Tax Allowances in Petroleum Industry - Assignment Example

Tax allowances in petroleum industry and their importance for attracting foreign investment into Kazakhstan and Azerbaijan oil sector of the Writer] [Name of the Institution] Abstract All governments try to attract foreign investment to develop their natural resources sector. This is seldom easier said than done since such attempts need a holistic approach rather than a segment by segment incentive. Governments should be committed to create a conducive atmosphere suitable for the investors together with a cooperative and transparent administration coupled with speedy redressal of problems. Mineral processing is a capital intensive and long term investment where the payback period can stretch to a couple of decades. Conditions of profitability have to be predicted over a very long future which calls for a stable ground. The paper seeks to identify the impact of tax reforms and tax allowances extended to new ventures in the petroleum industry and their impact in improving foreign investment prospects in the sector. Earlier experiences from such attempts by other nations have been considered for comparative analysis of the factors. The paper comprises of four parts. Introduction Azerbaijan and Kazakhstan are two states that broke away from the Russian federation after the fall of the former Soviet Union. They are both members of the CIS and have immense wealth of mineral oil and crude deposits. Together they comprise more than a third of the CIS's total energy reserves. However they are both classified as nascent developing states and as nascent states have it, the political economy of both countries suffer from huge administrative lethargy. Both countries bet heavily of the oil reserves and are striving to attract foreign investments in these sectors. Azerbaijan has made great leaps and has overtaken Kazakhstan in terms of volumetric performance of the oil sector. But as economists point out, its fiscal policies lack the complexity to accommodate the sudden surge in revenue. Hence their revenue from oil will peak towards the end of the decade and then stabilise on a relatively low rate of declaration. Kazakhstan on the other hand has seen very little dramatic rise in revenue. But both states by far have failed to transfer the goodies to their citizenry. It is in these contexts that the fiscal reforms of the countries have to be considered as far as reforms in the oil sector taxation will be studied. 1. Overview of the tax systems in Kazakhstan and Azerbaijan Oil Industry Tax system in Kazakhstan oil industry The Taxation system in Kazakhstan is the most renowned model in the erstwhile Soviet Union. The Tax Code of 2002 implied an "international model of taxation, based on the principles of equity, economic neutrality and simplicity". During the year 1996, a Treaty on the Avoidance of Double Taxation was signed between United States and Kazakhstan. Kazakhstan has since signed 36 such agreements with various foreign governments until today1. The four main laws which govern the petroleum sector in Kazakhstan are: The Subsurface Law The Petroleum Law The Tax Code (2001) Law on Production Sharing Agreement for the sake of offshore oil dealings (zakhstan Oil and Gas Tax Guide) Taxation on Oil and Gas The new tax code that came in to force wef. 1st January 2002 has remarkably decreased the number of taxed sectors from a previous 53 to 36. The new code reflected better insight and clarity in the tax regime rather than the previous clumsy one. These new taxes were more detailed, and comprehensive. With this emerged a new framework on long term taxation issues in the petroleum industry and for the first time, long term financial planning and better feasibility studies could be effectively done by investors in the sector. The improved Tax Code which came in to effect from January 1, 2005 brought changes in tax regulations and lowered the economic load of investors considerably. The chief tax heads for companies dealing in the oil and gas sector are Corporate Income Tax, Value Added Tax, Rent Tax on Exports, Royalty, and the Tax of Surplus Profit2. Corporate Income Tax: This tax is applicable for all official units, whether residents or non-residents of Kazakhstan, who are doing business within the territory of Kazakhstan. The tax base is defined as a difference between the total annual revenue and deductions stipulated by the Tax Code. The price of environmental investigation and evaluation for a firm yet to start production and generate revenue is taxed too. The normal rate of the Corporate Income Tax is 30% for the residents of Kazakhstan and 15% - 20% for non-residents as well as foreign entities. Similarly, "under risk insurance policies are taxed at 10%; under risk reinsurance policies, 5%." Along with the Corporate Income Tax, the non-resident unit has to pay a 15% tax. The new Tax Code gives Corporate Income Tax exemption and benefits to companies working in the petrochemical industry The following are the conditions of the tax release: During the time period of three years, proper registration should be gained. New production facilities for a complete technological cycle should be commissioned within the same period. Sales revenue from petroleum products produced at the company's facilities from Kazakhstan's oil and gas should account for no less than 90% of the company's total annual revenue (the types of eligible businesses