The discovery of petroleum resources in East Africa has generated optimism among the local folk of a forthcoming economic bonanza.
Uganda, Kenya, Tanzania and Mozambique have witnessed a surge in their foreign direct investment in recent years driven by capital inflows to their extractive sectors. Further increase in petroleum sector investment is anticipated in the foreseeable future.
This will, however, depend on the stability and suitability of the policy framework to support the viability of the envisioned projects in light of the ever changing geopolitical and macroeconomic environment.
Countries that place onerous requirements on the transfer of Production Sharing Agreement interests can potentially discourage foreign direct investment in the sector. The transfer of interest in petroleum licences provides companies the opportunity to collaborate with others that have already played a key role in de-risking the country’s geological potential but are constrained by a shortage of capital and expertise.
Given the high risk of failure in the extractive industry, petroleum companies diversify interests as much as possible. Mitigation of risks in the upstream petroleum sector further means that the government is better positioned to negotiate for a high recovery of the economic rent accruing from the sector because the risks have been lowered.
Most PSAs explicitly provide that host states must not unreasonably withhold approval when petroleum companies exercise their right to transfer part or all of their interests in the PSAs. Others go a step further to provide express exemption from all taxes that may crystallise from domestic tax legislation at the time of transfer of these interests.
Controversy is usually stoked when the exemption from taxes at transfer in the PSA is not replicated in domestic legislation. Host states usually take the view that contractual terms set out in the PSAs cannot override the provisions of the domestic legislation. They are thus bent on taxing proceeds arising or deemed to arise from the transfer of petroleum interests even if the PSAs provides specifically for their exemption from tax.
The question of whether the terms of the PSA can override the provisions of domestic legislation is a contentious one. States usually query whether the contractual terms set out in PSAs can fetter their sovereign rights over natural resources as enshrined in the UN general assembly resolution 1803 of December 14, 1962.
It is common for host states to question the competence of their officials who negotiated contracts conferring tax exemptions or other contested terms arguing that they lack the powers to commit the state to any definite obligations. This can, however, be contrasted with the view that the host state’s sovereign right over its natural resources can be restrained by the contractual obligations they enter into.
It is common for countries to impose taxes on the actual or deemed proceeds arising from the transfer of PSA interests. A number of farmout transactions around the region have been subjected to this. Farmdown transactions are usually accompanied by overtones of windfall profits assumed to be made which seems to be the main driver of the tax policy presently applied to these transactions in the region.
In formulating the tax policy pertaining to transfers of interests in the extractive industry, governments ought to carefully consider all the circumstances surrounding these transactions. The majority of the farmdown transactions are geared towards mitigating risk as well as raising revenue to meet working obligations under the PSAs.
Taxing farmdown transactions aimed at raising finances to reinvest in the country may derail the flow of foreign direct investment to the petroleum sector. On the other hand, failure to tax transactions solely motivated to make a profit after which the investors immediately exit the country suggests imprudent management of a country’s petroleum resources.
Denis Kakembo is a senior tax manager at Deloitte and Touche
Source : The Observer