Mapping Risks to Future Government Petroleum Revenues in Kenya: A framework for prioritizing...

8/17/2019 Mapping Risks to Future Government Petroleum Revenues in Kenya: A framework for prioritizing advocacy, resea…

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Don Hubert PhDResources for Development Consulting

March 2016

MAPPING RISKS TO

FUTURE GOVERNMENT

PETROLEUM REVENUES

in kenya

A Framework for Prioritizing Advocacy,Research and Capacity Building

www.oxfam.org


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Oxfam Research Reports are written to share research results, to contribute to public debate and toinvite feedback on development and humanitarian policy and practice. They do not necessarily reflectOxfam policy positions. The views expressed are those of the author and not necessarily those of Oxfam.

For more information on this report, email the Tax Justice Programme Manager on [email protected],uk

© Oxfam International May 2016.


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Table of Contents

INTRODUCTION ........................................................................................................... 4

THE CHALLENGES OF TAX AVOIDANCE/EVASION ........................................................... 4

TAX BASE EROSION ..................................................................................................... 6

SOURCES OF GOVERNMENT OIL REVENUE ..................................................................... 9

COST RECOVERY ........................................................................................................10

SPLITTING PROFIT OIL ................................................................................................10

WINDFALL TAX ......................................................................................................... 11

STATE PARTICIPATION .............................................................................................. 11

OTHER POTENTIAL SOURCES OF GOVERNMENT REVENUE ..............................................12

REVENUE RISK ANALYSIS ...........................................................................................12

RISKS FROM DEPRESSED OIL PRICE ............................................................................12

RISKS FROM INFLATED COSTS ................................................................................... 14

COST RECOVERY RISKS ..............................................................................................15

THE IMPACT OF INFLATED COSTS ................................................................................17

PROTECTING GOVERNMENT REVENUES ....................................................................... 18

NOTES ......................................................................................................................21


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Introduction

The loss of government revenue due to tax avoidance/evasion strategies by

multinational companies has received significant attention in recent years in bothdeveloped and developing countries. It is widely accepted that the extractive sectoris particularly vulnerable to tax evasion. Kenya has the opportunity to benefit fromthe lessons learned in other jurisdictions in order to maximize the revenue benefitsit receives from oil and natural gas. This paper seeks to provide a framework forassessing the risk of potential revenue loss and prioritizing possible responses.

The analysis below is based on four different sources of information. First, theresearch focused on the existing legal framework and production sharing contracts.Although a new Petroleum Law and model production sharing contract are currentlyunder review, it is the existing production sharing contracts that will determinepotential government oil revenue in the coming years. A second key source ofinformation was the growing body of literature on the challenges of taxadministration in the extractive sector.1 Third, case studies have been used, wherepossible, to illustrate the risks that governments, developed and developing, face intrying to secure a fair share of extractive sector revenues. Finally, estimates of thepotential scale of revenue loss have been generated from an economic modeldeveloped to forecast potential government revenues from Turkana oil.

The Challenges of Tax

Avoidance/Evasion

Concern about tax avoidance and evasion has been growing in recent years in bothdeveloped and developing countries. There are some common sets of challengesthat affect all countries and all sectors including treaty shopping, transfer pricingand the use of tax havens and low tax jurisdictions. Ultimately, however, the threatsto government revenue from tax avoidance measures are sector-specific, andsometimes even project-specific.

There is no doubt that the extractive sector is particularly vulnerable to tax evasionstrategies. But as the text box below illustrates, there some characteristics ofpetroleum and mining that increase vulnerability to revenue loss and othercharacteristics that decrease vulnerability.2


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Securing a fair share ofgovernment revenue fromextractive sector projects is atwo-step process:establishing a fair tax rate for

the project at the outset, andthen protecting the tax base over the lifespan of theoperation. Shortcomings oneither front can result insignificant loss ofgovernment revenue.

Establishing the Tax Rate

The tax terms that should

determine the proportion ofextractive sector projectrevenue allocated to thegovernment are normally setout in both project-specificcontracts (host countryagreements) as well as national tax and investment laws and regulations.