are named by Kazakhstan's Government.) Minimum investment in mainstream business facilities should equal to no less that 5 million monthly benchmark amounts stipulated by Kazakhstan's Budget Law for a given fiscal year. Value Added Tax: The Value Added Tax is described as the distinction between "the value added tax amounts charged for goods (works, services) sold and the value added tax amounts payable on the goods (work, services) bought. This tax is employed on all products manufactured for trade within the country. The present rate for Value Added Tax is 15% of the value addition done by the firm. Export goods are exempted from VAT. Geological exploration for sub-soil use is also exempted from payment of VAT. Excise Tax: Excise duties are charged on specific goods that re produced in the country as well as some imported goods. The petroleum products that are charged excise duty are petrol, diesel fuel, crude oil and gas condensate. This tax is also employed on those who are engaged in "wholesale or retail sale" of petrol and diesel fuel in Kazakhstan. Rent Tax on Exports: The Rent Tax on exports was introduced in Kazakhstan for the first time in January 2004. This tax is charged on all the exporters of liquid hydrocarbons, excluding the subsoil users. The Rent Tax is connected with the real worth of export crude and gas condensate and is calculated on true sales volumes of export crude and gas condensate. Royalty: The Royalty is paid by subsoil user who has involvement in minerals in any manner, both for personal as well as commercial use. The object of royalty payment is the volume of minerals produced or the volume of the first commercial product (including, oil, natural gas, and condensate) produced from actually extracted minerals. Tax on Surplus Profit: The Tax on Surplus Profit is made for all subsoil customers, except for those who function under the "production sharing agreements." It cannot be more than 10%. Tax system in Azerbaijan oil industry The tax rates for crude oil is 26%, for natural gas is 20%, for valuable metals is 8%, and for mineral waters is 8%3. In order to promote foreign investors, the government has implemented three separate tax management laws for different sectors. They are: The Statutory Tax Regime The Production Sharing Agreement (PSA) Tax Regime The Host Government Agreement (HGA) Tax Regime The oil and gas sector plays a vital role in the country's economy. With the help of some international assistance, the country is attempting to harness its resources. This progress brought in new technology and improved the old ones. In order to increase the economic stability, the government is working on the improvement of oil industry. On 20 September 1994, the government signed a Contract of the Century, an agreement with international oil companies for joint efforts on the path of success in Azerbaijani oil sector. Current estimates of oil reserves in Azerbaijan are at 500 million tonnes. Excise Tax is a tax for the sale price of "excise" goods. All authorized companies or group of people who are involved in the making of excise goods in the Republic of Azerbaijan or import such items, have to pay this tax. People living in Azerbaijan engaged in the making of excise goods and manufacturers of items made up of raw materials are also required to pay this tax. Counting the petroleum items and tobacco made things; the tax need to be paid is on the cost received. Following things are the list of objects on which excise tax is involved: Alcoholic drinks Tobacco goods Oil products 2. What allowances are granted to the oil companies In Azerbaijan and Kazakhstan, the new tax regimes have spelled so much of goodies on petroleum sector. According to the new provisions, allowances of exemptions may be granted on Corporate Income Tax Exemptions of Land Tax Exemptions of Property Tax Exemptions of Royalty charges These grants are also extendable to existing companies who wish to expand and their infrastructure. The exemption is granted in phases of up to five years or according to special decisions of the ministry concerned on a case-by-case basis. The exemption can be extended to a period of ten years if the government so deems fit Azerbaijan government has also extended these benefits to foreign entities, their contractors or even subcontractors! 3. The Objectives for Taxation in the Petroleum Industry The basic reasons for taxation in any economy is the central need to raise revenue to run the state and for the socio-economic development of the people of that country. However in many oil producing countries, various other reasons can also be attributed to the same. The Patrimonial factor model implies that the state sees their natural resources as their inheritance. High levels of taxation will reduce the number of participants in the industry and conserve the resources for future generations. The revenue factor is a common goal and it serves the purpose of meeting growing government expenditure and the welfare of its citizenry. Petroleum taxation has also become an important tool for wealth-redistribution. In the petroleum sector, this has global implications. It brings more revenue from the developed technology-oriented countries to developing county's whose resources are being extracted and mined. The environmental factor plays another key role in the tax determination pattern. The environmental damages caused by the industry have to be repaired