will sooner or later suffer from the
consequences of their exhaustion. These will undoubtedly involve further
expenditures to maintain the infrastructure and to revitalise the possibly
flagging economy. It is arguable that resource revenues should be
allocated to the regional/local governments to enable them to meet these
eventualities. With respect to the appropriate amounts it could be argued
that the shorter the life of the resource the greater the share of the
revenues which should be allocated to the regional government. This
follows because the duration of the revenues required to finance and
amortise the public investments required for the exploitation of the
natural resource would also be less.
d) Rates of Time Preference
It is quite possible that different tiers of government will have different
rates of time preference. This can be reflected in their attitudes towards
natural resource development and the associated flow of tax revenues
through time. One tier may have a relatively low rate of time preference,
and thus wish to develop and deplete the resource relatively slowly, and
maintain/build up the total capital stick of the relevant economy. Another
tier may have a higher rate of time preference and be primarily concerned
to obtain revenues as quickly as possible. It is arguable, for example, that
the UK central government in the 1970’s was primarily interested in a
fast pace of development to obtain large revenues as soon as possible to
improve the balance of payments, and reduce the large Public Sector
Borrowing Requirement (PSBR). On the other hand the Shetland Islands
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Council which was the local government on whose territory a large share
of the oil was landed was more concerned with the long term
consequences of oil developments.
The only general statement that can be made here is that the resource
revenues should go to the tier of government best able to allocate
efficiently through time by use of the capital market. Practice and
regulations in this respect differ widely around the world, but central
governments are likely to have much greater scope for borrowing than
regional ones. The problem of such differences in rates of time
preference should, however, not be ignored.
e) Risk Bearing Capabilities
Natural resource exploration is a risky activity. Petroleum exploitation
has very high risks at the exploration state. At the production stage price
variability is also very high. Governments, both national and regional,
participate in these risks through the tax and royalty system. Even with
bonuses (signature or bonus bids) there is risk-sharing in the sense that
the size of the bids reflect the perceived risks and rewards.
The central government in effect participates in the risks of all the
petroleum activity throughout the whole country. A regional government
participates in the risks of the activity only within its own area of
jurisdiction. The central government’s risks are more diversified.
Petroleum revenues will almost certainly be very variable, compared to,
say, those from valued-added tax or personal income tax. It is arguable
that a central government whose risks are more diversified is better able
to accommodate fluctuating oil revenues than a regional one whose risks
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are less well diversified. As noted above central governments are likely
to have better access to capital markets.
f) Redistribution/Poverty Alienation
It might be argued that devolving revenues on the lines indicated will
result in the regions in which the natural resources are located being
unduly favourably treated. This need not be the case if the amount of the
revenues allocated faithfully reflects the considerations discussed above.
Actual practice in most parts of the developing world indicates that
central governments have claimed the overwhelming share of the
revenues generated. There are many cases where the producing regions
have suffered noticeably from the external costs noted above and are
certainly not obviously advantaged from the exploitation of petroleum in
their locality. Obvious examples are Nigeria and the FSU. The pollution
costs in countries such as Nigeria and Azerbaijan are very noticeable. In
Soviet times Azerbaijan received very little compensation for hosting the
oil exploitation. There is no evidence that in the developing world the
local regions/lower tier governments have fared particularly well as a
result of petroleum exploitation within their areas. Devolution or sharing
of revenues could promote a redistribution of income in a more
egalitarian direction.
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g) Alienation Reduction
It is frequently the case in developing countries that petroleum
exploitation takes place in an enclave-type context. This refers not only
to the physical nature of the activity but also to the relationship between
the investor and the host government. Typically the host government is
represented by the central authority. Often the national oil company
plays a significant role. But it is responsible to the central government
and normally its key officials are appointed by the relevant minister.
Further, it is frequently the case that the relationship between the investor
and government/national oil company is conducted on a confidential (or
non-transparent) basis. Contracts are typically confidential.
While there may be sound commercial reasons for this type of
relationship the result can produce local suspicions and alienation. In
turn this can lead to strife and even violence. There are several well
known examples of this phenomenon with respect both to petroleum and
hard rock minerals. The economic, social, and human costs of such strife
can clearly be enormous. Revenue sharing could play an important role
in reducing the probability of the emergence of these disruptions. In
general the existence of revenue-sharing arrangements can help to
produce an enhanced sense of involvement and participation by local
populations which can reduce the likelihood of strife with the central
authorities.
