The spotlight is currently on Africa for all the right reasons — its resources. In recent times, there have been frequent and substantial new finds of oil and gas in particular.

These rich oil fields and prospects for further discoveries have transformed the continent into an important player and a key “target” in global oil production and resource extraction.

A joint study by the African Development Bank and the African Union on oil and gas in Africa shows that over the past 20 years, oil reserves have grown by over 25 per cent, and gas reserves by over 100 per cent. Oil production on the continent is expected to continue to rise at an average rate of six per cent per year in the foreseeable future.

More than 90 per cent of Africa’s oil production comes from Libya, Nigeria, Algeria, Angola and Sudan. Proven natural gas reserves are concentrated in four countries — Algeria, Egypt, Libya and Nigeria — which represent 91.5 per cent of Africa’s reserves.

Large deposits of natural gas have been identified in Mozambique and Tanzania; significant oil deposits have been found onshore in Uganda and Kenya, and offshore in the western part of Ghana.

In East Africa, gas finds take the lead, and with hopes high for more oil discoveries along the shores of the Indian Ocean, the prospects for the region seem promising. Forecasts indicate that will emerge as the world’s most exciting new gas exporting region in the next decade.

Advances in technology have encouraged exploration in previously unexplored acreage on different parts of the continent culminating in the emergence of the so called “new kids on the block” such as Uganda, Ghana, Kenya, Mozambique, Tanzania and South Sudan.

The discoveries made to date have been from relatively few wells, so there could be a lot more oil and gas that is yet to be discovered. It is envisaged that Mozambique could develop a liquefied natural gas (LNG) sector on the same scale as Algeria, which would involve capital investment of tens of billions of dollars.

Considering the current uncertainties about global energy supply, the policies of consumer countries (especially with respect to nuclear and other alternatives to oil and gas), and expected future global economic growth and advances in development, there is a need for the “new kids on the block” to establish their position by putting in place an enabling framework and developing strategies for future supply adequacy.

UGANDA: A case of throwing out the baby with the bath water

In East Africa, exploration activities have been stimulated by the enabling environment created through the existing legal framework on petroleum exploration, the taxation regimes and the production sharing agreements (PSAs) signed between the international oil companies (IOCs) and governments.

However, in recent times, there have been a number of policy and legislative changes that have brought into question governments’ commitment to the industry, and negatively impacted on exploration activities resulting in some cases in cancellation of drilling activities.

In Uganda, for example, IOCs have recently been dealt two blows. The first is their de-registration from tax exemptions. This meant that drilling a well in Uganda became 18 per cent more expensive, and most IOCs had to reschedule their plans.

The second is a ruling by the Tax Appeals Tribunal — in which the legitimacy of PSAs signed with the Ugandan government was questioned — on farm-in transactions. In its ruling, the tribunal concluded that a government ministry exceeded its powers by giving exemptions in the PSA.

READ: How URA-Tullow tax row could affect oil, gas production in Africa

Where one IOC invites another to participate in its exploration activities, it is said to have farmed-out, while the IOC acquiring the interest is said to have farmed-in. An IOC can enter into a farm-out agreement with another IOC if it wants to maintain its interest in a block but needs to reduce its exposure to risk associated with the exploration activities, or if it doesn’t have the resources to undertake exploration activities. Typically, the IOC farming out would be reimbursed its past costs by the IOC that is farming in.

The additional 18 per cent on the cost of drilling in Uganda, the relatively low ratio of drilled wells to viable discoveries and the dark cloud of uncertainty hanging over PSAs explain the reduced activity in the oil sector in Uganda . In short, Uganda is headed in the wrong direction.

KENYA finally getting its ducks in a row

With potential discoveries of commercial oil reserves onshore and offshore, Kenya appeared to be headed in the wrong direction.

However, after listening to the IOCs, understanding the unique aspects of the industry and perhaps realising the negative consequences that policy and legislative changes would have, the country now appears to have found its bearings.

Kenya had introduced a 10 per cent tax on farm-out transactions. This meant that in addition to reimbursing the person/company farming out a proportionate amount of his past costs based on the interest acquired, the person/company acquiring the interest was required to factor in the additional cost.

Exploration activities are risky and expensive, which is one of the reasons governments invite IOCs to undertake them. IOCs in turn enter into farm-out agreements to mitigate risks and acquire funds necessary for exploration activities.

In farm-out agreements, the IOC invites the person farming-in to participate in the impending risk by assigning him an interest in the block in return for the conduct of, or payment for drilling or testing operations on that acreage. Imposing the 10 per cent tax made farm-out agreements more expensive, and Kenya unattractive.

Kenya has proposed to overhaul its legislation relating to the taxation of upstream, midstream and downstream operations. The proposed changes, which are supposed to take effect from January 1, 2015, seek to harmonise the provisions in Kenya’s Income Tax Act with those in the PSAs that the government has signed with IOCs.

READ: Kenya’s proposed laws on exploitation seek to maximise future taxes

Once the proposals are enacted, tax will be imposed on any gain that is realised from farm-out transactions. In addition, where there is a direct or indirect disposal of shares in an IOC having an interest in Kenya, the net gain in such transactions will be subject to tax in a manner similar to a farm-out transaction. The proposed law also clarifies how future work obligations will be treated for tax purposes.