by the state. Money towards this has to be collected in taxes from the industry. Taxes also bring money to the home country to be used for the education of its citizenry and thereby growing indigenous technology in the industry and other sectors. Tax allowances are also an important factor in achieving foreign investment goals. While all the other risks are weighed equal among two competing countries, the tax benefit is of certain advantage to any nation that extends it. 4. The Fiscal policies of Kazakhstan and Azerbaijan The world shares a deep interest and desire to see to it that the resource rich countries of Caspian would avoid the mistake of so many other resource rich countries. What is of supreme importance for any good fiscal climate is the role of transparency, a vibrant civil society and a real democracy play in the use of petroleum revenue and planning new tax models. However the geo-political risk for a nascent economy with high deposition of natural resources is great. The chances of civil wars and political indiscipline are also higher. Many African countries and nations of the Amazon basin give ample evidence to this theory. Such economies show slower economic growth, greater poverty, higher debt etc - in short calling for more attention on fiscal reforms and transparency. It is not a matter of coincidence that a large number of the world's oil producing countries are not democracies. Azerbaijan and Kazakhstan have learned lessons from the mistakes of other countries. They have been careful enough to avoid large spending and control inflation and see to it that they maintain exchange rate stability. Azerbaijan has given birth to a poverty reduction plan and both countries have set up oil funds to look after their earning from the oil sector. But excellence in revenue management goes beyond fiscal policy. It also requires the institutionalisation forces of government to be upgraded. While Azerbaijan has done a good job of restoring its macro economic stability and growth, it also needs to put in more checks to avoid the resource curse. Predominantly, oil revenue is a very short window of opportunity and it will grow on until 2010 and then stabilise until new field discoveries are made. It will also deplete in 2020 and the country will have to be ready with an alternate economy. In this short span, the country has to address the poverty problem of over half of the population. The geopolitical crisis faced by the nation include a conflict over territory with the neighbouring Armenia which has not been resolved. The challenge is to find final settlement which does not consume a vast share of its oil resources. The nation's manufacturing sector need to be revived as it has been steadily declining even as the annual economic growth powered by the oil industry is at a modest 10%. The oil fund is currently under the care of the president. It is sound democratic norm to change the existing fund administration mechanism and formulate bodies for the task. In a few years time, the oil fund will be bigger than the state budget. Kazakhstan has also done a good job about repairing its macro economic fundamentals since independence. It has a relative advantage over Azerbaijan that its reserves will last atleast five decades and its poverty ratio is not as bleak as it is in Azerbaijan. But policy decisions have to be stepped up. If you consider that in a town by name Mangistau Oblast, where a huge oil field is located, the unemployment rate is as high as 87%. For these reasons, Kazakhstan has to identify avenues to spend funds from the oil fund and create a sustainable population and a portion of this should be used to rebuild domestic infrastructure. Transparency has also been lacking in the country. Major contracts it has signed with foreign oil companies are still kept secret. Since the tax receipts from petroleum are handled outside the state budget, there is no information on the volume of these money available to the public. Independent press is also marginal and most opposition leaders are still languishing in jails or are in exile. As a first step towards economic development, the government should draft and enact a freedom of information law to ensure more transparency. 5. Effects of Tax Allowances in the Oil Industry The oil industry operates on low margins and is a long term investment. Further, scientific upgradation and exploration charges eat in to the profits of the company. Since the oil industry is also one of the riskiest ventures in business, tax incentives are seen as a boost to the sector. The return of investment graph can also be maintained at satisfactory levels with lower tax rates. Oil companies have to consider the geo-political risk, oil price slimming risk and many such uncertainties to remain afloat. As a general rule, the world over, oil is subsidised by various governments in the developing world to keep the prices stable. The tax incentives can take the participating companies a long way towards economic freedom and gives them ample scope for expansion. Petroleum exploration, mining and processing are all long-term industries which require long term financial and profit analysis and projection unlike conventional industries where the returns on investment are quicker. This is a capital intensive business. Investors are mostly largely owned state companies or large state-supported corporations. Protection of invested money, security of