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Russia's petroleum-taxation dilemma

The petroleum fiscal regime in Russia is ineffective and confusing for investors. Could an economic-rent tax cut the Gordian knot, asks Zaur Muslumov, senior consultant, Palantir Solutions*

RUSSIA has achieved a remarkable growth in hydrocarbons output over the past decade (see Figures 1 and 2). Although most of this growth is a result of improved recovery rates from mature producing fields, new projects have also contributed to rising production. Both investors and the government recognise that maintaining such growth will require substantial investment in new development, but investment depends on the attractiveness of the country's fiscal regime for petroleum producers.

The country has recently introduced two important changes to its fiscal regime. The oil-export duty was brought into force for 22 oilfields in eastern Siberia, albeit at a reduced rate, from July. Until then, the region was granted an export-duty holiday in an attempt to attract investment. In addition, the government confirmed a 61% increase in the Minerals Extraction Tax (MET) rate for natural gas from January 2011.

These policy measures appear to be aimed at bridging Russia's budget deficit, which is expected to exceed 5% of GDP in 2010. But any changes must also ensure minimal disturbance to the oil and gas sector and maximise the long-term benefits to the Russian economy.

The existing Russian fiscal regime – not including production-sharing agreements, which have their own, separate rules – has three main elements: MET, export duty and profit tax. Both MET and export duty are charged on a per-tonne basis and are determined using formulas linked to the price of oil. The profit tax is charged at the rate of 20% on companies' profits.

Export duty is the government's most important fiscal instrument, providing the lion's share of receipts from the oil and gas industry. With oil prices at around $80 a barrel, the combined government take from MET and export duty constitutes more than 60% of the sales value of exported oil volumes.

Neither export duty nor MET take into account project or company profitability – both use revenue as the base and ignore associated costs. Such a system is relatively easy to administer, because the tax authorities need only production volumes, export volumes and the oil price to calculate export duty and MET. Furthermore, it leaves little room for tax optimisation and almost completely eliminates the transfer-pricing issue, whereby a producing arm of a company may sell oil cheaply to its trading arm based outside of the country, thus minimising its tax liabilities. And the existing fiscal regime provides strong incentives for cost reduction and innovation: because the revenue upside is limited, producers concentrate on reducing their costs.

However, the existing fiscal system has several significant drawbacks. First, it is not focused on the economic rent, which creates windfall opportunities for low-cost developments and deters investments in relatively high-cost projects. This situation also necessitates differentiated, regional fiscal systems to induce investment in more remote, and riskier, areas of the country (such as eastern Siberia), which have undeveloped infrastructure. A second problem is the perceived instability of the existing fiscal system resulting from a relatively high number of changes made in recent years. Additionally, the existing system accelerates cessation of production at old fields, which the government tries to offset by lowering the MET rate for fields with depletion rates in excess of 80%.

Solving the paradoxes of this regime requires a clear understanding of the economic rent and the ability to determine it by both the government and investors. The term economic rent generally refers to the return on investment in a project that is in excess of the value required by investors to allocate funds to the project. Such excess value does not affect supply decisions and can be taxed at up to 100%.

Because most oil and gas companies use discounted cash-flow techniques (such as net present value, internal rate of return, discounted payback, or capital productivity ratios) to allocate capital it would be reasonable to use a measure that accounts for the time-value of money in determining the economic rent. The internal rate of return is such a measure and is used in a number of fiscal regimes, including those of Australia, Denmark and Azerbaijan.

The idea is that investors require a minimum risk-adjusted rate of return on their projects. The economic rent is the return above that rate of return. The revenue and cost items to be included in calculating the rate of return for economic rent must be determined. Ring fencing at the project level is also a pre-requisite of such a mechanism – ring fencing treats individual business segments, fields and projects as separate taxable units, and disallows the offsetting of costs and transfer of revenues from one unit to another. The tax is then applied at either a single or a sliding-scale rate to the profits generated in excess of the investor's agreed return requirements.

At the moment, the Russian fiscal regime is applying similar rules to projects with varying returns on investment. Profit tax accounts for a company's profitability, but it represents only a small portion of the total government take. Consequently, a project generating a 7% rate of return is taxed at almost the same rate as another project with a 35% rate of return – so, the government takes more than an economic rent from some projects, but under-taxes others.

There are some incentives in place providing a favourable tax treatment for MET and export-duty purposes, but their existence confirms the overall ineffectiveness of the existing regime. In addition, such incentives appear to be temporary measures, so may not have a significant effect on investment decisions for new projects.

The Russian government seems to recognise the need to move away from revenue taxation and towards taxing profits. But the complexity of such a move combined with current budget imbalances would make this reform unpopular. Nevertheless, the amendment of the petroleum fiscal regime must happen if the government is to attract long-term oil and gas sector investment.

The government could retain the present regime for producing fields and gradually introduce regime changes for new developments. But new fiscal terms must apply to all geographic areas at once to avoid artificial differentiation between regions in need of similar levels of financing. The government can still exercise control over the geographic distribution of investment through its management of the licensing process.

An effective petroleum fiscal regime requires a number of important attributes: it must have signals and incentives to efficiently allocate the economic resources, such as capital, labour and natural resources; it must distribute economic benefits according to the respective risks borne by resource owners and investors; and it must be stable and predictable, so that investors can make informed investment decisions, while the government can plan for its budget.

A fiscal regime combining a royalty and an economic-rent tax could meet all these criteria. The royalty is a resource fee compensating the resource owner for the foregone value of his subsoil resources. The logic is simple – natural resources are similar to money in a bank, so any withdrawals must be compensated. The economic-rent tax would ensure the government allows investors to generate a fair return on capital invested, while enjoying the entitlement to the majority of excess value added. This would limit the upside potential for the investor, but also eliminate payments if no economic rent is generated.

An economic-rent tax also has windfall-tax characteristics (the government take grows along with profitability), which would ensure long-term stability and minimum future changes to the regime.

*Palantir Solutions provides economic planning, consultancy and software to the global oil and gas industry

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