Each country blessed with oil and gas discoveries initially tries to create a tax regime that maintains the balance between generating tax revenues from the extraction of these hydrocarbons while also encouraging investment. If the country gets too greedy and imposes an excessive tax burden, the inverse effect occurs - investors abandon their projects and corresponding budget revenues decline. Problems arise when the Government forgets about and fails to take care of investors and even worse, when investors are abused and taken advantage of, thus eliminating investor trust and any possible further investment. The current situation in Ukraine is a stark example of this.
We’re all well aware of the current financial state of Ukraine. Years of corruption and incompetence has led to the need to restore the country’s budget through short-sighted reforms and appeals to “save Ukraine” as, “Everybody in the free world should be doing more to help Ukraine. “ Ukraine has thus imposed exorbitant taxes on local oil and gas producers - 55% on natural gas produced out of wells above 5,000 meters depth, and 28% on wells deeper than 5,000 meters. These punitive taxes have already forced a number of investors to pull back and leave the country.
The International Monetary Fund (IMF) called for recovery of the damaged Ukrainian gas production industry and the restoration of investor confidence in the Ukrainian Government. In its short-sightedness and inexperience in running a country, the new government has not only deterred investment in the sector but has critically damaged the strategic energy security and independence of Ukraine. As investment continues to decline in the sector, gas and coal supplies from Russia increase. IMF experts believe that in order to maximise budget revenues in the long term, the Government should first of all balance its tax policy and build a strong motivation for investors.
Competing For Investors
Investors, as the government is painfully beginning to realise, don’t invest to save countries. Patriotic appeals fail. They invest to make money. The only thing that motivates investors is reasonable, transparent and stable investment regimes with rules that are more attractive and reliable than those offered in other countries. This is not only about taxation; Ukraine’s investment rating is still weak and non-competitive in terms of all key components for investors (i.e. transparency, regulatory policy, protection of property etc.). Related: Have Natural Gas Prices Bottomed?
For example, currently Ukraine is in 96th place in the World Bank’s Doing Business ranking (out of 189 economies), while its neighbours Bulgaria and Romania are included in the top-50 countries in the world (38th and 48th positions respectively). The taxation regimes in these countries are also liberal and favourable: in Romania investors pay reasonable royalties calculated on the basis of the production volumes, in Bulgaria – they pay depending on the payback of investments. The tax rates do not exceed 28%.
It is clear that with current draconian rates of up to 55% of the gas price, Ukraine is not able to compete for investments with its neighbours. At the same time, a lower tax rate is not the only factor of importance for a new taxation model in Ukraine, as it should take into account a number of other important factors.
Varying Costs of Production
As a “mature” gas producing country, Ukraine has different reserves and deposits according to type: large and small, old and newly discovered, conventional and unconventional, deep and shallow. It is absolutely impossible to come up with one or two general rates of gas production tax that would equally treat investors in the fields of given variety and complexity of the geology. In this context, the Government’s traditional approach to link the tax rates to only depths of production wells cannot withstand any criticism.
When arguing about the private producers’ cost of gas production and rate of return on their projects, state fiscal officials in Ukraine are, for some reason, still reluctant to recognise simple facts that the geological risks, exploration, seismic and service costs vary from one project to another, but all have a direct impact on the amount of investment required to take gas out of the ground. A good tax regime should recognise these differences and allow for a corresponding and reasonable rate of return.
Next Steps to Take
In 2014 the Parliament adopted a number of important amendments to the Tax Code of Ukraine. The new rules provide for change in the main accounting principle for corporate income tax accounting - the taxable profit will now be determined under Ukrainian statutory or International Financial Reporting Standards. The Government’s next step in the right direction could be the adoption of official accounting standards for oil and gas industry. Absence of clear and transparent rules led to a variety of different policies developed by companies, only to have them challenged by the tax authorities. A common financial reporting language based on IFRS would enable the subsoil users to achieve greater consistency and transparency and should help the Government to have a standardized approach to administering and applying the tax. Related: Russia To Power Arctic Drilling With Floating Nuclear Reactors
Finally, the new regime should also account for the capacity of the Ukrainian tax authorities to administer the suggested taxation model. The International Monetary Fund repeatedly called for introduction of the so-called “R-factor” (which is calculated as a ratio between the investor’s revenues and their investment in the project) - the higher the payback is, the higher the tax rate should apply to a company. Although this approach corresponds to the best international practices, administration of such taxes requires special expertise and additional capacity of the country’s tax authorities.
At the same time, lack of understanding coupled with inadequate preparation could result in an administrative “bottleneck”. Given this background, we see implementation of the R-factor model of taxation (being a complete novelty in the Ukrainian tax system) as a very questionable measure, given the current reality in Ukraine, unless donor funding is provided to ensure sufficient institutional capacity, which, given the tight timeframe also does not seem feasible.
The Government’s Position
The Ukrainian Government has repeatedly claimed that one of their final and irrefutable requirements is what they call a ‘neutrality’ of the new taxation model. Neutrality in the language of the Ukrainian Government means that any new model of oil and gas taxation by any means must not affect the level of revenues or result in any losses for the state budget in the coming years. That basically means that, from the Government’s perspective, the level of fiscal pressure on the industry should not change at all!
Needless to say that this is a short-sighted approach, which would not motivate any investors to invest. The current punitive tax regime imposes an excessively high tax burden without offering meaningful incentives for investment. While in the short term tax revenues may increase, in the long run gas production will drop and the Government’s revenue stream out of royalty tax on gas production would dry up and the energy security gap will widen. Related: EU Needs To Invest €400B By 2020 To Keep Renewables On Track
Moreover, the current royalty tax is levied on the gas sales price (not even on the company’s profit), which is ultimately fixed at the discretion of the Energy Regulator, often with time lags and disconnected from the latest market price.
The Government explains that the expected budgeted revenue from the royalty tax was fixed in the State Budget for 2015 on the basis of the currency rate of 21.7 UAH per US$1 and with a forecasted average price of imported natural gas of a maximum of US$270 per 1000 cubic meters. These assumptions look rather weak and uncertain, as the actual figures have already gone out of line. Starting from February 2015, the official currency rate has already exceeded 22.5 UAH. The average price of gas imported in Q1 amounted to US$332 and it is not expected to be lower than US$285 per 1000 cubic meters in 2015 on average. This means that the State Budget would receive more revenue from the royalty tax than it was supposed to, but even knowing so, the Government just does not want to loosen its grip on the industry.
As a result, the private gas producers are suffering significant losses and have no choice, but to reduce their capital expenditures and suspend any investment and work programs to offset the impact of higher production taxes. The new taxation model should remove these distorted, false or vague assumptions. To make it fair, the taxes must be linked solely to the market price of natural gas (for example – the price of imported gas) and ideally paid only after the gas is sold by the producer.
The new taxation model for the oil and gas sector in Ukraine should find a balance between stable and gradually growing budget revenues and encouraging more foreign investment in the country’s industry. In this respect, a key to the success of the tax reform is the government’s willingness to accept compromises and to take a long-term approach. The dialogue between the State and the private sector, which has been sporadic at best, will facilitate the exchange of opinions and understanding of expectations and international standards among the different groups. The Ukrainian government, if it truly wants to be reformist and address investment and energy security, should really take decisive and immediate steps to restore the investors’ confidence and trust, ensure stable and encouraging investment conditions, and ultimately restore growth of domestic gas production.
By Robert Bensh for Oilprice.com
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