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.
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.