infrastructure, unhindered production, stable pricing, tax reforms and many other such characteristics mark this industry. An important case study is the Latin American oil basin where American oil companies invested fortunes and the American government has to deploy the CIA in covert and semi-covert operations to keep those ventures viable. The political and economic environment is of crucial importance to any person who walks in to invest in the sector. Another factor is the import duty on machinery and such other tools imported to set up the industry. This is more crucial in industries such as refining. The long term implications of refining are not known. It is said that after 2010, the refining requirement will be lower and the industry could be facing an over-capacity problem globally. Oil prices largely depend on peace and global stability. Oil prices have shot up in the first quarter of 2006 and such unprecedented fortunes have helped the economies of Azerbaijan and Kazakhstan. Analysts feel that the money so acquired is not being put to proper use by the respective governments and these may bring about massive long-term economic problems in these countries. Another factor is the diplomatic relations that the oil-rich countries maintain. Energy sector is basically controlled by contracts between friendly countries since it is a strategically important sector for any investor or buyer. 6 The problems arising from granting of Tax sops The outlook for the host country looks bleak in the long term. Oil is a non-renewable source of energy and it cannot be regenerated. It gets depleted very soon and the resource is finished before you realise. This is a bad thing for a developing country. Depletion of resources has to be looked upon as a serious problem. Lesser taxes mean lesser revenue for the state and growing deficits. The oil industry is environmentally demanding and the governments have to invest huge money to rescue the citizenry from the consequences of the environmental hazards. If the host country does not impose right taxes, then it means that they will have to spend it from their hands which add more constrains to the nation's development. Further the socio-economic benefits brought from such taxes will also have to be foregone. ie. the governments will have less money to be spet on education and proper healthcare. The investment sops will also create a huge divide between the haves and the have-nots globally. While rich countries make use of these sops and get richer, the poor country who is selling their resources and not making enough money out of it will get still poorer. Depending on the high oil price and the resultant revenue is only a temporary phenomenon. Countries such as Azerbaijan have not implemented any long term projects that will trickle down the goodies of such accumulation of wealth to its citizenry. They are merely riding the dream bubble. It may break any moment. While governments such as UK and Australia give incentives to oil companies, it is largely required because the cost of operations in those countries are equally high. Developing countries should emphasise on the lower wages and other operating costs that the company can use and not play the tax fiddle. Conclusion After taking in to consideration, the various fiscal factors endemic to the two nations and their proposals to impart tax concessions to the petroleum industry, the following factors have been discovered The countries involved should develop their fiscal transparency, particularly in relation to the oil accounts as both of them have maintained huge sums of money received from the petroleum sector as non-budgetary funds. Improper spending of this money will lead to long term problems as petroleum is a non-renewable resource. This is true of tax reforms as well since the two governments have not made public the terms of its contracts with foreign oil companies. Oil brings in money only until the reserves last. Azerbaijan's reserves will last for less than 15 years and it has a 30 million strong population under the poverty line. The tax discounts imparted to the companies in the business should take in to consideration the plight of the under privileged and lead to steps that will resolve this problem of social inequality. The concessions should also take in to consideration, the socio-economic factors such as generation of new employment. Studies have shown that the tax reform alone does not bring about any particular favours towards a country in terms of FDI. It also depends on many other factors such as geo-political stability and peace. Tax discounts only help when these factors are the same among two competing nations. As far as the research has shown, there is an entire lack of transparency in the oil deals engaged by both the governments. Global auctioning and tendering process can eliminate some of these ill will groups from making huge profits from depleting these national properties. The state can also attract more investment without compromising on the amount of taxes collected. 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See also Article 27 of the Mexican Constitution As given in the official government website of Kazakhistan(http://www.state.gov/e/eb/ifd/2005/42065.htm). posted on 21/03/06 accessed on 04 May, 06. Oil & Gas Vertical Analytical Service http://www.eu-tax-az.org/ a comparative study of taxes for investment purposes accesses on 04th May 2006 Read More