Potential Petroleum Revenues for the Government of Kenya: Implications of the proposed 2015 Model Production Sharing Contract | Taxes | Profit (Accounting)

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As Kenya establishes the terms for the future exploitation of oil deposits, one challenge is how to maximize the benefits to the country as a whole through design of the fiscal regime, and specifically production sharing contracts with oil companies. This research report looks at the current model contract and asks whether recent changes are consistent with best practice and will contribute to improvements in potential government oil revenue. It looks particularly at the shift from a deemed to a paid income tax and argues that this could have a major impact on project economics and potential government revenue. Decisions on contract models should be made with full awareness of the significant change that it represents to the Kenya’s petroleum fiscal regime.
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  POTENTI L PETROLEUM REVENUES FOR THE GOVERNMENT OF KENY Implications Of The Proposed 2015 Model Production Sharing Contract D on Hubert, PhD   #$%&'(#$ )%' *#+#,%-.#/0 1%/$&,02/3 March 2016 www.oxfam.org      Oxfam Research Reports are written to share research results, to contribute to public debate and to invite feedback on development and humanitarian policy and practice. They do not necessarily reflect Oxfam 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 wkinyori@oxfam.org,uk  © Oxfam International May 2016.   # TABLE OF CONTENTS SUMMARY ............................................................................................................. 4   CONTEXT ............................................................................................................... 5   ALLOCATING PROFIT OIL ......................................................................................... 6   ASSESSING CORPORATE INCOME TAX ...................................................................... 8   FINANCING COSTS .................................................................................................. 9   COMPARATIVE ECONOMIC ANALYSIS ..................................................................... 10   CONCLUSION ....................................................................................................... 13   NOTES ................................................................................................................ 15     $ 45667 8 The Petroleum (Exploration, Development and Production) Bill, 2015 and associated model production sharing contract (PSC) are currently in the final stages of Parliamentary review. The development of a new regulatory framework for the petroleum sector was driven by the need to modernize a regime that was first established in 1986 and to take into account recent discoveries of both oil and natural gas. Of the changes proposed in the 2015 Bill and model PSC, the focus of this analysis is on the fiscal terms; that is the sources of Government revenue and the specific terms applicable to them. The new fiscal system that would apply to PSCs negotiated in the future will be significantly different than the one that applies to all existing PSCs, including those for the promising blocks in the Turkana region. Attention is given to the three main differences between the existing and future fiscal terms. First, the 2015 model PSC proposes to replace the existing approach to the sharing of profit petroleum from one based on the daily rate of production (DROP) combined with a windfall profits tax imposed when oil prices are higher, to one based on a measure of profitability (r-factor). Second, under the 2015 model PSC, corporate income tax would become tax paid by the company rather than paid out of the government’s share of profit oil. Third, the 2015 model PSC changes a significant investment incentive by replacing the cost recoverability of interest on debt incurred for development costs with a 15% uplift on development spending. As it is difficult to comprehend the significance of the proposed changes in the abstract, both sets of terms are applied to a potential oil project based on public domain data for Blocks 10BB and 13T in the South Lokichar region. It is important to note that past PSCs contain stabilization clauses and as such there is no suggestion that the 2015 terms would be applicable to the Turkana project. The objective of applying the 2008 and 2015 terms to this hypothetical oil project is to allow for a direct comparison of project economics and potential government revenue under varying scenarios of production, price and costs. Two clear conclusions emerge. The adoption of the R-factor and the development cost uplift are both consistent with best practice and provide modest economic benefits for the government. The adoption of an R-factor profit split as set out in the 2015 model contract generates some additional revenue for the government and is economically more efficient than the combination of the DROP profit split combined with the windfall tax. Similarly, the development cost uplift generates some additional revenue and closes significant potential loopholes. In contrast, the shift from a “deemed” corporate income tax to one actually “paid” by the company has a profound effect on project economics and the proportion of revenue that would flow to the government. The inclusion of a paid income tax increases the government by roughly 10%. It could add billions of dollars to government coffers over the lifecycle of a project. The additional revenue however also constitutes a significant extra burden on the contractor. Following successful oil discoveries, countries often tighten fiscal terms for future contracts. The change from a deemed to a paid corporate income tax may be appropriate in light of the Turkana oil finds. But it is a choice that should be made deliberately, with full awareness of the significant change that it represents to the Kenya’s petroleum fiscal regime.
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