The law that will implement these changes was registered with the Verkhovna Rada and outlines both the reduction in royalties and the introduction of a new additional profits tax.
The changes return royalties to where they were 29 percent (14 percent for ultra deep wells greater than five kilometers) before last August for current investors and introduce a new regime for new investments made in the New Year.
For wells drilled after Jan. 1, the royalty rate will be reduced to 20 percent (10 percent for ultra-deep wells), corporate income tax will be levied at the rate of 18.5 percent as with other companies, and additional profits tax will be levied at the rate of 30 percent on profits although there will be a few adjustments in how this tax is calculated versus regular corporate income tax.
The oil and gas business is striking in its contrasts.
Hydrocarbon reservoirs take tens if not hundreds of millions of years to accumulate, yet the volatile and fast moving markets on the surface require a hawkish attention to payback periods often measured in months. The generally accepted metric of profitability in the industry is the payback period per well. Most onshore wells require a 12-18 month payback to pass the industry’s investment hurdles. Achieving payback is so vital that almost all additional profits tax regimes recognize 100 percent or more pay-back as the point at which the tax should kick-in.
Without getting into too many technicalities, the 30 percent additional profits tax will apply to operating profit, but investors will be allowed to shield 70 percent of their operating profit with deductions for past investment and interest. This means that the 30 percent tax will apply to 30 percent of operating profit regardless of whether the investor has recouped the original capital investment.
This is a major deviation from global benchmarks which allow full investment recovery.
Because of this claw back, the effective revenue tax (royalty) will be 25-26 percent of revenue (not much less than the old 29 percent) and investors if they recover their investment will pay regular corporate tax of 18.5 percent plus another effective 20 percent after investment recovery.
There are positive features of the additional profits tax.
Taxes will be ring-fenced around the field which provides a strong incentive to reinvest cash flow in new production as when wells pay-out the surplus profit tax can be deferred by new capital investment in new wells. One negative feature of the tax is that it will be calculated on the regularly taxable income of producers (with adjustments) rather than creating a separate tax regime. As many producers complain that some legitimate expenses are excluded from their tax declarations overstating income, there is no reason to expect this type of tax creep won’t apply to the new much higher APT.
This new regime will keep Ukraine as the highest tax country in the region. The countries in the region with which we compete for investment charge 5-20 percent royalty with no excess profit tax. We remain uncompetitive against our main competitor investment destinations: Romania, Poland and Turkey. Clearly tax rates vary based on a country’s mineral wealth; taxes in Ukraine are much lower than Russia. But as the new proposed regime is worse than the tax regime which existed before August of last year it is unreasonable to assume this will unlock new investment potential.
The new tax regime will not encourage exploration.
The new tax regime will probably result in an increase in development drilling of existing discoveries. However, exploration of unconventional hydrocarbons or new fields is much more risky than brownfield development and new taxes will not revive the moribund exploration sector. Hopefully this will be addressed in public discussion and new discoveries and unconventional fields receive the same tax treatment as ultra deep wells – 10 percent royalty with surplus profits tax. The presentation of this new tax regime in Washington was disingenuous as it should not be seen as a tax cut with incentives. In actuality this was an announcement of a return to old royalty rates and added corporate income taxes.
On balance these changes will stop the existing natural gas producers form bleeding-out. It creates an incentive for reinvestment but does not make Ukraine a competitive destination for new investment. We will hope to see new investors come to the country, but without 100 percent payback before additional profits tax and 10 percent royalty for new discoveries Ukraine’s undiscovered mineral wealth will probably stay in the ground. The oil and gas has been there for tens of millions of years and the new additional profits tax will not make anyone hurry to get it out.
Christopher Glover, a Canadian lawyer and businessman, has worked in Ukraine for more than six years and is an expert in Ukrainian energy, primarily assisting foreign investors in unconventional gas exploration.
