Navigating through changes in petroleum taxation

 - The Writer holds an MSc in Eurasian Political Economy & Energy from King’s College London and also an MA in European Studies from Sabancı University.

As the developing world continues to increase its thirst for oil at a formidable rate, many governments around the world are forced to reassess their fiscal policies to meet burgeoning energy needs. Against this backdrop, petroleum taxation becomes a decisive factor in determining the volume of investment in a country. If a fiscal policy is poorly designed, production aspirations for oil companies would be undermined and could even cause production declines. 

To serve both the financial interests of oil companies and resource owners, a balance needs to be struck. Therefore, various policy options need to adapt to the changing business environment for the successful implementation of petroleum taxation.  

The main challenge that most governments face is with balancing petroleum tax policies to generate a fair share of revenue while simultaneously providing investors with sufficient incentives to invest. Therefore, these two objectives need to complement one another.

Petroleum taxation significantly differs from other sectors and industries. Oil price volatility, large upfront operational and development costs along with the unpredictability of exploration in the industry are some of the key characteristics of this sector.

With the aim of implementing an appropriate tax policy and to keep a balance between government and industry’s interests, tax rates cannot be too low or too high. The upfront costs of many petroleum projects are extremely high and the time lag between field discovery and first production can be lengthy, further complicating the formulation of an appropriate tax policy mechanism. Therefore, a timely implemented fiscal regime could boost the trade-off between the government and the investor companies. 

A poorly designed fiscal regime could cause production declines – the opposite of its intention. Another major mistake that many policymakers make in formulating a petroleum tax policy is with the perception that higher oil prices mean higher tax returns. In particular, when the rig count increases to meet increasing demand, the overall costs of hiring rigs rise to the extent that even an oil price surge would not create the expected revenue bonanza.

A variety of tax instruments have been utilized globally in an effort to maximize oil activity returns. Among these instruments, four are key, namely: royalty, income tax, resource rent tax brown taxing. Each of these fiscal regime choices works under specific circumstances, and what works well for one country does not necessarily suit the needs of another. Economic factors to differences in geological prospects can all determine what policy option would best suit the needs of a country.

To obtain property rights, some countries opt for the royalty tax model, which imposes taxes on the amount of output and ensures a share of revenue once production starts. However, as royalty tax is a regressive tax not strictly based on profits, countries like Norway and the U.K. have chosen to abolish this instrument. In comparison, income taxation ensures that corporate net income is taxed and when profits are zero, so is the tax rate. 

Brown taxation is the oldest type of extractive taxation policy based and determined on cash flows. When cash flow is positive, companies pay tax, but in negative cash flow scenarios, they receive a rebate instead. 

Resource rent tax, which very much resembles brown taxing, applies mostly in less developed countries. When cash flow is negative, the state chooses to postpone paying rebate and instead deducts tax credit later on when the cash flow turns positive.  

Other factors including technical, political and commercial risks add to the pressures at each stage of a project lifecycle. For this reason alone, governments have to take the existing project complexities into consideration in structuring the most appropriate fiscal regime.

The tax regime applied around the world varies according to the needs, structure characteristics of a country’s oil and gas industry. While Saudi Arabia chooses to apply corporate income tax in accordance with a petroleum concession agreement along with royalties; Norway and the U.K. both profit from special taxation and corporate income taxation. In Russia, however, a combination of royalties, corporate income tax export duty are employed.  

The U.S.’ fiscal regime consists of a combination of royalty, corporate income tax, and severance tax. The rate of royalty payments changes depending on whether it is an onshore or offshore project. Since the U.S. is a pioneering country in unconventional oil and gas production, the terms and provisions applied in conventional fields are also applied for unconventional fields.  

From an investor’s points of view, there is no single all-encompassing taxation policy that works in which governments are able to ensure a fair share between state revenues and a company’s profits for optimal balance. To create the least distortions, a combination of two or three policy regimes have to be employed. Since each taxation regime is tailored for specific circumstances in a country, it is not possible to apply a blanket policy option, which leaves individual governments choosing the most appropriate options for their respective countries.

- Opinions expressed in this piece are the author’s own and do not necessarily reflect Anadolu Agency's editorial policy.