41958 No. 8 Petroleum Sector Briefing Note November 2007 Contracts for Petroleum Development - Part 2 Petroleum contracts are long and complex. Production sharing agreements, the type of contracts being signed in Cambodia, are no exception. However, they are important to the country's future economic and development options and hence it would be helpful if the public had a basic understanding of how these contracts work and, in particular, how government revenues are determined. This briefing note, part 2 of a three-part series, describes the terms used in defining payments made by petroleum companies and the order in which they are paid. M anydevelopingcountriesaroundtheworld flowingtothegovernmentincreaseswithincreasing useproductionsharingagreements(PSAs) income¾that is, government income rises at a faster togoverntherelationshipbetweenthestate rate than the net-of-cost project income¾the fiscal andpetroleumcompanies.PSAsintheoilsectorwere parameterisprogressive.Progressiveparameterstend first developed in Indonesia; theAsian governments to be based on some measure of profitability.To re- that have used production sharing include China, In- flect profit elements, two approaches are often used. dia,Malaysia,Pakistan,thePhilippines,TimorLeste, and Vietnam. Beginning in 2002, the government of An R-factor is the ratio of cumulative receipts Cambodia has signed a series of PSAs. fromthesaleofpetroleumtocumulativeexpendi- Briefing Note No. 7 gave an overview of the le- tures.Thisratioisinitiallyzero¾duringexplora- galframeworkgoverningthepetroleumsectorandtwo tionthereisnosaleofpetroleumwhiletheremay typesofcontractualsystems,concessionaryandpro- be considerable expenses¾and gradually grows ductionsharing[1].Thisnotediscussesinmoredetail in time.An R-factor less than 1 would mean that differentaspectsoffiscaltermsinproductionsharing. costs have not been fully recovered yet: total ex- Thereisafundamentalconflictbetweenpetroleum penditures exceed total receipts. The larger the companies, referred to as contractors in production R-factor, the more profitable the operation. The sharing,andthegovernment:bothwanttomaximize royaltyrateorthegovernment'sshareofproduc- theirrespectiverevenuesandminimizerisks.Thegov- tionmayincreasewithincreasingR-factor. ernmentcanpotentiallyincreaseitsrevenuebysetting In the rate-of-return contracts (also referred to tax,royalty,andotherratesathighlevels,butdoingso as resource rent royalties, resource rent taxes, or coulddeterinvestment,especiallyinmarginalfields,and triggertaxes),thegovernmentreceivesadditional reduce,ratherthanenhance,thegovernment'soverall income from the contractor's cash flows in ex- revenue.Judgingwhatwouldbeareasonableburden cessofspecifiedthresholdsfortheinternalrateof onpetroleumcompaniesisoneofthechallengesinset- return.Therate(forroyalty,tax,productionshare) tingupaneffectivefiscalsystem. due to the government increases with increasing Responding to Market Incentives rate of return¾the more profitable the operation, thehighertherate. Briefing Note No. 7 explained that some fiscal terms are regressive and others are progressive. Fiscal parameters based on either of these are Briefly, if the percentage of the net-of-cost income amongthemostprogressive. 2 Petroleum Sector Briefing Note November 2007 Revenue Streams tor to recover the costs of exploration, development, Typical revenue streams in a PSAare shown in and production. Most PSAs limit the amount of cost Figure 1. Oil (or gas) produced is split into cost oil, oil that can be retained in a given accounting period. profitoil,andtheroyalty. Costs that are not recovered are carried forward and Royalty recoveredlater;mostPSAsallowvirtuallyunlimited carryforward.Thecostoillimitistheonlysubstantive Royalties are based on the volume or value of distinction between concessionary systems and pro- petroleum extracted. Royalties may be paid in cash duction sharing. It is another avenue available to the orinkind;ifthelatter,specifiedamountsofoil,gas,or governmenttoensureearlyrevenue. both are delivered to the government. Royalties are Certain expenses may not be eligible for cost re- paid as soon as commercial production commences, covery. Examples include bonuses (see below), roy- thereby providing early revenue to the government. alties;interestorotherfinancingrelatedpaymentsand They also ensure that contractors make a minimal overheadsbeyondspecifiedlimits;andcostsoutside payment. Simple royalties¾for example, 10 percent the