Sunday July 20 2014

Can government give with one hand, take with other?

Oil experts at an oil exploration site in Hoima i

Oil experts at an oil exploration site in Hoima in 2011. URA last week won a case against Tullow oil. file photo 

By Emmanuel Mugarura

On October 8, 2001, Australian-based Hardman Petroleum Pty Ltd, and the UK-based Energy Africa Ltd entered into a Production Sharing Agreement (PSA) under which they were granted exploration, development and production rights in Exploration Area2 (EA2). It was signed by Ms Syda Bbumba, the then minister of Energy and Mineral Development, for and on behalf of Uganda the government.

Article 23.5 of the PSA for EA2 allowed the oil companies exemptions on capital gains tax/income tax, which exemption was subject of the tax dispute. Last week, the Uganda Tax Appeals Tribunal ruled that the said exemption is invalid under the tax laws of Uganda and that the minister acted outside legal authority.

The exemption was granted to the oil companies to attract investment into the then virtually non-existent oil and gas industry - characterised by small exploration players such as Hardman, Energy Africa and Heritage Oil.

The exemptions were granted for EA2 at a time when there were no exploration competences in Uganda and almost no international risk capital for investment in a country that had no previous history of oil.

The oil exploration business is a highly risky business in technical terms, with exploration success rates averaging 25 per cent globally, meaning that nearly 75 per cent of all investment in exploration ventures leaves exploration companies empty handed and writing off losses in hundreds of millions of dollars.

This explains why most exploration projects are undertaken as joint ventures - so as to spread the financial risks, which could otherwise wipe out a single explorer investing without partners.

Risk-sharing partners
For this reason, it is very common in the industry for initial license holders to sell part of their interests or ‘farm-down’ to other players who come in as risk-sharing partners. The farm-downs result in a profit for the seller, against the price paid to acquire and develop the asset, called a ‘capital gain,’ which most governments seek to tax.

Where there is scarcity of technical expertise, investors and risk-capital, governments often grant Capital Gains Tax (CGT) exemptions to international oil companies to give them an additional incentive to take the risk of investing hundreds of millions of dollars that might be wiped out, as indeed happened to Neptune Petroleum and Dominion Petroleum, who burnt their fingers with zero per cent exploration success rates in West Nile and south-west Uganda.

Tullow, Cnooc and Total have had an 84 per cent exploration success rate.

The CGT exemption was granted as an incentive to attract the oil companies as well as the big investment needed to realise Uganda’s oil dreams.

Indeed, significant players have since been attracted into the sector such as Tullow Oil which invested $1.5 billion (about Shs4 trillion) and bought out Hardman, Energy Africa and Heritage, then subsequently farmed down at $2.9 billion (about Shs7.5 trillion) to China’s Cnooc and France’s Total E&P.

Tullow inherited a CGT exemption granted to the earlier license holders by then Energy minister Syda Bbumba, who acted with the consent of Uganda’s Attorney General.

The Uganda Revenue Authority (URA) took the position that the Energy minister acted outside her powers by granting the Tullow exemption via the PSA instead of via tax laws managed by URA and the matter ended up with Tullow dragging URA to the Uganda Tax Appeals Tribunal.

By ruling that the said exemptions/incentives were illegally given to the oil companies, the Tax Appeals Tribunal has given a short term victory to URA but in terms of investment climate, the ruling casts a dark shadow over the reliability of Uganda’s image as an investment destination and the reputation of government as a business partner that upholds contracts it has entered or keeps promises it has made.

The picture drawn by this ruling is one in which government effectively short-changed international investors.

It used a tax exemption to convince them to come in and risk their capital - which investment government was not able to finance, but now that they have delivered their end of the bargain and the oil finds have been confirmed, government has gone back on its contractual commitments under the PSA.
The other contentious matter concerns the Capital Gains Tax payable for Exploration Areas 1 and 3 where Tullow does not have an exemption. For these contracts, Tullow’s position was that CGT was fully payable.

Tullow had, in fact, sided with the Uganda government against Heritage who had tried to argue that CGT was not payable in Uganda but lost the case.

