If the country gets too greedy and imposes an excessive tax burden, an inverse effect occurs – investors abandon their projects and corresponding budget revenues decline. Problems arise when the government forgets about, fails to take care of investors and even worse, when investors are abused and taken advantage of, thus losing investor trust and further investment.
The current situation in Ukraine is a stark example of this.
We’re all well aware of the current financial state of Ukraine. Years of corruption and incompetence have led for the need to restore the country’s budget through shortsighted reforms and appeals to “save Ukraine” as, “Everybody in the free world should be doing more to help Ukraine.”
Ukraine thus has imposed exorbitant taxes on local oil and gas producers – 55% on natural gas produced out of wells above 5,000 meters depth, and 28% on wells deeper than 5,000 meters. These punitive taxes have already forced a number of investors to pull back and leave the country.
The International Monetary Fund called for recovery of the damaged Ukrainian gas production industry and restoration of the investors’ confidence in the Ukrainian government. In it’s shortsightedness and inexperience in running a country, the new government has not only deterred investment in the sector but has critically damaged the strategically critical energy security and independence of Ukraine.
As investment continues to decline in the sector, gas and coal supplies from Russia increase. IMF experts believe that in order to maximize the budget revenues in the long term, the government should first of all balance its tax policy and build a strong motivation for the investors.
Competing for the investors
Investors, as the government is painfully beginning to realize, don’t invest to save countries. Patriotic appeals fail. They invest to make money for investors. The only thing that motivates investors is reasonable, transparent and stable investment regimes with rules that are more attractive and reliable than those offered in other countries.
This is not only about taxation.
Ukraine’s investment rating is still weak and non-competitive in terms of all components that are of a great significance to the investors (i.e. transparency, regulatory policy, protection of property, etc.).
For example, now Ukraine holds only 96th position in the World Bank’s Doing Business rank (out of 189 economies), while its neighbors Bulgaria and Romania are included in the top 50 countries in the world (38th and 48th positions respectively).
The taxation regimes in these countries are also liberal and favourable: in Romania investors pay reasonable royalties calculated on the basis of the production volumes, in Bulgaria, depending on the payback of investments. The tax rates do not exceed 28%.
It is clear that with current draconian rates of up to 55% of the gas price, Ukraine is not able to compete for investments with its neighbors. At the same time a lower tax rate is not the only factor of importance for the new taxation model in Ukraine, as it should take into account a number of other aspects.
Varying costs of production
As a “mature” gas producing country, Ukraine has different reserves and deposits by their types: large and small, old and newly discovered, conventional and unconventional, deep and shallow. It is absolutely impossible to come up with one or two general rates of gas production tax that would equally treat investors in the fields of given variety and complex geology. In this context, the government’s traditional approach to link the tax rates to only depths of production wells cannot withstand any criticism.
When arguing about the private producers’ cost of gas production and rate of return on their projects, state fiscal officials in Ukraine are for some reason still reluctant to recognize simple facts: that the geology risks, exploration, seismic and service costs vary from one project to another, but all have direct impact on the amount of investments required to take gas out of the ground. A good tax regime should recognize these differences and allow for a corresponding and reasonable rate of return.
Next steps to take
In 2014, the Parliament adopted a number of important amendments to the tax ode of Ukraine. The new rules provide for change in the main accounting principle for corporate income tax accounting -t he taxable profit will be determined under Ukrainian statutory or International Financial Reporting Standards.
The government’s next step in the right direction could be adoption of the official accounting standards for oil and gas industry. Absence of the clear and transparent rules led to a variety of different policies developed by the companies, but then challenged by the tax authorities.
A common financial reporting language based on IFRS would enable the subsoil users to achieve greater consistency and transparency and should help the government to have a consistent approach to administering and applying the tax.
Finally, the new regime should also account for the capacity of the Ukrainian tax authorities to administer the suggested taxation model.
The IMF repeatedly called for introduction of the so-called “R-factor” (which is calculated as a ratio between the investor’s revenues and the investments in the project) – the higher the payback is, the higher the tax rate should apply to a company. Although this approach corresponds to the best international practices, administration ofsuch taxes requires a special expertise and additional capacity of the country’s tax authorities. At the same time lack of understanding coupled within adequate preparation could result in an administrative “bottleneck.”
Given this background we see implementation of R-factor model of taxation system (being a complete novelty in the Ukrainian tax system) as a very questionable measure in the current reality in Ukraine, unless donor’s funding is provided to ensure sufficient institutional capacity, which given the tight timeframe, also does not seem feasible.
Government’s position
The Ukrainian Government has repeatedly claimed that one of their final and irrefutable requirements is what they call a ‘neutrality’ of the new taxation model. Neutrality in the language of Ukrainian government means that any new model of oil and gas taxation by any means must not affect the level of revenues or result in any losses for the state budget in the coming years. That basically means that from the government’sperspective the level of fiscal pressure on the industry should not change at all!
Needless to say that this is a shortsighted approach, which would not motivate any investors to invest. The current punitive tax regime imposes anexcessively high tax burden without offering meaningful incentives forinvestment. While in the short term taxrevenues may increase, in the long run the gas production will drop and the government’s revenue stream out of royalty tax on gas production would dry up and the energy security gap will widen.
Moreover, the current royalty tax is levied on the gas sales price (not even company’s profit), which is ultimately manually fixed by the energy regulator, often with time lags and disconnect with the latest market price.
The government explains that the expected budgeted revenue from the royalty tax was fixed in the state budget for 2015 on the basis of the currency rate of Hr 21.7/$1 and the forecasted average price of the imported natural gas of maximum $270 per 1,000 cubic meters. These assumptions look rather weak and uncertain, as the effective figures have already gone out of line.
Starting from February, the official currency rate has already exceeded Hr 22.5/$1. The average price of the gas imported in Q1 amounted to $332 and it is not expected to be lower than $285 per 1,000 cubic meters in 2015 in average. This means that the state budget would receivemore revenue from the royalty tax than it was supposed to, but even knowing so the government just does not want to loosen the grip on the industry.
As a result the private gas producers are suffering significant losses and have no choice, but to reduce their capital expenditures and suspend any investment and work programmes to offset the impact of higher production taxes. The new taxation model should remove these distortions, false or vague assumptions. To make it fair the taxes must be linked solely to the market price of the natural gas (for example – the price of the imported gas) and ideally paid only after the gas is sold by the producer.
Conclusions
The new taxation model for oil and gas sector in Ukraine should find a balance between stable and gradually growing budget revenues and encouraging the investors to invest more into the country’s industry. In this respect a key to success of the tax reform is the government’s willingness to accept compromises and to take a long-term approach. The dialogue between the state and the private sector, which has been sporadic at best, will facilitate the exchange of opinions and understanding of expectations and international standards among the different groups. The Ukrainian government, if it truly wants to be reformist and address investment and energy security, should really take decisive and immediate steps to restore the investors’ confidence and trust, ensure stable and encouraging investment conditions, and ultimately restore growth of domestic gas production.
Robert Bensh has more than 15 years of experience leading energy and resource companies in Ukraine and more than 25 years of experience in the energy sector. He is the managing shareholder of Leadville Resources Inc, and the managing partner of Pelicourt LLC., a private equity firm focused on the energy sector in Ukraine and eastern Europe.
