Tax disputes throw oil production plan in turmoil

The ongoing deadlock between government and oil companies over payment of capital gains tax and tax waivers has yet again thrust the oil industry in turmoil, scurrying the country’s hopes of joining oil producing countries from 2023 to the earliest, in 2025, but could even take longer, according to projections.

Initially, the prospect of commercial oil production starting by end of 2023 was hinged on probability that government and oil companies would conclude the Anglo-Irish Tullow Oil Plc’s sales transaction, technically known as farm down, in time, finalise the remaining agreements on the crude oil export pipeline and close Final Investment Decision (FID) by the end of this month.

A committee set up to steer FID chaired by the Energy ministry Permanent Secretary Robert Kasande and comprising various government officials had, until last month, managed to thrash out several sticky issues at hand but the tax question has now set back arrangements.
FID is an agreement on capital investments on a long-term project: when money for the project is availed and project execution commences.
First oil production, both government and oil companies say is three years from FID, which remains uncertain now.

However, government is now looking at FID by June 2020, the ongoing deadlock notwithstanding but each time the FID date shifts, so does the oil production start date.
Tullow, which set foot in Uganda in 2004 and has had several run-ins with government, including allegations of attempting to bribe President Museveni to forego taxes, premised its decision to farm down to raise money for reinvestment in development of oil fields and pipeline.

UK-based consultancy Wood Mackenzie in a financial analysis last week described the botched farm-down as “a huge blow for all partners involved, particularly Tullow” which was to receive $258m (Shs940b)—comprising cash payment and working capital adjustment—which would have strengthened the company’s balance sheet.
The consultancy firm detailed that the Tullow is at best broke, with its net-debt in the ranges of $2.9b (Shs10b) and gearing is still relatively high at 52 per cent.

To start oil production, projections show the oil companies have to invest a minimum capital of $10b (Shs36 trillion); $6.7b (about Shs24 trillion in developing the oil fields—Tilenga fields in Nwoya/Buliisa districts and Kingfisher in Kikuube, and $3.55b (Shs13 trillion) for the export pipeline from Hoima to Tanga in Tanzania.
After collapse of the farm down, Tullow said it was going back to the drawing table to further engagements with government and its partners—French Total E&P and China National Offshore Oil Company (Cnooc), to possibly try reach a middle ground on the polarising tax question.

When asked about the prospect for this option, an oil company executive said: “Insanity is doing the same thing over and over again, but expecting different results. Who knows; maybe yes, maybe not.”
In the likely event that this might delay or take longer, Tullow has the option of heading to the market to find new buyers.

However, with delays that have bedeviled the oil project and past rancorous disagreements particularly over taxes that have played out in public view, new players would be likely be cautious.
With estimated reserves of 6.5 billion barrels, of which between 1.4 billion barrels and 1.7 billion barrels are recoverable, Uganda’s oil project is by any measure attractive but the means to commercialise it remains burdensome, which partly works against Tullow’s prospects of attracting new buyers.

At stake
Mr Ali Ssekatawa, the director for legal and corporate affairs at the Petroleum Authority of Uganda (PAU), the oil industry regulator, said government has showed “absolute commitment to the earlier commercialisation plan agreed upon; from hurriedly going to the market to acquire loans for 600kms of roads and an airport to facilitate activities, to putting in place the enabling environment.

“If we had 16 points agreed on, we have two or three remaining, relating to commercial transactions. This other (farm down) transaction that everyone is talking about was not part of the production license bargain,” Mr Ssekatawa said last Friday.

“Therefore, the option of looking for financing is on the person with the licenses. Government has taken a position that this resource will be managed for value for generations, and therefore, there are certain minimum positions we must follow; any attempt to balance should satisfy both shareholder (IOCs) value and interest of our clients who are Ugandans,” he added.
The oil industry usually reacts to such developments by scaling back on activities, laying off workers, and reducing sub-contracts to service providers.