The sources of government revenue from extractive sector projects are oftendifferent than for normal businesses. In the mining sector, the mix of fiscal

instruments commonly includes royalty payments, corporate income tax (andincreasingly a windfall or “resource rent” tax). In the petroleum sector, a productionsharing system is common, though sometimes in combination with a royaltypayment and/or corporate income tax.

There are often concerns that governments’ have negotiated bad deals that will seethe bulk of project profits go to foreign companies. In some cases these bad dealsappear to be the result of corruption, but in many cases they are likely the result ofthe profound asymmetry of expertise between multinational companies andrelatively inexperienced government officials. It is also common for governments tooffer investment incentives or tax holidays in order to encourage companies to

explore and produce. Exemptions are routinely provided for import and export taxes,customs duties and VAT. In some cases corporate income taxes are reduced or eveneliminated.

Once the basic tax rate is established, it is difficult to change. Extractive sectorcontracts normally contain stabilization clauses that provide protection for theinvestor from changes to the fiscal terms. There are certainly many examples where

Textbox: Extractive Industries Revenue Risks

Factors increasing vulnerability to governmentrevenue loss include:

o large scale extraction undertaken by foreign

owned multinationals;o operations financed with foreign capital;o highest value goods/services are imported;o goods and services are provided by intra-firm

management and service companies;o high rates of taxation increase incentives for

profit shifting.Factors reducing vulnerability to government revenueloss include:

o commodities not “branded” products, theycan be physically weighed and measured;

o prices for most commodities are quoted on

international exchanges;o costs normally involve genuine operations

and expertise rather more nebulous conceptssuch as intellectual property.


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governments have decided to renegotiate the tax terms in contracts, but there isstrong pressure to respect the sanctity of the original contracts.

Tax Base Erosion

The tax rate described above determines what “should” be paid to the government.These headline terms tend to attract the bulk of the attention in comparisons offiscal regimes. For example, a comparison of fiscal terms commonly compares therates of profit oil sharing or the rate of corporate income tax. At least as important isthe amount of income (i.e. the tax base) that those rates should be assessedagainst. For example, a 30% corporate income tax rate only becomes meaningfulwhen applied against a company’s annual income. Is the tax to be paid 30% of $1

million or 30% of $10 million?

The challenge of protecting the tax base is common to all economic sectors. It is amajor focus of revenue authorities. The tax base is even more important in thepetroleum sector due to the relatively high effective tax rate. Previous analyses ofthe existing fiscal regime for petroleum in Kenya suggest that about 60% of thedivisible (after cost) revenue would be allocated to the government. This is a muchhigher tax rate than would normally apply to parent companies incorporated in OECDjurisdictions where tax rates are often around 30% or in tax havens where they maybe as low as 0%.

There are two basic paths through which the tax base can be eroded. First, grossrevenues can be under-reported. This can be done either through reporting lessproduction than has actually taken place or by reporting a sale price below the fairmarket value. Less revenue reported in Kenya results in greater company profits. Inthe mineral sector, production and price risks are both considerable. In thepetroleum sector, it is comparatively easy to monitor production volumes. Pricetherefore represents a far bigger risk to government revenues.


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The second main path to tax base erosion is the inflation of project costs. Becausethe bulk of government revenue normally comes from profit-based taxes – that istaxes that areassessed onnet income

(after costincome) –inflated costscansignificantlyreduce the taxbase.

The difference between the tax rates in different jurisdictions create majorincentives for companies to minimize the tax base by both shifting profits out ofKenya and shifting costs into Kenya. By doing this they minimize the tax paymentsthat they willbe required tomake in Kenyawhilemaximizing the

profits shift tozero or low taxjurisdictions.

The ability tomove revenuesand costsbetweenjurisdictions isbased on theincreasingly

complexcorporate structures adopted by multi-national corporations.3 As shown in thefigure above, parent companies often use conduit companies – subsidiariesincorporated in tax havens or other low tax jurisdictions – as part of the chain ofownership leading to the petroleum producers in the host country. The parentcompany may also have affiliates that are involved in purchasing petroleum,providing contractor services, and/or providing management services and financing.