budget, unless approved by the government. ofthevalueoftheoilextracted¾areeasytoadminis- ter,butdonottakeintoaccounttheprofitabilityofthe Profit oil project and hence are regressive.As such, royalties Profitoilistheshareofproductionremainingaf- deterinvestment.Onewayofredressingthisistomake ter the royalty is paid and cost oil has been retained the royalty rate depend on the level of production, by the contractor. Profit oil can be paid in cash or in increasingitwithincreasingproduction.Therationale kind. In its simplest formulation, the agreement may is that larger production levels lead to greater profit- stipulate that the profit oil be split, for example, 40/ ability because of economies of scale (this is not al- 60¾the contractor's share being 40 percent and the ways the case, because many factors other than the government's share 60 percent¾irrespective of the scaleofproductionaffectaproject'sprofitability).In world oil price or production level. Production shar- that case, royalties are said to be on a sliding scale. ingcanalsobeonaslidingscale:thepercentshareof Some countries have designed the royalty rate to de- thegovernmentcanincreasewithincreasingproduction pend on the R-factor. level,cumulativeproduction,R-factor,orrateofreturn. Cost oil Income tax Cost oil refers to the oil retained by the contrac- In Figure 1, the contractor is subject to income November 2007 Petroleum Sector Briefing Note 3 taxbasedontaxableincome.Incometaxispaidafter velopment (such as building roads) on a voluntary productionissharedinthisfigure;itisalsopossibleto basis.Trainingoflocalemployeesisanotherexample. write a PSA in which income tax is paid before pro- Trainingofgovernmentofficialsisnormallyacontrac- ductionsharing(seeBriefingNoteNo.9).APSAdoes tualobligation. not have to provide for the actual payment of taxes, and instead can include the tax equivalent portion in Accounting Rules the government's share. Known as a pay-on-behalf Accountingrulesalsoaffecthowmuchandwhen scheme,itassuresstabilitywithrespecttoincometax. the government will receive revenues from contrac- The tax equivalent portion is subtracted before pro- tors.Itisnottheintentionofthisnotetoexplainthese ductionsharing. rules, but they are mentioned to give a sense of what Bonuse contractors look for. They include ring-fencing by contract (or sometimes by field), depreciation rates, Bonusesarethemostregressivefiscalparameters allowanceforaccelerateddepreciation,losscarryfor- and give early revenue to the government.Signature ward,treatmentofpre-productionexpenses,uplifting bonuses are paid when the contract becomes effec- of costs, rules against thin capitalization, and treat- tive, and can be considerable in highly prospective mentofabandonmentcosts. areas. For example, the first financial report for the NigeriaExtractiveIndustriesTransparencyInitiative Foreign Tax Credit Considerations showedthatShellNigeriaUltraDeepLimitedin2003 Foreign petroleum companies must pay income paidUS$210millionasasignaturebonus[2].In2006, tax to their home governments. Foreign companies a new record was set when Sonangol-Sinopec Inter- are allowed to credit taxes paid to the host govern- national,ajointventurebetweentwonationaloilcom- ment (the government of the country in which petro- panies fromAngola and China, bid a total of US$2.4 leum operations are being conducted) against tax li- billionfortherelinquishedpartsoftwoblocksinAngola abilitiesintheirhomecountries,providedthatthetax [3]. Production bonuses are paid at the start of com- inquestionisanincome/profittaxandataxcertificate mercial production and when production reaches is issued by the host government.1 In pay-on-behalf specifiedlevels.Bonusesaregenerallynotrecognized schemes,toenableforeigntaxcredits,thehostcoun- as cost-recoverable expenses. try taxes are still calculated and the host government Surface rental and other fees issuesataxcertificate. Everythingelsebeingequal,itdoesnotmakesense Contractorspayannuallyforacreagecoveredby to set the income tax rate markedly lower than those a PSA. Surface rental fees are often given in mon- prevailinginthecountrieswherecontractorsarehead- etary units per square kilometer, so that the overall quartered, because that would likely mean that the flowtothegovernmentdeclineswitheachrelinquish- difference would be paid to foreign tax authorities - ment. There are other fees, such as fees paid by bid- thehostgovernmentwouldbesacrificingtaxrevenue dersinlicensingroundsorcontributionstothetraining