The 11th International Petroleum Tax Conference

Ladies and Gentlemen:

I would like to thank the Norwegian Petroleum Society (NPF) and the Norwegian Oil Industry Association (OLF) for the invitation to be here to day to speak to this distinguished audience. I welcome the opportunity to talk about the findings and recommendations of the recent Commission on the taxation of offshore upstream petroleum activities. I will be speaking at this conference strictly in the capacity of member of the Tax Commission. Although I work in the Ministry of Finance, what I say today can not be taken as the views of the Ministry.

In the spring of 1999 oil prices were at a record low, looming around the 10-dollar mark for a period in February. There was general concern in the industry that low prices and diminished profitability could endanger new field developments and reduce interest in further exploration activities in Norway. High-cost developments on the Norwegian Continental Shelf stand to loose out in an environment of low petroleum prices and high perceived price risk.

In response to industry concerns, Norwegian authorities put in place several measures to improve the overall conditions on the Shelf. Royalty was tapered off for the fields that still are liable to royalty payments, the carbon dioxide tax was reduced and changes were made in the licensing policy. The Parliament, in its treatment of the Revised National Budget for 2000, also asked the Government to look into the petroleum tax system, in turn leading to the commissioning of the report I will speak of today.

We must remember that the petroleum tax system has a role, but certainly only a limited role, in creating conditions for a sound business climate and sensible resource management in upstream petroleum activities. The outlook for the sector in Norway depends chiefly on the availability of attractive acreage, the ability to create profitability by reducing costs and, of course, oil price developments. White Paper No 39 speaks of improving cost competitiveness, i.e. through technological development and co-operative project management, as the main challenge in improving the competitiveness of the Norwegian Shelf.

The role of the tax system is mainly a vehicle to share the returns in the sector between the companies and the State, preferably in a way that does not run counter to sound business and resource management. But the tax system does not work alone in the task of providing income to the State from the sector. Also, state ownership, directly through SDFI (State Direct Financial Interest) and indirectly through company ownership, plays an important role in canalising sector revenues to the State and the Norwegian society as a whole.

So, lets not forget that the tax system is a narrow focus against the background of the very complex set of conditions shaping the future of the sector, of which some conditions are government decided, but very many are beyond government influence.

The first question one may ask is if it is worthwhile to give much attention to the tax system. If future developments were few and/or only modestly profitable, there would be less of a case for rent collection in these fields through taxation. This is the situation the British perceived themselves to be in in 1993 when the Special Tax, the PRT (Petroleum Revenue Tax), was abolished for new fields. As current PRT payments were consumed by tax breaks for new developments, and even became negative, there was seemingly little to loose and something to gain from doing away with the PRT. Even before the oil price hike, however, there were concerns about the Treasury getting an appropriate share of offshore income.

But what is the situation in Norway when it comes to remaining resources and profitability?

The slice diagram on the over-head shows that out of total expected resources of about 13 billion Sm ³> o.e. 21 per cent have already been produced. Another 22 per cent are reserves in producing fields or fields with an approved development plan. An additional 30 per cent of total resources have been discovered, but not yet decided, while the remaining 27 per cent are unmapped or undiscovered resources.

The left part of the overhead shows the same resource classes divided between oil and gas resources. The picture also illustrates uncertainty by giving high and low estimates.

The next over-head shows break-even prices for some 60 projects, large and small, under consideration. These break-even prices tell us what price is needed in each project for cost recovery, including a real rate of return on capital of 7 per cent. Break-even prices have dropped substantially over time due to i.e. technological developments. The lower line in the diagram corresponds to an oil price of 65 NOK/bbl, or about USD 7, while the upper line is 95 NOK/bbl or about USD 10. An overwhelming number of projects are profitable at quite low oil prices.

To my mind, the figures show that there are very good prospects for profitable oil and gas developments on the Norwegian Continental Shelf for many years ahead. The picture is certainly not one of a sunset industry with marginally profitable opportunities.

In my view, this makes it still very worthwhile to care about the workings of the tax system for the sector. The question of how a tax system should be designed in order to secure an appropriate share of income to the state is the main focus in the mandate given to the Tax Commission.

The mandate asks four major questions. These are (overhead)

The mandate states that the tax system should reduce effectiveness and income creation as little as possible. Taxation should also enhance an optimal use of resources.