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Intra-firm transactions between these subsidiaries create the opportunities foreroding the tax base through profit shifting.

As the main risk togovernment revenues

is mispricedtransactions betweenassociatedcompanies, thecommon solution is tobenchmark sale priceand project costsagainst third party(so-called “armslength”) transactions.The idea is that

transactions betweenunrelated companiesestablish what mightbe called a “fairmarket” price.

While the solution sounds simple, its practical application is challenging even forwell-seasoned tax administrators. First, the definition of associated companiesneeds to be much broader than just the parent company or subsidiaries within thewider corporate family. A sustained business relationship with any company createsopportunities for transfer mis-pricing. In many cases however these looserassociations can be difficult to uncover. Second, assessing the fairness oftransactions between associated companies depends on the availability ofsubstantial data on comparable transactions between non-associated companies.Access to an insufficient number of “comparables” is a widespread challenge fordeveloping countries. According to the OECD it is a particular problem where “thereare many “first movers” who have come into existence in many of the sectors andareas hitherto unexploited or unexplored; in such cases there would be an inevitablelack of comparables.”4 This is exactly the situation currently facing Kenya’s

petroleum sector.

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Sources of Government Oil

Revenue

Kenya operates a traditional production sharing system. The bulk of governmentrevenue would be expected to come from a share of oil production that is allocatedto the government. In addition, the contracts contain a “windfall tax” that is appliedon oil when prices exceed a specific threshold ($50-$65 per barrel depending on thecontract). The government also holds the right to participate (hold an equity stake)

in all oil operations, whether directly or through the National Oil Company of Kenya.!"#$%& ( illustrates the sequence in which these three fiscal elements are engaged.

The principal source of government revenue for Turkana oil is the government shareof the oil produced. There are two steps in the allocation of oil produced: first, thecontractor recovers costs, and second, the remaining oil is divided between thecontractor and the government.

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Cost Recovery

Production sharing systemsallow the contractor to recover

their exploration, production andoperating costs through anallocation of an initial amount ofproduction termed “cost oil.” Asis common in production sharingsystems, there is a limit on howfast capital costs can berecovered (20% per annum) andon the overall proportion ofproduction that can be allocatedto costs in any given year (60%).5 These limits have an impact onthe timing of government – withgreater revenue generatedearlier in the project lifecycle –but not on the overall amount of revenue.

Splitting Profit Oil

Once costs have beenrecovered, the remaining oilproduction, known as “profitoil”, is split between thecompany and thegovernment. The Kenyanfiscal system employs a“production-based”allocation. A review of thePSCs in the public domain as well as the fiscal term summaries for other blockssuggests that there is only modest variation in the profit sharing terms. An examplefrom Block 10A is provided in =0F6- D. For production up to 10,000 barrels of oil perday (bopd), the company receives 50% of profit oil and the government receives50%. For production exceeding 10,000 bopd up to 40,000 bopd, the split changes to40% for the company and 60% for the government.

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Windfall Tax

Existing Kenyan PSCs contain a“windfall tax.”6 The tax is applied

to the company share of profit oilthat is generated from oil pricesthat exceed the “threshold price”at the point of export. In theexample shown in J5@+*- ", anadditional tax of 26% would beapplied to the $25/bbl of windfallprofit with the threshold pricesset at $50/bbl. Note that in somePSCs, the threshold rate is set at$65/bbl. In both cases, the priceis adjusted for inflation from thesigning date of the contract. Fora contract signed in 2008, thethreshold price of $50/bbladjusted for inflation would be around $59/bbl. In addition, the discount related tooil quality (perhaps as high as $10/bbl) would also be deducted prior to theassessment of the windfall tax. As a result, the windfall tax has no impact ongovernment revenues unless prices were to be well above $65/bbl.

State Participation

The Kenyan production sharing contracts all provide for the participation of thestate either directly or through the National Oil Corporation of Kenya.7 The minimumstate share is 10%; for some contracts it is as high as 22%. Taking an equity interestin a project means that the State participates on essentially the same terms asother joint venture partners, once the project moves into the development phase.Once production begins, the state would pay its share of costs within the jointventure and secure its share of profit oil.

