Capital gains tax may scare oil and gas investors

In 2011, an upstream investor called Cove acquired interests in Kenyan exploration blocks in the Lamu Basin.

Cove also had upstream interests in Mozambique which had just discovered large volumes of natural gas. In mid-2012, Cove sold its Mozambique and Kenya assets to the Thailand Exploration and Production Company (PTTEP), making a one-time huge profit in excess of $1 billion (Sh88.7 billion).

In respect of the Kenyan assets sale by Cove, Mr Kiraitu Murungi, the then Minister for Energy complained, “This company has done absolutely nothing.

So, we cannot sit back as a government and allow somebody to trade a piece of paper for Sh3 billion. We want a share of that money to be able to transfer (the block) to a third party.”

It was clear that Cove was into speculation, monetising their assets immediately after exploration successes for a quick, opportunistic gain.

But Kenya had no policy or law to permit taxing Cove for gains made on Kenyan assets. Hurriedly, the government announced intentions to tax capital gains on all petroleum companies.

But expert opinion argued that this would equate to unfair retroactive enforcement of a non-existent law. Now, the Treasury has come up with comprehensive capital gains tax proposals that include upstream oil and gas assets transfers.

The Mozambicans on the other hand were more bullish. Although they had no capital gains law at the time, they made the Cove sale to PTTEP conditional on a 12.8 per cent capital gains tax. The government was paid about $200 million (Sh17.7 billion) tax to sign off the sale.

Across the border in Uganda, a capital gains law was already in place for many years.

In 2010, when Heritage sold its 50 per cent partnership to Tullow for $1.45 billion (Sh128.6 billion), Uganda Revenue Authority raised a capital gains demand note for 30 per cent of the sale price which equated to Sh38.6 billion.

Although this was followed by appeals and legal suits, there was no doubt on the law which was clearly applicable.

What motivates transfer of block ownership (farm-ins and farm-outs) among investors? As was the case with Cove, speculation can be a driver for sale of assets.

And this may have happened right here in Kenya where some “investors” with limited financial and technical capacity may have been allocated exploration blocks. Such speculators may already have sold out and bolted, leaving only serious investors.

There are others who search for new partners because they want to tap in more working capital and technical capacity to explore and develop oil.

Some investors (especially the larger independents) are experts at searching for and finding oil, but when it comes to high cost production development, they seek more capitalised partners. This may be what prompted Tullow to bring in Total and CNOOC into the Albertine basin in Uganda.

Then there are those companies that are undertaking corporate assets restructuring and rationalisation. This is routinely taking place everyday across the globe.

Is the proposed five per cent capital gains tax a fair level of tax? It depends on many factors.

The key one is the level of risks associated with exploration and development of resources in Kenya. It is the new investor (asset buyer) who analyses, perceives, and accepts/rejects the risks and costs of acquiring and developing exploration interests.

So far, Kenya has substantially de-risked only one specific area, the Lokichar sub-basin in Turkana where oil discoveries have been adjudged commercial.

All the other basins in Kenya remain prospective. This means that risks of not finding commercial resources in those basins abound. And we have recently seen investors plug dry or marginal holes, absorb losses and call it quits.

Kenya clearly needs to make it attractive for new “risk capital”. Capital gains tax clearly reduces flexibility to bring in new and more capitalised partners to push forward oil and gas exploration and development. The tax is potentially an extra cost.

I think it is all a question of timing and Kenya needs to adopt a philosophical approach on the subject of capital gains tax. There may be justification in delaying imposition of the tax, which is a premature disincentive to oil finding endeavours.

When oil is ultimately found in good amounts, the government has opportunities to make even more money from hydrocarbons revenues. But more oil can only come if more risk money is poured into Kenya’s upstream sector. And capital gains do not help.

If sufficient oil is ultimately found, imposing capital gains tax shall be a normal and the right thing to do. This may even prompt tax rates much higher than five per cent, and this would be on higher values of de-risked transactions. “Fatten the goat first, and a juicy roast will be the result.”

The Treasury has given the public until September 30 to present their opinions on the taxation bills. Let the investors present their case, and let the Treasury be open-minded to their submissions.

Prudence should prevail in determining the modalities and quantum for capital gains tax. We need to avoid unintended consequences of reduced upstream investments

In respect of the “windfall profits” from crude oil or natural gas sales, this is a normal practice usually detailed in the production-sharing agreements (PSA).

The tax specifically refers to unplanned increase in oil revenues due to upsurge in commodity prices, over and above the reference selling prices assumed in the PSA. The reverse can also happen when global market prices drop. Windfall taxes are more of a PSA issue than tax bill issue.

Mr Wachira is director, Petroleum Focus Consultants. Email: [email protected]