Not surprising, the additional 10 per cent cost has contributed to a decline in drilling activities in Kenya, and since 2010, there have been no farm-out transactions. However, it is anticipated that the revamped Ninth Schedule under the Income Tax Act will help spur activity in Kenya’s oil and gas sector.

It is also commendable that though Kenya enacted a new VAT Act, favourable provisions that had been enacted to encourage growth in the sector were retained.

TANZANIA, a case of shooting itself in the foot

IOCs operating in Tanzania have had their fair share of hiccups ranging from enforceability of their PSA provisions to interpretation of the law.

One such example is the confusion created by the Tanzania Revenue Authority on the application of withholding tax on payments relating to persons living outside Tanzania for services that they performed while in the country.

This provision is aimed at bringing Tanzanian non-residents — who provide services (and consequently earn income from Tanzania) and then leave without paying taxes — into the tax net.

Unfortunately, Tanzanian tax authorities have interpreted withholding tax on service fees from a payment perspective as opposed to source perspective as required by the wording used in the legislation.

TRA contends that service payments have a source in Tanzania (and are, therefore, subject to the 15 per cent withholding tax). They have disregarded the source rules, which require the services to be rendered in Tanzania by a non-resident for withholding tax to apply.

This erroneous interpretation by the TRA, which the tax adjudication bodies have acquiesced, has generated confusion as far as services are concerned, and left the IOCs between a rock and a hard place with regard to paying their sub-contractors for services rendered. The IOCs services contracts with their non-resident service providers are now 15 per cent more expensive.

IOCs have also expressed their concerns about the proposed VAT Act 2014, which is to be tabled before Parliament later this year. The Act proposes to repeal the current VAT legislation and introduce a new law that seeks to restrict tax exemptions.

While goods and services procured by IOCs in relation to exploration activities currently enjoy VAT exemptions, one of the changes proposed in the VAT Act 2014 is restricting the exemption to only goods imported for exploration activities. The oil and gas sector will certainly be affected negatively by this and other changes in the proposed VAT Act 2014.

In addition, the removal of VAT relief on capital items with the IOCs planning an onshore LNG processing facility has meant that IOCs are currently re-evaluating the economic dynamics of their future investment decisions.

While ideally the VAT should not be a business cost, the uncertainty in the turn around time between lodging VAT refund claims and receiving the money from the government means that the IOCs have to factor in unnecessary cash-flow costs in their financial modelling for exploration activities and the LNG processing facility.

The misunderstanding about farm-out transactions and whether they constitute a sale of shares or assets has manifested itself in Tanzania with the TRA adopting the position that a farm-out transaction constitutes a disposal of an investment (shares) and have gone ahead to demand 30 per cent tax on a couple of farm-out transactions.

The motivating factors for a farm-out agreement include drilling so as to fulfil PSA continuous development clauses, sharing risk, sharing of geological information etc.

Seeking to tax farm-out transaction discourages IOCs from farming-in, which means that exploration campaigns are rescheduled or cancelled altogether. Tanzania should borrow a leaf from Kenya regarding the treatment of farm-out transactions.

The Tanzanian oil and gas industry has been relatively calm and stable, and the fruits of this can be seen from the planned joint LNG facility, which is currently in the planning stage.

However, the waters seem to be getting rough as evidenced from the policy and legislative changes and also from the feedback from the fourth licensing round.

The fourth licensing round was based on the 2013 Model PSA, and there were seven deep-sea offshore blocks and one in Lake Tanganyika on offer. While the results of the licensing round are yet to be released, the feedback is that the 2013 Model PSA is unfavourable, which would explain why there were no bids submitted for four offshore blocks, and the blocks where bids were submitted only received conditional offers.

Even though there has been a lot of buzz about offshore gas discoveries, Tanzania cannot afford to be overly bullish about them. Unfavourable PSA terms will deter prospective interest from IOCs, particularly with regard to offshore exploration, which is more expensive and risky.

Lesson from Papua New Guinea

East African countries could borrow from Papua New Guinea the kind of policies to create an enabling environment that have helped the country export its first LNG cargo ahead of schedule.

To be fair, discoveries in Papua New Guinea were made almost 30 years ago and the process of putting up an LNG facility has been plagued by challenges, most of which were outside the country’s control. However, once everything was in place, it took seven years between initiation of an LNG feasibility report (in 2007) and the first shipment of LNG (this year).

It is disappointing and perhaps difficult to comprehend that the oil discoveries in Ghana and in Uganda were made at around the same time. Ghana is now an exporter of oil while the dynamics in Uganda have taken a turn for the worse, and it is still uncertain whether international oil companies will want to bring their projects to fruition.

No business person seeks out the most expensive, unpredictable and unstable place to set up shop. Retrogressive and uninformed legislative changes, refusal to honour agreements and adopting policies that paint the region as unstable and unpredictable only delay such projects, and could make capital-intensive oil and gas related projects economically unviable for the region.

Joseph Thogo is a senior tax manager with Deloitte East Africa based in Tanzania. The views expressed here do not necessarily represent those of Deloitte.