It is therefore clear that the mandate is a very wide one, and does not seem to preclude any topic that the Commission would decide to pursue. Given the time restraint, however, the Commission saw it as its task, first and foremost, to try to answer the specific questions put to it. It is fair to say that the Commission has concentrated on a few, but very important features of the tax system. Other topics are treated very superficially or barely mentioned at all. Among these, there are certainly several topics that deserve more attention. One is the very huge issue of transfer pricing. A tax jurisdiction with a marginal tax rate as high as 78 per cent may attract more costs than should strictly be allocated to the Norwegian Shelf. Very little is said by the Commission on this topic. Next to nothing is said on the norm price system. The tax treatment of abandonment costs could be looked into with an aim to simplify today’s treatment. Furthermore, more work on the scope of the petroleum tax regime must be expected in the event of more sub-sea installations and onshore treatment plants.

As the industry changes, so must the tax law in order to adequately deal with developments. The call for a stable and predictable tax system must, to my understanding, mean that the tax system continuously fulfils its stated intentions. I would believe that also the industry, in the light of a continuously changing environment, is interested in responsiveness and flexibility in the tax system. It is therefore unavoidable, and even desirable, that the law changes to take into consideration new developments. Stability and predictability can not mean the freezing of a system that needs overhaul.

The industry is very upset that the Commission has not suggested a lower level of taxation. In line with the mandate, the Commission has seen a clear case for continuing the Special Tax at a high rate, but the Commission has not recommended a specific rate. This means that the Government, if it chooses to recommend changes to the Parliament, in these preparations must balance state revenues against what can be achieved by lower taxes. Undoubtedly, stakes are high on both sides. Returns may be worthwhile from influencing this balancing act, a balance that in the end must be struck politically.

I will return now to the themes of the report. There are three main findings corresponding to the specific questions raised in the mandate.

The first is the concern that Norwegian petroleum taxes "pay for" oil companies’ investments in other tax jurisdictions, be it on the Mainland, or in other countries. The allocation rule for interest expenses place a too large share of total interest payments in the petroleum tax regime where they can be deducted against the high marginal tax rate of 78 per cent. The result is to decrease petroleum taxes and stimulate oil companies operating on the Norwegian Shelf to invest elsewhere. The misallocation of interest expenses gives the oil companies an advantage in business where they compete with non-oil companies and therefore works adversely against "fair" competition in several markets.

I have not detected any effort on the part of the oil companies to defend this anomaly. I will shortly return to the concerns, related to tax treaties and tax credit for Norwegian taxes, raised as a result of the Commission's proposed treatment of interest expenses.

The second problem concerns the generous tax treatment for investment outlays. The combined effect of depreciation, uplift and interest deductions works to make investments too inexpensive after tax. The problem is not one of too low uplift as has been claimed by the OLF, but quite the opposite.

When today’s uplift was decided in 1992, the Government claimed, as correctly has been brought out by the OLF, that the proposed system would be neutral with respect to investment decisions. When the Commission now holds that it is not, there is one main explanation. As far as the Commission can see, the 1992 system did not aim at an ordinary taxation of normal returns in the petroleum sector. In stead, the present system in effect only taxes extraordinary returns above a generous rate.

The Commission has taken the view that normal returns in the petroleum sector should be taxed in line with normal returns in other sectors in Norway, or the taxation of normal returns in other countries for that matter. In a context where normal returns in other sectors are taxed, the pre tax required return would be lowered in sectors with no taxation of normal rents. We see no reason why the tax system should favour investments in the petroleum sector which evaluated on a pre-tax basis are less profitable than in other sectors.

The generous tax treatment of investments may lead to investments which are not profitable on a pre tax basis. In practice, probably all field developments on the Norwegian Shelf have been expected to be profitable, before tax as well as after tax. But the generous tax treatment may skew investment decisions within a project. The tax system stimulates the use of too much capital in any project.

The view that investments are treated favourably is acknowledged by the industry in their arguments for the provision for a special tax treatment for rented production facilities. The aim of this provision is to make rental as favourable as in-company investment. If oil companies' investments, that is company ownership of installations, were not stimulated by tax rules, there would be no need for the special provision.

The Commission believes there are barriers to entry created by the tax system. We do not know how important these barriers are compared to other barriers, for example in the licensing policy. We acknowledge that tax barriers will not be directly present if companies enter the Shelf by acquiring a share in a producing licence. Such shares are, however, not necessarily readily available, and it could be that entrants are paying up for the benefit of the tax paying position. The point is that tax barriers when applying for licenses may be harmful and are unnecessary.