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Other Potential Sources of

Government Revenue

According to the PSCs, no additional taxes are imposed on companies engaged inpetroleum production in Kenya. Article 27(5) of the 2008 model PSC clearly statesthat the government’s share of profit oil is inclusive of all income or profit-basedtaxes including corporate income tax and the dividend withholding tax. This sameformulation exists in all Kenyan PSCs in the public domain.Similarly, Article 32 of the model PSC provides exemptions for taxes, charges, fees,duties or levies of any kind in the export of petroleum as well as for the customsduties and other fees associated with importation.

Revenue Risk AnalysisPrevious analysis of the Kenyan fiscal regime applied to a plausible project inTurkana indicates that the government’s share of profit oil constitutes the vastmajority of potential government revenue. As discussed above, the windfall tax is amuch more modest source of government revenue and is activated only at pricesabove $65/bbl. And while government revenue through state participation could besignificant (perhaps 10% of project divisible revenue), the potential risks to thatrevenue relate more to the operations of a state owned enterprise than to petroleumeconomics. The analysis below therefore focuses exclusively on the risks to the

government share of profit oil.

Risks from Depressed Oil Price

The starting point in protecting the tax base is to ensure accurate reporting of thetwo components that comprise gross revenue: the total volume of oil produced andthe sale value of that oil. Determination of the volume of oil produced does not

normally create significant risks to government revenue, as the methodologies formeasurement are widely accepted. This is the case even where multiple sources ofoil move through the same pipeline. The risk is greater in accurately assessing thetrue market value of the oil. One specific concern is that oil may be sold to anaffiliated company for a price below true market value. In countries where taxadministration is weak, this kind of transfer pricing can create opportunities for taxevasion (See Textbox on Alaska and oil price).8


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The starting point for an analysisof oil price is the valuationprovisions in the PSC. Twoprovisions are particularly

important: the point of valuationand the determination of the salevalue. The valuation point isnormally set at the port of exportor the place where the petroleumpasses from upstream(exploration and production) todownstream (refinement andsales). According to thedefinitions in the Kenyan 2008model contract, the “Sales Value

of Crude Oil shall mean the grosssales price at the Delivery Pointof export or the agreed deliverypoint in Kenya or the point ofentry into a refinery.” Clarity onthe valuation point is particularlyimportant as it determines whatcosts can be recovered withinthe production sharing system. There may still be some uncertainty on the point ofvaluation in the case of pipeline transportation.

The second key question is how the value of the petroleum will be determined. It iscommon in production sharing agreements to base valuation on sales to non-associated companies. However, as the case study of Alaska demonstrates thissolution remains vulnerable to abuse. Some countries are moving towards usinginternational benchmark prices as quoted on commodity exchanges, sometimestaking into account quality differences.

The 2008 model PSC states that oil valuation will be the weighted average of oilsales “to third parties at arm’s length during the calendar quarter,” adjusted forgrade, gravity and quality of such crude oil as well as for transportation costs. If

there have been no crude sales to third parties, oil valuation will be the “fair marketvalue” determined as the average price for crude oil produced in Kenya and in themajor crude oil producing countries, and adjusted for grade, gravity and quality aswell as for transportation costs and any other appropriate adjustments.

The economic benefits to the company from depressing oil price are found in thereallocation of oil production from profit oil to cost oil. Lower prices mean that a

Alaska Sues Oil Companies for Undervaluing Oil

The American state of Alaska illustrates the risks togovernment revenue of oil mispricing. Over the first 25 years

of oil production, Alaska received approximately $70 billion inrevenue from royalty payments and corporate taxes.However, based on independent analyses and audits,Alaskan officials claimed “industry chronically reduced thebases for calculating royalty, severance, and income taxpayments by underestimating the market value of a barrel ofoil at the point of sale.” Specifically, companies sold smallvolumes of oil at below market prices and used these “low”prices for their overall royalty and tax calculations.

In order to secure a fair share of revenues, Alaska paidlawyers and accountants hundreds of millions to pursuelegal claims that ultimately generated an additional $10.6billion in government revenue. And these figuressubstantially under-estimate the scale of abuse. Many otherclaims were launched against companies but were settledout-of-court and the resulting payments are thereforeconfidential.


