Lagniappe

 

 

Oliver L Campbell : Windfall profit

 

Call it a sudden, unexpected or windfall profit--but how do you calculate it?

The Venezuelan tax authorities are looking at how they can tax the oil companies that make a “ganancia súbita” which, in Spanish, translates as a sudden or unexpected profit. Its English version of a “windfall profit” has a different connotation of good fortune or a lucky break but is the same thing--the intention is to tax the unexpected profits arising from the jump in oil prices.

A government spokesman recently justified this tax because he said it affected the state company PDVSA just as much as its partners in numerous joint ventures. However, this argument does not hold water because any increase in income tax that PDVSA pays forms part of the government take which passes directly to the Venezuelan tax authorities. But the situation with its partners is quite different because, for them, the extra tax burden is a cost which reduces the net profit of the joint venture and so the amount of dividends they can receive.

A simple example, assuming PDVSA holds 60 percent, and its partners 40 percent of the shares, will show this is so.

Joint Venture
Figures in millions of US$

	Normal	Extra Tax
Income before royalties and income tax	10.000	10.000
Royalties*	4.000	4.000
Income before income tax	6.000	6.000
Normal income tax*	3.000	3.000
Additional tax on excessive profits*	-	1.000
Net income	3.000	2.000
Net income 60% PDVSA	1.800	1.200
Net income 40% Partners	1.200	800
Government take*	8.800	9.200

It is clear the Nation benefits by the $400 millions that PDVSA’S partners forgo through a reduction in net income. The other $600 millions are just a transfer from one pocket to another since PDVSA contributes that sum in additional tax but that then reduces its net income by the same amount--from $1,800 millions to $1,200 millions. I trust the tax authorities have understood this--the only benefit to the Nation is the extra tax contributed by PDVSA’S partners.

The largest joint ventures are those in the Orinoco Oil Belt where, taken together, PDVSA has a total 78 percent of the equity. That means that only 22 percent of the windfall tax will be contributed by PDVSA’S partners, and that this is the extent by which the Nation benefits. The 78 percent which PDVSA contributes is a transfer from one pocket to another--it increases tax but reduces net profits.

I can see the logic for a windfall tax but, in practice, it causes several problems. I was in doubt whether to use the blander “excess profits” or the more emotive “excessive profits” but plumped for the latter because that is the way the government sees them. It is not so much a question of the profits being sudden or unexpected, but of being higher than the government finds acceptable i.e. excessive. The arguments in favour, or in contra, a windfall tax have been well rehearsed but I will summarise them here:

1) In favour:

a) Part of the present profits is fortuitous because it has arisen from an increase in market prices which has nothing to do with the efforts and efficiency of the oil companies.

b) The return on capital has grown to an extent which the oil companies did not expect to attain.

2) In contra:

a) How is it determined that a company has made excessive profits?

b) What is the starting point used to calculate the amount of excessive profits?

c) The tax is discriminatory if it is not applied to other industries--coal, iron, aluminium, etc--and other activities such as the banking, insurance and financial services.
d) Oil prices are high right now, but they can also fall suddenly and unexpectedly.

e) Oil companies need large profits because increasingly higher investment is required to explore for and develop new oil fields to replace those in decline.

The companies stress point e) and I quote just two statements that appeared in the press:

" The oil companies need to reinvest this profit back into securing future supplies, and hopefully pushing prices down. They need to explore new oil fields and build more refineries so that there is no shortage in world supply."

Shell's Chief Executive, Jeroen van der Veer, described the company's 2007 performance as "satisfactory" as it made progress in launching new exploration projects. He added: "If you get additional taxation, in the end it means you can invest less. The money has to come from somewhere and over time it will impact on our production.”

The points in contra show that it is not as simple as some people think to apply a windfall tax. The oil companies do not like it because they do not know what their effective tax rate will be and, during the financial year, they need to set aside an unknown amount to meet the additional tax. As no one knows beforehand if there will be excessive profits, it may be more practical to wait till the end of the financial year to determine the amount and apply the tax that has been established.

The fact is a windfall tax is a disincentive to investment and it may have that effect on potential investors in Venezuela. It is thus advisable to weigh the advantage of receiving more tax against the disadvantage of scaring off investors. The oil companies have other investment opportunities, and the effective tax rate is one of the considerations they take into account.

The application of a windfall tax is by no means common. I can only recall the example of the United Kingdom where the industry in the North Sea was “hit with the two windfall taxes in 2002 and 2005 that had added 20 per cent to its corporation tax bill.” No such tax has been applied since 2005, despite high profits, because the Chancellor of the Exchequer wants to encourage the companies to invest much more in the North Sea. The oil fields are in decline--on the down side of Hubbert’s Curve--and it is hoped new investment will delay the fields’ depletion which may occur as early as 2013.

The USA has not applied such a tax despite record profits made by ExxonMobil and other oil companies. This is probably because the oil industry in the USA has a particularly powerful lobby. Also, the fact Mr George W Bush was in his family’s oil business, Mr Dick Cheney was the CEO of Halliburton, and Ms Condoleezza Rice was a director of Chevron Corporation may have helped.

The President of the Finance Commission, Mr Ricardo Sanguino, and his colleagues have the unenviable task of defining what excessive profits are and of deciding how they are calculated. They must then decide how the latter are taxed--at one flat rate on the total, or with progressive or regressive rates on a two or more tranches.

I have been thinking of the different approach between Venezuela and, for instance, the European Union on the matter of tax regulations. I came to the conclusion that the main difference is that, while the Venezuelan tax authorities see the companies as an enemy to be defeated, the EU ones sees them as an ally whose cooperation is sought.

The different approach is that Venezuelan tax authorities impose the regulations on the companies, while those of the EU consult with the companies before enacting legislation. Of course, the authorities have the last word but, in the process of consultation, injustices are eliminated, unpractical aspects are avoided, and the drafting is improved so that legislation is produced which both parties can live with.

To arrive at a definition of excessive profits, which treats all oil companies justly despite their different sizes and disparate profit levels, is no easy task. May I suggest to the Finance Commission that, on this occasion, they try consultation with the oil companies and see if produces a better result? In any event, I trust they enjoy the intellectual challenge of coming up with a satisfactory solution.

Oliver L Campbell, MBA, DipM, FCCA, ACMA, MCIM was born in El Callao in 1931 where his father worked in the gold mining industry. He spent the WWII years in
England, returning to Venezuela in 1953 to work with Shell de Venezuela (CSV), later as Finance Coordinator at Petroleos de Venezuela (PDVSA). In 1982 he returned to the UK with his family and retired early in 2002. Petroleumworld does not necessarily share these views.

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Petroleumworld News 03/14/08

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