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h) Transparency
The lack of transparency in petroleum contracts can produce not only
suspicion but the possibility of corruption. When contracts are
confidential and only a relatively few individuals in one tier of
government are intimately involved in their negotiations the scope for the
emergence of corrupt practices is increased. Where more than one tier of
government is involved the probability of such corruption may be
reduced. With more parties being involved the potential exists for more
checks on the flows of revenues.
Of course, the involvement of more than one tier of government with the
revenue flows does not guarantee either transparency or absence of
corruption. It merely increases the potential for such outcomes. The
specific nature of the fiscal arrangements is also of some relevance.
Where the revenues are shared according to a formula which divides the
total among the tiers according to a pre-determined formula there will be
a clear interest across the different tiers in ensuring that the total revenues
are properly determined prior to sharing. In this case each tier will have a
legitimate right to examine the basis for the calculations. Where one tier
has exclusive rights to one element in the overall government take the
rights of the other tier(s) to see the details of the calculation may not be
so strong. (Such rights are, however, still arguable. For example, in the
circumstances where Tier A receives all of a specified royalty and Tier B
receives all the profits tax, the representatives of Tier B can argue that
they are entitled to see the basis for the royalty calculation because, as a
prior charge, it determines the taxable base for profits tax). The rights of
the respective parties regarding inspection rights can readily be clarified
in legislation or regulations.
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Even when the division of revenues among the different tiers of
government has been determined in a manner satisfactory to all parties
further transparency issues remain. The extent to which the any single
tier of government is transparent regarding its (agreed) receipts remains
an issue. As noted above non-disclosure of these is often masked under
the cloak of contract confidentiality. The need for this is often greatly
exaggerated. Full contract details do not always need to be made public
for the purpose in hand. (It should be noted that in many countries
licenses and/or contract terms are public documents). Transparency in
the present context requires only that revenue receipts are transparent.
Generally the full tax details relating to a company’s activities are
confidential between the taxpayer and the tax authority. This is, of
course, understandable but it does not mean that selected information
cannot be made public. Sometimes investors voluntarily publicise the
amount of tax they are paying in a country, usually to emphasis the large
size of the payment. Recently BP decided to publish the payments it was
making to the government of Angola and the national oil company in the
interests of transparency. It was noteworthy that Sonangol indicated its
disapproval of this on the grounds that contract confidentiality had been
breached. BP was obviously less concerned about this than the issue of
transparency.
i) Promotion of Accountability
The promotion of accountability is a wide-ranging subject, and many of
the issues relating to that subject are well beyond the scope of this paper.
It is arguable that transparency with respect to natural resource revenues
can help to promote accountability. This applies to all stakeholders,
including investors, government, employees in the sector, and the
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electorate. It applies even when revenues are not allocated to
decentralised tiers of government. When several tiers of government are
involved in natural resource exploitation the presence of devolved
revenues with knowledge of their respective sizes can make a significant
contribution to improving the accountability of the governments to their
electorates.
j) Tax Compliance
The issue of compliance is an important consideration in tax design and
practice. There are several relevant issues. These relate particularly to
(a) degree of compliance with the tax rules, and (2) compliance costs
(investor as well as government). The extent of compliance depends in
turn on several factors. These include on the taxpayer’s side the degree of
tax evasion (illegal) and tax avoidance (legal), and on the government
side the degree of diligence and honesty displayed by inspectors and
collectors. The extent of tax avoidance depends on the opportunities
which the legislation provides and the vigour and imagination with which
these opportunities are pursued.
In the petroleum industry the price at which crude oil is transferred from
producers to customers has often resulted in debates and fears that tax
revenues are less than they should be. When the transfer is from a
producing company to a refining/marketing affiliate there is often scope
for differing views on what the transfer price should be. The incentive to
seek advantageous (low) transfer prices emanates from the fact that the
tax levels are generally much higher at the upstream stage compared to
downstream. The government revenues at stake apply to royalties, profit
oil shares as well as profits tax.