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greater proportion of total production must be allocated to costs, resulting in lessprofit oil to be allocated to the government.

Risks from Inflated osts

Government revenue from the extractive sector are determined by four mainvariables: the volume of resources sold, the price at which they are sold, the costsinvolved in production and the rates of taxation. Of the four, the least attention isnormally given to costs. Yet experiences in other resource-rich developing countriessuggest that ineligible and inflated costs are a major source of lost government

revenue.

As discussed above, the main source of Government revenue in a production sharingsystem is the share of overall production (profit oil) allocated to the government.Profit oil is divided between company and government only after “cost oil” has beenallocated to the company to reimburse eligible project costs. Any increase in projectcosts will result in a decrease in available profit oil. Where increased expenses arelegitimate, both the company and the government suffer. There is simply less “profitoil” to be shared. But where ineligible or inflated expenses are accepted, thecompany receives the full value in cost oil rather than a portion of the value through

profit oil.

In some cases, expenses claimed are simply ineligible. Examples, drawn from actualcases, include companies seeking to claim expenses:

o incurred prior to the signing of the PSC;o for personal interests of expatriate employees and families;o for technical training of expatriates;o involving duplicate invoices for goods or services that have already been

expensed;o ineligible expenses according to the PSC such as oil and gas marketing fees,

or expenses related to mergers, acquisitions, or transfers in participating

interests.

In other cases, the price of legitimate goods and services are intentionally inflated.This practice, known as transfer mis-pricing or mis-invoicing, is of particularconcern for transactions between affiliated companies. For example, offshoredrilling is contracted to another subsidiary of the same parent firm. The invoiceultimately submitted for the work is inflated by 10% beyond what the drilling wasactually worth. The 10% in this scenario is recorded as a cost to the project, but is in

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There is no simple answer to the obvious questions of whether inappropriate claimsare honest mistakes or attempts to avoid taxation. There is often a disconnectbetween the spending money as part of petroleum production, and the claiming of

expenses as part of cost recovery. Developing and operating petroleum projects isthe realm of engineers and project managers, while maximizing company revenuesby minimizing tax payments is the realm of accountants and lawyers. Consider forexample the following advertisement for a “cost recovery auditor” to work for aCanadian oil company in Chad. The first responsibility for this employee is “Managingthe maximization of cost recovery and reimbursement by identifying variances andspecific costs as stated within the companies' Production Sharing Contracts (PSC).”

Proving that mistakes in company expense claims are intentional is difficult.Companies never want to admit to purposeful fraud. Even when companies agree to

tax settlements, they seek to avoid any implication that of intentional wrongdoing.

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Who benefits from inappropriate expense claims however provides some insight intothe question of intentionality. It seems almost impossible to find examples in auditsof oil company books where errors resulted in an increase rather than a decrease intax payments to government.

Timor Leste Uses Tax Audits and Lawsuits to Defend Government

Revenues

Timor-Leste is the most oil dependent economy in the world. At peak oil prices,petroleum revenues accumulated at a rate of more than $250 million per month. Themoney flowed so fast that for many years that Timor-Leste devoted little effort makingsure that they received what they were actually owed. The international accounting firmErnest and Young acted as the independent auditors from 2007-2010 and, as iscommon practice, were paid by the companies. It is alleged that the accountingcompany contested few if any of the company expense claims.

In 2011, Timor Leste initiated a series of tax audits covering the years 2005-2010. Theaudit process had an immediate short-term impact on revenues with a reported $79million being recovered in the first round. The longer-term implications could be evenmore significant with the government reporting that it is continuing to pursue a further28 assessments against the oil companies that could amount to hundreds of millions,even billions, of dollars in back taxes.

The Timor Ministry of Finance reported that during 2012 alone it had received more than$400 million from “audit-related activities.” In that same year, the government launchedlegal action against ConocoPhillips to recover more than $200 million in unpaid taxes. InFebruary 2016, following arbitration in Singapore, the parties reached a settlement. Theoutcome however is unknown, as according to the terms of the settlement the amountthat ConocoPhillips is to pay will not be disclosed.