toforeigngovernmentswhendoingsooffersnoaddi- ofgovernmentpersonnelwhich,ifnotspent,arepay- tionalincentivesforinvestment. ableincash. How PaymentsAre Made Other taxes Signature bonuses, as explained above, are paid Other taxes include withholding tax, foreign na- before any work starts. Surface rental fees and a few tionalandsub-contractorincometax,valueaddedtax, other fees and taxes are paid prior to production, but andcustomsduties. they are relatively small. Once commercial produc- Payments in kind tionstarts,Figure1givesanillustrationofwhathap- pens to receipts from petroleum sale. The royalty is Contractorsmayundertakesocialprograms(such paid first. The contractor is next allowed to recover asbuildingschoolsandclinics)andinfrastructurede- costs,oftenuptoaspecifiedlimit,intheformofcost 1To avoid double taxation, there are often, but not always, formal agreements between governments to coordinate taxation provisions so that the net income is not taxed twice. Cambodia has no bilateral tax treaties. However, income tax paid in Cambodia can be credited if it meets the criteria of income tax in the home country. In the United States, for example, foreign income tax is creditable against U.S. income tax liabilities if it is a tax on net income. 4 Petroleum Sector Briefing Note November 2007 oil.Revenuesremainingafterroyaltyandcostrecov- for these two barrels, and the contractor can take as ery constitute profit oil (or gas), and are shared be- cost oil the full cash expenditures incurred because tweenthegovernmentandthecontractor.InFigure1, US$25 is less than the maximum allowable limit of thecontractorisfurtherrequiredtopayincometaxon US$60. itsshareofprofitoil. This leaves profit oil of US$65. The production Whilebonusesandroyaltiesstartflowingearlyon, split in the PSA is 40 percent for the contractor and corporate taxes and the government's share of pro- 60percentforthegovernment.Thegovernmenttakes duction usually do not start flowing in significant 60 percent of US$65, or US$39, and the remaining amounts until costs are substantially recovered. Be- US$26 goes to the contractor.The contractor has to cause upfront investment costs in oil and gas may be pay income tax out of its share of profit oil. For pay- verylarge,itcouldtakeseveralyearsfromthestartof ing income tax, there are no limits on deductible ex- production before the government receives any siz- penses in the way there are limits on cost oil. (In this ablerevenue. example, however, costs recovered in this account- Illustration ing period happens to be the same for both cost oil andforincometaxpurposes.)Thetaxableincomeis AverysimplifiedcaseisgiveninFigure2toillus- US$26 (100­10­25­39), giving an income tax of trate how the system in Figure 1 may work. For sim- US$7.8. The end result is that the contractor retains plicity,onlytheroyalty,productionshare,andincome US$43 and the government takes $57. tax are considered; bonuses, depreciation and loss In practice, calculations of revenue streams are carryforwardrules,surfacerentalandotherfees,and more complex because of depreciation, loss carry other taxes and payments due are not considered. forward, and the determination of deductible costs (fortaxpurposes)whichnormallydifferfromrecov- erable costs (for computing cost oil). The next brief- ing note will illustrate how different fiscal terms can affect revenue flows to the government over the life of a contract. References [1] World Bank. 2007. "Contracts for Petroleum Development­Part1."PetroleumSectorBrief- ing Note No. 7, October. [2] Hart Group. 2006. "Nigeria Extractive Industry TransparencyInitiativeFinancialAudit.Finan- cialFlows1999"2004."www.neiti.org/files-pdf/ FARFinFlowsUpload.pdf. [3]GlobalInsightDailyAnalysis.2006."Angolaset Figure 2 considers the proceeds from the sale of fornewlicensinground,Gimboafielddevelop- two barrels of oil at US$50 each, giving a total of ments."August31. $100 in gross revenue to be shared between the con- tractor and the government. In accordance with Fig- For more information contact: ure 1, the royalty is paid first. At 10 percent, this Mr. Bun Veasna amounts to $10 going to the government. Out of the Infrastructure Officer Email: vbun@worldbank.org or remaining $90, the contractor recovers costs to the Masami Kojima limit permitted, in this case 60 percent of the gross Lead Energy Specialist revenue or US$60. The total expenses incurred (in- Email: mkojima@worldbank.org cluding pre-production expenses) amount to US$25