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A necessary (but not sufficient) condition for the reduction or elimination
of losses from transfer pricing schemes is the establishment in legislation
of clear and enforceable rules on price determination for tax purposes.
This is not always easy as experience in Russia has amply demonstrated.
Where the petroleum is being exported the fair market value can
generally be calculated without much difficulty, especially if there are
significant independent third party transactions. Where the internal
market is segregated from the international one, and where many of the
transactions are between affiliates the determination of fair market value
is more difficult, and the scope for avoidance schemes becomes greater.
In Russia because of the great difficulties in establishing fair market
values the authorities have persevered with unit production taxes despite
their manifest economic efficiency compared to ad valorem royalties and
profit-related taxes.
Where multinational companies are undertaking the investment in the
developing country the normal tax and PSC rules allow the recovery of
legitimate costs. It is common that multinational companies incur
legitimate costs outside the host country. These are frequently in the
parent country of the investor. The size of such costs which can
appropriately be set against income incurred in the host country is often a
matter of debate. From the viewpoint of the tax authority in the host
country assessing such costs is not easy even when much diligence is
displayed. A useful device is to establish a clear formula in the PSC or
other agreement. This can be included in the Annex on Accounting and
Financial Procedures in a PSC.
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There are other areas where diligence on the part of the authorities can
reduce or eliminate tax avoidance. One relates to loan interest. This is,
of course, a legitimate cost, but the extent to which debt capital can be
legitimately employed is a matter of debate. It is sometimes used as a
device to reduce taxable income and export profits before they are subject
to profits tax or even profit oil sharing. To limit the amount of any
avoidance there should be clear rules regarding (a) the maximum debt:
equity ratio permitted, and (b) the determination of the appropriate
interest rate.
It is clear that tax evasion is reduced by increasing the diligence and
honesty of tax officials. In turn this depends on several factors including
the adequacy of training and the provision of competitive salaries which
reduce the temptation to participate in tax evasion schemes.
Compliance costs also depend on several factors. The type of fiscal
devices employed are important considerations. The greater the amount
of information required to determine the required payment the bigger the
compliance costs. Thus unit production taxes require little information.
They do not require knowledge of the value of the product.
Unfortunately they are not well targeted on economic rents. Exploitation
costs are not deductible. The scheme is also inflexible in relation to price
behaviour. Ad valorem royalties are a little more efficient economically.
They require knowledge of the value of the product but not the full
exploitation costs. (Conventionally transport costs from the wellhead to
the point of sale are allowed as a deduction but not other costs). Again
the problem is that the conventional royalty instrument is not targeted on
economic rents.
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Profit-related instruments such as standard profits tax, resource rent tax,
and profit oil sharing schemes where the state’s share is based on the
contractor’s rate of return or R-Factor (ratio of contractor’s accumulated
net post-tax revenues to contractor’s accumulated costs) are well targeted
on economic rents. The information required is very much greater. All
exploration, development, and operating cost information is required as
well as fair market values for the products. Expertise is required by the
investor in preparing returns and by the government authority in assessing
the returns. Because of the specialised and complex nature of the rent-
collecting schemes conventional tax inspectors are unlikely to have the
required expertise.
This does not mean that sophisticated schemes should be abandoned in
favour of simple, crude ones where the instrument is not well-targeted
and thus economically less efficient. In typical situations the gains from
investing in specialised expertise will greatly exceed the costs. The more
sophisticated schemes should ensure that the share of the potential
economic rents collected by the state is enhanced. The investment costs
in the necessary expertise will typically be comparatively small given the
relatively small number of relevant taxpayers and the potentially large
revenues involved.
The issue of compliance costs is now examined in the context of fiscal
decentralisation. The specific type of arrangement is important. If the
payments are simply to be shared among the different tiers of government
then only one submission and assessment should be necessary. As noted
above sharing could apply to one or more elements in the rent-collecting
package. If the sharing applies only to, say, the royalty but not to profit
oil sharing or profits tax there should be a requirement for only one
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royalty assessment. There will have to be some agreement among the
parties about who actually makes the assessment on the government side.
Arrangements also have to be made regarding the mechanism for the
disbursements of payments by the taxpayers to the different tiers of
government.
