A few days before the New Year, the Parliament of Ukraine was quite busy, trying to adopt the Budget and Tax Reform package initiated by the Government. Among other measures, the Ukrainian Government suggested to keep, on a permanent basis, the draconian rates of the subsoil use tax (the royalty) for natural gas produced by private companies at the level of 55% (for natural gas extracted from deposits up to 5km) and 20% (for natural gas extracted from deposits deeper than 5km). On December 28th, 2014 the Parliament caved in under pressure of Arseniy Yatseniuk, the Prime-Minister of Ukraine, and passed both the tax reform legislation and the State Budget-2015 bill.
The Law on Tax Reform has experts and industry participants expressly articulating that the tax burden is enormous in comparison to any other European country that is competing for investors in their oil and gas markets. Consequences of this measure are expected to be disastrous not only for private gas investors, but for the country as a whole, as it struggles to gain energy independence from Russia.
Initially, such excessive tax pressure on natural gas producers was introduced back in summer 2014. It was supposed to be a temporary government revenue enhancement measure, necessary when state finances had been drained by military actions against pro-Russian rebels in the Eastern regions of the country. Through adopting the increased tax rates on a permanent basis, the Ukrainian Parliament and Government in fact diverged from their own promises not to apply such high tax rates in 2015, not once, but twice: the first time, in August 2014 when the Prime Minister promised this would only be a temporary measure; the second time – when representatives of the various parties in Parliament signed the Coalition Agreement which suggested that the gas production tax should not exceed 30% for independent private businesses.
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Despite the strong lobbying efforts and a number of open letters submitted to the President, the Prime Minister and the Parliament, the Tax Reform Law No.1578 was passed as part of the so-called “Parliament’s fight with the gas oligarchs” campaign. This was rolled out under pressure from populists claiming that the gas producers generate incredible profits by extracting mineral resources that belong to the people of Ukraine and, therefore, must pay higher taxes. It is worth noting that the Tax Reform legislation was adopted by Parliament under immense pressure from the government that kept alluding to the war in the East, an effective, universal and arm-twisting argument. The bill received votes from 250 Members of Parliament, although the parliamentary coalition has close to 300. Interestingly, the first attempt to adopt the Tax Reform bill failed (the number of the votes was insufficient), and it was approved only on the second try. Likely only few of the MPs understand that the Draft Law (which is to become the Law once the President signs off) not only contradicts the declared policy of the gas market liberalization, but threatens to destroy the private gas production industry in Ukraine in the very near future.
During the last 5 months, the Government did its best to scare away foreign investors by waging the real war on private gas producers in Ukraine. Among other unwise decisions were the doubling of tax rates and driving the private companies out of the gas supply business by making Naftogaz, the largest state-owned company, the monopolist gas supplier of gas to industrial and commercial consumers in breach of all laws and international treaties. These actions are a far cry from the “market opening” policy declared by the Yatseniuk’s government on numerous forums. In the opinion of many international institutions, the government’s efforts should be directed in the opposite direction.
For example, in its September Country Report the International Monetary Fund mission expressly recommended that the Ukrainian Government abandon the policy of increasing subsoil charges as “the large increase in gas extraction royalties may delay investments in this strategically important sector of the economy, especially if expectations that it will be extended beyond 2014 take hold”. The Energy Community Secretariat had previously requested clarification regarding the government's decision to suspend the open gas market by obliging the largest industrial consumers to buy gas exclusively from the state-owned Naftogaz. Apparently, the Tax Reform Law goes against the recommendations from the IMF and the EC. The international institutions still expect the Ukrainian Government to ensure the non-discriminatory, transparent and stable environment for foreign investments, especially in such an important sector as production of hydrocarbons.
The major issue is that these days when the Cabinet of Ministers in Ukraine should have been focusing on maximizing the country’s domestic gas production, the new Tax Reform Law actually dismantles the private sector of the gas production industry in such an energy thirsty country. By raising the royalty tax rates to levels unprecedented in Europe, the government ruins the major incentive for the foreign investors – a relatively high netback. As a matter of fact, no European gas importing country has ever established such high taxation on domestic producers. Usually the rates in such countries rarely exceed 20%. At the same time, according to various calculations, Ukraine will require some extra 37000 MCF of the natural produced domestically already in 2015. But the growth of hydrocarbon production in Ukraine is conditional upon significant growth in capital investment, and according to some experts’ estimates, the country needs at least USD 1 billion annually during the following five years in order to achie
ve energy independence. Increased fiscal pressure resulting in erosion of capital in the sector, an unstable economic situation, the threat of an open conflict with Russia and withdrawal of major international servicing companies will most likely discourage investors from directing additional capital in the gas production industry.
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The tax burden in Ukraine is so high that the gas sector has already become unattractive for FDI. For example, British public companies JKX Oil & Gas and Regal Petroleum have announced that they will not spend capital in 2015 to offset the impact of higher production taxes. The second-largest U.S. energy producer Chevron Corp. took the decision to pull out from the Production Sharing Agreement with the Cabinet of Ministers of Ukraine for exploring the Olesska field in western Ukraine. According to unofficial sources, Chevron grew frustrated with the Ukrainian government’s failure to modify tax rules and red-tape under which foreign explorers have to operate in the country and its failure to reduce the “endemic corruption”.
The Tax Reform Law will only worsen the level of corruption in Ukraine as companies will not be able survive this unsustainable level of fiscal pressure on the industry. Transparency International has already stated in 2014 that Ukraine is still “in the club of totally corrupt countries”. High taxes have always been one of the main drivers of corruption, while reduction in the tax pressure is likely to lead to a reduction in the size of the shadow economy and corruption. European countries are trying to create a virtuous circle by lowering taxes to minimize incentives for businesses to be corrupt. At the same time, Ukraine creates a vicious circle in the other direction.
As a potential result of the Tax Reform Law, Ukraine may remain dependent on gas supplies from Russia and end prospects of reviving its chaotic economy. Already weighed down by the conflict against pro-Russian rebels and teetering on the verge of default, Ukraine may now only have foreign capital to develop its domestic gas resources. The best way for the country to gain energy independence, bring down the level of corruption in the energy sector and comply with expectations of international donors is to create a favorable investment climate with acceptable stable tax regime.
By Robert Bensh for Oilprice.com
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