At the Tax Appeals Tribunal, Tullow argued that URA had disallowed deductible costs incurred in the development of the asset and that URA was therefore taxing more than the net ‘gain’ taxable under CGT laws. The Tribunal ruled in favour of URA.

Particularly for Tullow Oil, the ruling is bound to leave a bitter taste given that Tullow came in when no major international players were interested in risking their capital.

The tax demand by URA and now the ruling will hit Tullow Oil in the face and certainly create great caution possibly even at Cnooc and Total, about investing several billion dollars in a country that does not uphold contracts entered by its government. This should raise the concern of all stakeholders who hope to see first oil.

The upstream production project that the three oil companies are developing requires an $8 billion (about Shs21 trillion) investment, excluding the refinery and the pipeline, which will raise the investment to approximately $15 billion (about Shs40 trillion).

An investment of this amount, worth more than half of Uganda’s GDP, usually requires governments to sign Production Sharing Agreements (PSA’s) containing specific stabilisation clauses for the fiscal and tax regime, in order for large investors to choose such countries over more risky markets.

Uganda’s PSA’s contain stabilisation clauses, which have not been respected by the government and URA.

The idea that government can cherry-pick on which aspects and clauses of the PSA it can uphold or disallow creates serious questions around the trust international investors can have in the government and raises a major sanctity of contracts risk for major infrastructure investors.

If government is at liberty to start disrespecting selected parts of PSA’s, can the international oil companies be sure that the contractual provisions on revenue-sharing will be respected? The revenue-share is core to their reason for investing.
Once confidence around such a core matter becomes debatable, can Ugandans remain sure that the oil project will be financed by nervous investors and can Ugandans remain sure that the oil will come out of the ground?

The ruling poses serious questions around the sanctity of all other investment contracts signed by government with other international investors, especially those with earn-out or revenue share models, structured over longer periods.

This could eventually affect the trust, especially given that the affected ministry - Energy - has over the last decade entered into a number of long term contracts with companies involved in electricity production and is trying to kick-starting the mining industry, alongside the game-changing oil industry.

The government’s share of future oil revenues has a present value estimated at $50 billion (about Shs130 trillion) which can only be realised in a stable partnership with international oil companies bringing in the expertise and financing.

The ruling also brings into disrepute the seriousness of Uganda’s legislative process and how its Cabinet works.

If one government piece of legislation – authorising the Energy minister to negotiate and sign a PSA - can be played off against another piece of government legislation, a tax law - all passed by Parliament and assented to by the same President, then something is seriously amiss.

In this case, one wonders, of the two - tax laws or energy laws, which one is superior and how is a foreign investor expected to assess them?
Tullow has announced that it is going to appeal the ruling in the High Court. The same PSA also commits both parties to international arbitration in the event of disputes.

The arbiter’s ruling is final. In fact, Tullow has already exercised this option and at the end of last year, dragged the government of Uganda to the International Centre for the Settlement of Investment Disputes (ICSID).

ICSID is a neutral international arbitration institution which facilitates arbitration and conciliation of legal disputes between international investors.

The ICSID is a member of the World Bank Group and is headquartered in Washington, DC, United States. It was established in 1966 as a multilateral specialised dispute resolution institution to encourage international flow of investment and mitigate non-commercial risks.

Uganda is not the first country to try and take away with the left hand, what it has given international investors with the right hand.

At least 13 third world governments have won similar cases in their home courts but without exception lost all of them at the ICSID and similar arbitration tribunals which do not accept that the financial and legal consequences of uncoordinated government can be rebounded on unsuspecting foreign investors who come in assuming that a government speaks with one voice.

There are 13 precedents in similar cases at ICSID where all the rulings were in favour of international investors against governments. URA’s victory at the Uganda Tax Appeals Tribunal might therefore be short-lived and it is unlikely that they will eventually get the $407 million (about Shs1 trillion) paid into government’s accounts.

The government ought to redeem its reputation by resolving this matter through negotiations and restore the sanctity of its contracts if Uganda is to remain a prime investment destination, with our oil being realised and benefiting the citizens.

The author is head of Secretariat, Association of Uganda Oil & Gas Suppliers