The three oil companies indicate they have jointly invested close to $3b (Shs11 trillion), so any further delay works in their disfavour but comparatively they still hold much leverage over government.
In a statement to this newspaper, Cnooc indicated that as they wait for FID, in light of ongoing developments, the company “has adjusted its overall operating strategy by, lowering costs and improving efficiency” by laying off some employees.

“As with all companies in our industry, we continually reassess our business needs and take necessary actions to ensure we remain competitive amongst our peers and ensure our long-term economic viability,” Ms Aminah Bukenya, the company’s senior public relations supervisor, said. “We take all decisions on our organisational structure very seriously, and as is our practice, we will treat all affected staff fairly and with respect,” she added.

Total E&P has so far decommissioned mostly its engineering staff in London working on the oil pipeline but if the impasse prolongs, it will likely not take long for the company to start scaling back costs in Kampala.
The company said they remain “committed to working closely with the joint venture partners and government to minimise the potential impact of the termination of the Tullow transaction on FID and delivery of the project.”

Local service providers, who were gearing to cash-in on the lucrative tenders during the Engineering, Procurement, and Construction (EPC) phase will likewise be hit hard by the state of affairs, tales of defaulting on loans, businesses folding, and service industries like hotels hit by reduction in clients, are widespread.

According to the Association of Uganda Oil and Gas Service Providers (AUGOS), at least 30 companies have already folded owing to delays of the past months as government and oil companies deadlocked on oil pipeline/farm down negotiations.
Mr Emmnauel Mugarura, the AUGOS’s chairperson, said people have been investing, borrowed and built capacity to position themselves “so this development is hell for them.”

“It means that all efforts— time and money have been put to waste. What is even more puzzling is they do not know what is next whether government and oil companies will go back to the drawing table, or not,” he added. Payments in form of taxes to the Petroleum Fund, where revenues from all petroleum-related activities is deposited, have in recent past been central in nourishing government’s spending appetite.
With the last publically stated withdrawal of Shs200b to finance the budget for the last financial year 2018/2019, the Fund certainly requires replenishment.

The deadlock
Tullow’s decision to farm down came five months after government awarded eight production licences; five to the company, and three to Total E&P.
Issuance of the production licences, after the oil companies demonstrated fully that they understood the oil fields in which they operate as detailed in the technical submissions, took long which government blamed on the companies submitting unsatisfying information which sparked off back and forth shuffling.

Earlier in 2014, government and IOCs had signed and MoU detailing a commercialisation plan for Uganda’s oil, including a crude oil export pipeline, and a refinery.
“We gave them licences in 2016 on understanding that they have financial and technical capacity to move forward the project,” Mr Ssekatawa added.

The current deadlock relates to a tax amounting to $185m, which is approximately 30 per cent of the $617m (Shs2.2 trillion) cost oil or costs previously spent by Tullow on exploration and appraisal activities that Total E&P and Cnooc were supposed to inherit.

In January 2017, Tullow announced intent to sell 21.57 per cent of its interest in each of the three exploration areas to Total E&P. Each company, Total E&P, Cnooc, and Tullow, owns 33.33 per cent shares in each of the three exploration areas 1,2 and 3.

The total consideration for the transaction was $900m (Shs3.4 trillion), structured in two ways; $200m (Shs722b) in cash consisting of $100m (Shs361b) on completion of the transaction and $50 (Shs180b) million at both FID and First Oil, and secondly $700m (Shs2.5 trillion) in deferred consideration which would be used by Tullow to its 11 per cent equity in developing the oil fields and pipeline.

The farm down transaction was upended in March 2017 after Cnooc exercised its preemptive rights, a key clause in the Joint Venture agreement they operate, to acquire half of the shares floated to Total E&P which sparked off the back and forth haggling, including payment of Capital Gains Taxes (CGT).

CGT is a tax on the profit when you sell something (for example an asset) that has increased in value.
Tullow, offered to pay only $85m (Shs310b) on premise that part of the money $700m was going to be reinvested in the development phase while government, which didn’t buy the argument, insisted on a sum of $167m (Shs609b) assessed by Uganda Revenue Authority (URA).