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First, there is the question of the relative proportion of company debt compared tocompany equity used to fund capital costs. Many tax regimes put a limit on the debtto equity ratio in order to avoid excess debt financing, a phenomenon known as“thin capitalization.” Limits are often placed on this ratio so, for example, a countrymight accept only two parts debt to one part equity (a 2:1 ratio).

Second, there is the question of the interest rate charged on the debt. As withtransfer mispricing, affiliated companies often provide the financing. This raises therisks that interest rates are not based on arms-length “market” prices but are ratherdesigned to inflate recoverable cost.

In many countries operating production sharing systems, interest costs areexplicitly listed as ineligible for cost recovery. The Kenyan PSCs however are clearthat the costs of financing are recoverable. The 2008 Model PSC indicates that“Interest incurred on loans raised by the contractor for capital expenditure inpetroleum operations under the contract at rate not exceeding prevailing

commercial rates may be recoverable as petroleum costs.”15

Protecting Government Revenues

The analysis above indicates that there are major risks to government revenuethrough the mis-pricing of oil sales and the inflation of project costs. Hundreds ofmillions of dollars are at stake. What then can be done to protect governmentrevenues?

Clarify Contract Provisions: Clear, simple provisions are widely seen as the bestdefense against revenue loss. Revising the Petroleum Law and preparing a newmodel contract will reduce the risk for PSCs signed in the future. Petroleum revenuesover the next decade, however, are almost certainly going to be based on alreadysigned PSCs. The terms of these existing PSCs are not easily changed. As is common,the contracts contain a stabilization clause that requires the government to ensurethat the relative economic benefits as set out in the original contract remain inplace.16 That said, there will be significant negotiations when companies transitionfrom the exploration to development phase of the project, as is likely to happen inthe coming years for Tullow’s operations in Turkana. These negotiations provide anopportunity to clarify the interpretation of key provisions in order to minimize thepotential for abuse.

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Strengthening Tax Administration

Priority must be given to strengthening broader tax administration, particularly as

the skills required toadminister a PSC are verydifferent to thoserequired for the auditingof normal businesses.Greater capacity willobviously required in theMinistry of Energy andPetroleum and the KenyanRevenue Agency. Effortsshould extend beyond

these core organizations,however, to include theTreasury, the Commissionon Revenue Allocation,the Office of the AuditorGeneral and officials fromrelevant countygovernments. The KenyaPetroleum TechnicalAssistance Project (KEPTAP), a World Bank supported $50 million technical

assistance project designed to strengthen government capacity, includes a focuson the administration of revenue to be generated from the oil sector. This includesspecific capacity building in forecasting and collection of oil revenues and taxes aswell as “the verification and auditing of recoverable costs proposed by oilcompanies.” But the challenges of stopping transfer pricing should not be under-estimated as the case of Transocean illustrates (See Textbox).21

Encourage Joint Ventures: The asymmetry in expertise between international oil andgas company accountants and lawyers and Kenyan tax administrators, createsobvious challenges. One way to defend Kenyan government revenues from mis-pricing of oil sales or inflated project costs is to encourage joint venture

partnerships. The economic interests of partner companies – to reduce costs andincrease revenues in order to maximize their share of profit oil – are closely alignedwith those of the Kenyan government.

The Challenges of Catching Transfer Pricing

Transocean, the world’s largest oil drilling company, providesan interesting example of the challenges of effective taxadministration related to transfer mis-pricing in developedcountries. On several occasions through the 2000s, the UStax authorities assessed penalties against Transoceanamounting to hundreds of millions of dollars. In each case,following extensive litigation, the company managed to avoidpayment. Transocean was also at the heart of Norway’slargest ever tax fraud case. The government claimed that

Transocean dodge as much as $1.8 billion in tax throughtransfer pricing on the sale of 12 oil rigs between 2000 and2002. The case lasted for more than a decade before an Oslocourt rejected the charges and the Government decided todrop its appeal. The loss is a major blow to the tax fraudoffice in Norway and may represent a setback for someprovisions of Norwegian corporate income tax law.


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