Where the different tiers of government have independent tax raising
powers further complications arise. For example, if a lower tier has
devolved responsibilities for royalty only, but, as is conventional, royalty
is a deduction for profit oil sharing and profits tax, the higher level tier of
government will still be interested in the royalty calculation, as this
determines the basis for profit oil sharing and profits tax. If friction
and/or lack of trust is prevalent the compliance costs could rise.
5. Special Petroleum Tax Office
As noted above modern revenue collecting schemes in the petroleum industry
are complex and sophisticated. On the government side there is merit in having
a specialised group with expertise in petroleum contracts and taxation, at least in
situations where there is significant oil exploitation. This should reduce errors
and the time involved in making assessments and generally dealing with
taxpayers. It should be very cost effective given the potentially large revenues
at stake. Some countries such as the UK have had specialised Oil Taxation
Offices for a considerable time.
The constitutional arrangements for such a body would be important. It would
be responsible for the assessments, collection of payments from the taxpayer,
and their subsequent disbursement to the proper government authorities. There
would be benefits from the presence of transparency in its operations. Thus
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information on the payments received from the industry and disbursements
subsequently made to the appropriate government authorities could be made
transparent. In the UK tax and royalty receipts from the oil industry are
regularly published.
6. Alignment of Taxation and Other Stakeholder Interests
Where more than one tier of government is involved the issue of alignment of
interest can arise. The tier of government in whose jurisdiction oil exploitation
is taking place may have different priorities from central government. Thus the
regional government may give a high priority to issues such as (a) the
environmental and other external effects of the activity, (b) accelerating the
development of the activity, and (c) maximising the opportunities for local
suppliers. Central governments may have the size of resource revenues as the
highest priority. If priority is given to items (a) and (c) above the overall tax
base could be reduced and the timing of payments delayed.
The constitutional arrangements play a main role in determining how these
potential conflicts are resolved. Thus the licensing authority – whether national
or local – will have a major influence in determining the pace of exploration and
development. Practice varies as discussed above. The tier of government
which owns the mineral rights is obviously in the lead role. In Russia mineral
rights are jointly held by Federal and Regional governments (and by
autonomous Republics where relevant). This can, of course, create tensions and
delays to the development of the activity. Generally the Regional government
gives a higher priority to accelerating exploration, development and production
because of the perceived importance of the local employment and spin-off
benefits generated.
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Different priorities to tax and other objectives can certainly give rise to tensions.
It is arguable that the presence of devolved powers ensures that the interests of
local regions are not ignored. Over time this should lead to less local alienation
and strife. Arrangements which do not provide for significant local
involvement in decision-making are probably more likely to lead to strife.
7. Conclusions
There are several arguments for the involvement of decentralised governments
in natural resource exploitation. These relate not only to taxation issues but to
wider licensing and other regulations. In the case of petroleum the activity is
very capital intensive and the potential resource revenues very large. On equity
grounds some decentralisation of revenues is appropriate because of the benefits
provided by regional/local governments in the form of infrastructure necessary
for the exploitation of the resource. It is also arguable that the participation of
regional governments in revenues is appropriate because of the depleting nature
of natural resources and differences in rates of time preference compared to
central government. Differences in risk exposure and risk-bearing capacities
point to central government as the main recipient.
There are further arguments for the sharing of natural resource revenues relating
to redistribution of income and poverty reduction, local alienation reduction,
and possible improvements in transparency and accountability. Decentralisation
of responsibilities should on balance mitigate these problems. Complex tax
compliance issues arise with petroleum contracts. There is merit in the
formation of a specialised Oil Taxation Office. This can potentially enhance the
degree of compliance.
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The appropriate size of the share of natural resource revenues which
decentralised governments should receive depends on several factors. It is clear
that payments should be made for the provision of infrastructure services and as
a compensation for pollution and other external costs borne locally. Such
payments are not part of the true economic rents emanating from natural
resource exploitation. Even here the situation is not always clear cut because
decentralised governments may obtain special funding from central government
in the form of transfer payments specifically to deal with infrastructure and
other external costs. Practical specification of the precise share relating to
resource depletion, alienation reduction, redistribution and poverty reduction,
alienation reduction, accountability and improved tax compliance remains
elusive. The arguments for some decentralisation remain more persuasive than
those against.