Having identified these failures in the workings of the tax system, the Commission goes on to suggest certain changes. The suggestions are not very radical ones; the proposed changes are all within the main structure of today’s tax system.

The purpose of changing the depreciation rules is to ensure an ordinary taxation of normal returns also in the petroleum sector. The Commission offers little advice, however, on the details of these rules. On this issue more work is needed if changes in the spirit of the Commission's intentions are to be implemented.

The Commission's formulation of the Special Tax is based on the cash flow tax. Most academics and practitioners accept the cash flow tax as a neutral tax in the traditional strict sense. It is therefore surprising that some have denied that the proposed tax is neutral. In fact, the Special Tax formulated by the Commission is equivalent to a cash flow tax. In stead of writing off an investment immediately as in a cash flow tax, the investment is deducted over time, but, and this is the important point, every postponement in deduction is compensated by interest. This compensation is provided for by the allowance for return on capital, the so called KAF. The relevant interest rate, the one that adequately compensates the postponement, is the nominal risk free rate. For a tax paying company it is obviously the case that the postponement can be seen as a risk free investment. Giving up immediate write off in exchange for future certain deductions is a risk free investment, therefore the risk free rate. For a company, which is not (always) in a tax paying position, the proposed treatment of losses ensures that deductions are certain to reduce the tax bill, sooner or later, with an equivalent economic effect as for a tax paying company.

When the Special Tax is combined with the General Tax, the cost of capital for a risk free investment is the risk free rate after tax. Still, the pre tax rate is the correct one to use in the KAF. This is to avoid the Special Tax being levied on the tax that has already been levied on normal returns. The structure requires, however, that normal returns are effectively taxed in the General Tax.

Let me be very clear on one thing; the Commission has never said that the risk free rate is a reasonable return for investments in the petroleum sector as has been wrongly quoted by the OLF. The appropriate rate of interest in the KAF and a company's cost of capital are of course two different matters, also in the Commission's report. As a side point, worth mentioning in this connection, is the fact that the proposed system maintains its neutral properties irrespective of the estimate for the companies’ cost of capital. It is this property that makes it possible and meaningful to discuss tax bases and tax rates separately.

The important point concerning the proposed design of the Special Tax is that the tax is equivalent to a cash flow tax. The problem is that this will appear not to be the case if the tax value of postponed deductions and the KAF are not discounted by the risk free rate. The tax value of immediate write offs and the total tax deductions offered by the proposed system are equivalent if these tax deductions are discounted correctly using the risk free rate.

If companies use their normal cost of capital when discounting the tax value of deductions, the proposed system will appear less attractive than the cash flow tax, even though it is not. The proposed system will seem not to be neutral and the taxes will be overestimated in any project with an internal rate of return above the risk free rate. This is the picture that the OLF draws. On the basis of numerous computations done by Wood Mackenzie and others, all of which are wrong, very severe conclusions are drawn and harsh characteristics are distributed. Spokesmen from the industry have been quoted to say that they have problems envisaging that any field now under consideration could be undertaken in the new regime. The statements are based on incorrect computation methods in evaluating project economics using The statements are therefore hard to take seriously.

Companies say they do not practice discounting with different discount rates for different cash flows components in a project. Perhaps there has been less reason to do this before. With the proposed tax system it will be necessary. But several companies have long since found it useful to evaluate individually separate cash flow streams in a project. In stead of adding up cash-flow components and then discounting (as is the traditional DCF-method), they discount the components first and then add. The Norwegian Petroleum Society three years ago held a two-day seminar on the merits of valuing separately different components of a project's cash flow. Speakers from oil companies displayed in depth understanding of the issues involved. This seems very reassuring. Oil companies generally have very high expertise in both theory and practice of finance and investment analysis.

So, when companies hold that the tax system proposed cannot be neutral because it does not suit the way projects are currently analysed, one may wonder if there could be other reasons for the criticism.

Since a tax of the proposed type is equivalent to a cash flow tax, you may ask why the Commission did not propose a cash flow tax. There are three main reasons for this. The first is that in general it seems like a good tax policy rule to tax profits as they occur. Front loading of deductions, as is already the case in the current system, may stimulate strategic behaviour, on the part of companies as well as tax authorities, in harvesting periods. The second reason is that it would seem an unnecessary complication to have, in effect, two sets of depreciation rules, one for the General Tax and one for the Special Tax. This would complicate i.e. the computation of gains and losses when disposing of assets or licences. The third reason is that a cash flow tax could easily raise questions with respect to the creditability of the Special Tax.

