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.