Kenya is seeking more revenues from oil and gas explorers with proposed regulations that could see firms pay higher taxes and change the formula for calculating proceeds to be earned by government.
Draft regulations prepared by two consultants hired by the government and the World Bank — US-based Hunton & Williams and British firm Challenge Energy — propose a change in the profit-sharing formula and introduce capital gains tax as part of the conditions explorers will commit to before they are licensed to operate in the country. This will see companies pay taxes if involved in share transactions between non-Kenyan entities.
Also proposed are tough transfer-pricing rules to seal tax avoidance loopholes. These will also prevent double taxation that could scare away investors. Currently, Kenya has a broad transfer-pricing regime with no specifics on the oil and gas sector.
Transfer pricing occurs when locally registered subsidiaries are paid an artificially low price for their products by the parent companies registered overseas, which means the former pay artificially low taxes, while the latter profit from the difference.
Kenya introduced amendments to the Income Tax Act under the Finance Act 2012, under which oil companies, mining companies and mining prospecting companies will be subject to a 10 per cent withholding tax on the disposal of shares and assets.
The Bill does not define “oil companies,” a loophole the new proposals are hoping to seal. Under the proposed changes, capital gains tax was not included in the PSC signed with the oil firms meaning that legally, a sale of shares by a parent company (a non-Kenyan entity) to a buyer (also a non-Kenyan entity) does not attract a tax.
This means a company can transfer its indirect interest in a Kenyan entity without incurring capital gains tax on the profit thus made. Capital gains are not taxable in Kenya (while there is capital gains legislation, it has been suspended since 1985).
The consultants argued clarity on capital gains was likely to reduce the potential for high-profile tax disputes, and permit investors to gauge the impact of the tax regime before committing to a transaction.
In December, it emerged that the Kenya Revenue Authority (KRA) had written to Cove Energy, the UK oil explorer, demanding up to Ksh3 billion ($35.29 million) in taxes after it sold five off oil blocks in Kenya following its acquisition by a Thai company. Kenya was demanding a cut of the deal that saw assets in Kenya and Mozambique sold to Thailand’s PTTEP in August for Ksh153 billion ($1.9 billion).
Oil industry experts said the aim of the tax was to charge the upstream oil and gas companies, borrowing from the experience of Uganda, which through its capital gains tax raised a tax bill of Ksh39 billion ($450 million) when Heritage Oil sold its shares in oil and gas fields to Tullow Oil.
“Capital gains tax should not apply if a prospecting company sells part of its stake to another firm with a view to raising funds to accelerate exploration work or getting a strategic partner who is financially well endowed,” said Mwendia Nyaga, the lead consultant at Oil & Energy Services.
The regulations are the latest in a raft of policy changes in the wake of increased exploration and mining interest. Canadian firm Africa Oil and partner Tullow Oil have discovered oil in their license blocks 10BB and 13T but still need to confirm commercial quantities.
Kenya’s mining industry has largely thrived on secret contracts between government officials and multinational mining companies, sometimes attracting the wrath of communities and civil society groups over allegations of corruption and tax evasion.
The proposed reforms are expected to calm growing uncertainty in the oil and gas business as to whether, in the event of commercial oil and gas production, exploration companies will recoup their investment, and what percentage of the realised revenues the governments will demand.
Kenya, like its neighbours Uganda and Tanzania, is turning into a hotspot for oil, gas and mineral exploration, attracting millions of dollars in investments, but oil executives cited governments’ unpredictability as the biggest threat to doing business in the region.
“The biggest threat to business is governments shifting the goal posts. In our game, everything is a risk. Tax regimes and laws are changing overnight. To us, this is as risky as drilling a dry well,” said Tim O’Hanlon, Tullow Oil’s vice president for African business in a previous interview with The EastAfrican. “Sanctity of contracts is the only fixed point in a moving world — if it changes after you have taken the risk, that’s a nightmare scenario,” he said.
The current model of calculating government revenue based on the daily rate of production (DROP) in production sharing agreements (PSCs) will be replaced by the ratio (R-factor) of the firm’s cumulative hydrocarbons revenues to total costs.
Under the current arrangement, the government’s share is calculated from the daily rate of production of profit oil, not of total oil, and the contractor’s income tax liability is settled from the government’s share of production.
Despite the fact that Kenya has already discovered gas, the model of production sharing agreement is silent on how gas is to be commercialised. The new proposals seek to combine both oil and gas dealings into one production sharing framework.
The move aims to ensure government revenue increases to correspond to hydrocarbons output of licensed firms with production costs and total revenues realised being used to compute the state’s share after a discovery.
The R-factor balances taxation with project profitability and ensures the state receives a significant share of money.
Ministry of Energy officials said the intended shift to R-factor is meant to ensure government revenue rises progressively with an increase of hydrocarbons production while Kenya remains competitive and attracts investment.
“The R-factor is meant to ensure the fiscal regime remains stable as the state does not need to alter terms with the investor if the project turns out be more or less profitable than expected,” said a senior official in the Ministry of Energy.
“The current mechanism which is based on total output is less progressive as it does not take account of price of oil or costs while R-factor eliminates separate PSCs for oil and gas” said John Beardworth, Hunton’s lead consultant.
“Kenya has had a long exploration history with few discoveries, which increases the risk for investors due to greater uncertainty. With a progressive R-factor, if a discovery is not made, the investor’s loss is limited to costs incurred during the exploration phase,” he said.
The R-factor has been successfully adopted in Mozambique and India.