Another criticism from the industry, is the one concerning tax competition.

Partly, there is a misunderstanding, that the Commission's analysis is based on a closed economy case. The analysis the Commission has used is applicable for a small open economy. What is needed for the purpose of the analysis is an international cost of capital after tax that applies to international investments as well as investments in Norway. In this context, it is not the case that investments on the Shelf crowd out investments in other Norwegian sectors. Rather, the level of investment in Norway, or in any single sector for that matter, will be decided on the basis of the (amount) of the country’s or the sector's profitable investment opportunities.

A lot is said in responses from the industry on how individual companies direct resources which are perceived (to them) as limited. These types of considerations are probably quite universal in any type of business and are important inputs into any company’s strategy for profitable focuses.

The tax competition argument goes as follows: since oil companies are able to collect extraordinary high returns in other countries, their opportunity cost of capital or another input factor is high. The Norwegian tax system should then refrain from taxing the rents that could otherwise have been collected in other provinces. The argument relies on capital restraints, possibly other input restraints, which, although they feel real on the company level, may not be relevant on the industry level, at least not over time. Furthermore, it seems inconceivable how a tax system could be designed to take account of foreign profitability versus domestic profitability. One would probably have to resort to quite complicated mechanisms, which would depend strongly on specific, but uncertain assumptions. In any case, if it were the case that oil companies were consistently able to collect extraordinary profits, one would expect to see earnings in this industry above the average, which seems not to be the case.

We should also bear in mind that the Norwegian petroleum tax system does not collect all extraordinary profits, but leaves a share of these profits in the oil companies.

There is still another international aspect that is of serious concern to the foreign owned oil companies, especially the U.S. based. That is the potential impact on the ability of U.S. companies to claim a foreign tax credit for the Special Tax. The question is whether the replacement of current deductions for interest and uplift with an allowance for return on capital will threaten the creditability for U.S. tax purposes of the Special Tax and possibly even the General Tax. The Commission received advice from the industry that disallowing deductions for interest expenses could make the taxes’ creditability vulnerable to attack from the IRS and could raise claims for renegotiations of the U.S.-Norway Income Tax Treaty.

The Commission discusses the issues involved in broad terms in the report. The Commission, however, felt that it was not in a position to adequately assess the risks and consequences of a loss of the creditability safety nets. It would not be appropriate for the Commission to engage in discussions with U.S. tax authorities. In the event, this is a job properly left to the responsible authority, the Ministry of Finance. Furthermore, the Commission felt that it would not be appropriate to speculate in detail about the creditability question in an official report. If the Commission went too far in its elaboration, it could conceivably have adverse effects in the event of future negotiations. If the Ministry decides not to disallow deductions for interest expenses, a reformulation of the KAF to take this into consideration should be possible.

The Commission proposes that losses in the bases for the General Tax and the Special Tax may be carried forward with interest using the after tax risk free rate. Only losses arising after the implementation of changes should be granted interest. The purpose of the loss-carry-forward feature proposed by the Commission is to make the Shelf as attractive to new participants as it is to well established companies. This is seen as a positive measure by the industry. So is the proposal to allow trading in compounded losses in companies that are exiting the Norwegian Shelf. On this proposal more work is needed in order to formulate the measure so that it firmly secures the tax value of losses.

In broad terms, individual rulings (§10-rulings) in the case of transactions of licenses are necessary today in order to neutralise different tax positions and different financial structures between the selling and the buying company. With the Commission's proposals, there will, in a sense, be neutralisation of these factors within the general tax system. This means that, as a general rule, there will no longer be a need for individual rulings.

Summing up, in the view of the Commission, the proposed changes will lead to some major improvements in the Petroleum Taxation.

Firstly, the taxation will be more targeted towards income from the Shelf and to a lesser degree permit activities in other sectors, in Norway or abroad, to diminish the petroleum tax bases.

Secondly, the changes will discourage over-investments in the sector and reduce the risk of undertaking investments that are unprofitable on a pre tax basis.

Thirdly, the changes will put new entrants and established companies on a more equal footing with respect to tax effects of their activities. The changes are favourable to companies that are not in a tax paying position and will eliminate barriers to entry created by the tax system.

Forth and lastly, eliminating the case by case tax treatment of license transactions may help create a more efficient second hand market for licence shares.

Thank you for your attention.