The wrangling over the CGT appeared concluded in January this year following the first visit by Total’s chief executive and board chairman Patrick Pouyanné who, to break the impasse, offered a settlement contribution of $82m (Shs300b) split with Cnooc in exchange for Tullow’s contemporaneous rights and obligations” over its shares and assets.

PAU and URA put the spanner in works, arguing that full CGT is mandatory on such transactions—and there is already precedent when Heritage sold to Tullow and when Tullow sold to Total E&P and Cnooc—so the conditional offer for what is mandatory is null.

Also, Total E&P and Cnooc want a tax waiver of $185m (Shs673b) off the cost oil amounting to 617m (Shs2.2 trillion inherited from Tullow. Government says in effect the companies are paying $82m to benefit from $185m, a gain President Museveni has also rejected. PAU and URA also contend that this principle did not apply in the 2012 farm down when Tullow sold to Total E&P and Cnooc.

Total E&P and Cnooc are also upset with provisions in the Income Tax Act—which sources say were targeted at Heritage (exited) and Tullow (in exit mode), which they describe as “harsh.” The Production Sharing Agreements (PSAs) signed between government and the oil companies spell out the type of costs the firms can recover from government and those which are unrecoverable.

Recovery costs
Although much of the provisions of the PSAs remain unknown, after government declined to make the contracts public, officials have spoken openly about cushioning the oil companies through a provision that allows them to recover overhead exploration expenditures where oil is found.
Under the arrangement, a quantity of the oil pumped out when production begins—technically called ‘cost oil’—will be a share for the oil companies to recover money they invested.

The costs, according to PSAs, are staggered over a period of 25 years.
Then, in the 2010 amendments to the Income Tax Act government front-loaded payment of corporate income tax at commencement of oil production in spite of projected low early returns, and in the 2017 amendments put a cap on.

It also introduced a provision for such costs to be carried forward, which the oil companies argue that given that production will start with low volumes, they might not to be able to recoup their money within the stated time.

URA’s assistant commissioner for large tax payer’s office, which handles petroleum matters, Mr Sirajje Kanyesigye, described this as a “post (farm-down) transaction” issue, adding: “I am not aware of any assessment of $185m because our discussions so far have been on Capital Gain Taxes.”

“For us we are implementers of the law and have to implement and safeguard it the way it is. But i believe, like they said they were going to have engagements among them, we will wait,” he said.
Oil companies’ officials, however, justified their opposition on taxing cost oil, arguing that the industry is rife with uncertainties, and introducing a cap on how much they can recover instead increases risks.

“Just like government does forecasts for revenues, they keep going up and down based on the prevailing circumstances. If that provision remains and we begin production when the circumstances are not conducive, as they have been since 2014 when oil prices fell from the $100 mark and hasn’t gone back, it means bleak economics,” a company executive said.

Since Uganda announced commercial oil discoveries 13 years ago, no single issue has been prickly as the taxation regime. Government has in the past decade amended the tax laws at least seven times.
Previous tax disagreements have been arbitrated in court both in Kampala and in London, to government’s advantage.

Government officials say they have advised oil companies to seek court redress if discontented with its position but they have declined.
This stance by both sides has often resulted in protracted negotiations and shuffling back and forth, culminating in shifting oil production start dates several times—from 2009 to 2012, to 2016 to 2020, and eventually to 2023; dates which the oil companies did not committed to.

MAGUFULI WEIGHS IN
Last Friday, Tanzanian President John Magufuli advised Uganda to allow some short-term tax sacrifices for bigger benefits, including the $3.55b (Shs12.9 trillion) oil export pipeline. Mr Magufuli said in doing business, there is sharing and giving. “You have to lose a little to gain more,” he said.

In a rejoinder, President Museveni echoed what he has said before, and told oil company executives that: “This oil has been here: it has been in the ground for 2 million years. It will come out.” “Be sure that the government of Uganda will not be found wanting in implementing this project,” he added. The President’s comments, underlined both government’s unwavering stance, and the cloud of uncertainty.

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