Proposition no. 84 (2001-2002) to the Odelsting. The Economic Consequences of the Amendment to the Petroleum Tax Act

Proposition no. 84 (2001-2002) to the Odelsting. The Economic Consequences of the Amendment to the Petroleum Tax Act

Dear Sir/Madam

The economic consequences of the amendment to the Petroleum Tax Act have been described in section 3.2 in Proposition no. 84 (2001-2002) to the Odelsting. In the following we elaborate on the economic consequences of the amendment with a special emphasis on establishing the maximum conceivable gain (as a percentage of investment) for companies with a project that is subject to the accelerated depreciation scheme.

1. General economic consequences of the amendment to the Petroleum Tax Act

As a starting point, it is useful to establish that the direct gain per krone invested (measured in present value terms) is independent of both the size and the timing of the investment. A higher depreciation rate (shorter length of the depreciation period) implies that the companies receive their deductions in taxable income at an earlier point in time. Therefore the gain for the companies is solely related to an increased present value of deductions in taxable income. There is a constant, linear relationship between the value of an investment and the value of tax deductions due to depreciation for a given depreciation scheme (see below), so changes in the value of investments will therefore lead to proportional changes in the value of tax deductions, leaving the ratio of the two entities unchanged. E.g. doubling the size of investment would double the value of tax deductions both with the ordinary and the accelerated depreciation scheme, thus leaving the ratio of the economic gain (which equals the difference between the values of the two depreciation schemes) and investment unchanged. A change in the timing of investment is equal to changing the value of investment in present value terms, and the same reasoning as above obviously applies.

In general, the value of tax deductions, NV(I), for a linear depreciation scheme is given by the following set of equations:

In the equations, I is investment, s is the tax rate, a is depreciation for tax purposes each year, t is time, n is the first year of depreciation, N is the last year of depreciation and k is the discount rate (which for simplicity is assumed constant for the whole period). Changing the depreciation scheme amounts to changing n and N, thus changing the constant part of the investment which is depreciated each year. The formula clearly shows that the value of tax deductions is linear in I as stated above. Furthermore, all parameters in the equations are defined by the depreciation scheme or the tax system, with the exception of the discount rate which is market-based and possibly also may differ between different companies. In order to establish the maximum gain, we therefore need to consider the relevant discount rate.

In the Norwegian petroleum tax system, the value of depreciation for tax purposes may be seen as approximately risk free due to the rules of carrying forward deficits with interest and transfer of remaining deficits in mergers etc, cf. § 3 c in the Petroleum Tax Act. It would therefore be correct to use an approximately risk free rate of interest when evaluating these tax deductions. Below, a risk free, nominal rate of interest of 4,68 pct. after tax is being used, corresponding to a rate of 6,5 pct. before tax, cf. section 2 in the letter of 19 April 2002 from the Royal Ministry of Trade and Industry to EFTA Surveillance Authority.

Although there is a clear argument for using a risk free discount rate, we have noticed the interest of ESA to consider also other discount rates. If the risk characteristics of a given scheme is difficult to establish, one may argue that the use of a single reference rate with a moderate risk premium may facilitate comparison between different schemes. In accordance with this, ESA’s reference rate of 6,32 pct. is also used in the calculations.

Furthermore, one cannot completely rule out that changes in the general interest level or specific borrowing restrictions for some companies may lead to an even higher discount rate. To illustrate the effect of this, a discount rate of 10 pct. has also been used in the calculations below. In this case the direct gain amounts to approximately 8 pct. of the investment. Both in relation to general macroeconomic relations governing the general interest level and to the financial capacities of the companies on the Norwegian Continental Shelf, the Ministry of Finance would assign a very low probability to the relevance of a discount rate this high.

Table 1. Direct economic gain with different discount rates

In accordance with the discussion above, The Ministry of Finance would regard the estimate of a direct economic gain of approximately 4,5 pct. of the investment as most relevant. As stated above, the direct gain of 8 pct. of investment (using a discount rate of 10 pct.), is more of an illustrative nature than reflecting a probable outcome. The figure however reflects a theoretical upper limit for the direct gain that may be received by any single company at any point in time.

In addition to the direct effects above, accelerated depreciation has consequences for deductible interest that are of relevance in estimating the overall effects of the depreciation scheme. The period of depreciation affects the maximum interest bearing debt the companies may incur within the scope of Section 3 h of the Petroleum Tax Act (the provision on “thin capitalisation”). The provision calls for a scaling down of deductible interest payments in cases where a company’s debt exceeds 80 pct. of the total balance sheet. Accelerated depreciation for tax purposes leads to an increased differential between depreciation for accounting purposes and depreciation for tax purposes, and thus to increased deferred tax on the liability side of the balance sheet. Increased deferred tax is regarded as debt in relation to the provisions of Section 3 h, and thus reduces the scope for the companies of incurring interest-bearing debt without being subject to a scaling down of their deductible interest expenditure. A reduction in the deductible interest will increase the tax payments of the companies, and will thus to some extent counterbalance the net present value gain resulting from shortened periods of depreciation.

The net effect of the accelerated depreciation scheme when changes in interest bearing debt is taken into account, is given in table 2 for the same discount rates as in table 1. It is assumed that the companies have a debt ratio of 80 pct. and are therefore not subject to a scaling down of deductible interest expenditure. The borrowing rate is held constant at 7 pct. (before tax) even if the discount rate varies. For high discount rates, this assumption would tend to underestimate the effect of increased deferred tax and thereby tend to overestimate the net gain from accelerated depreciation.

Table 2. Net economic gain with different discount rates

In general, given the financial structure of companies on the Norwegian Continental Shelf, the calculations in table 2 would seem most relevant for an assessment of the net economic gain of the accelerated depreciation scheme. In two cases, however, the difference between the direct gain and the net gain will be smaller than stated in table 2.

One possibility is that a company is below the debt limit of the “thin capitalisation” rule. In this case, the company may increase its debt without being subject to a scaling down of deductible interest expenditure. This may lead to the conclusion that only the direct gain of the accelerated depreciation scheme is relevant to such companies. On the other hand, it seems natural to assume that a policy to exceed the equity requirement of the “thin capitalisation rule” is a policy that would not change if the company takes on another project. A further elaboration of this point would require a more detailed study of optimal financial policy when e.g. there are possible restrictions on company borrowing in the future. It is however relevant to note that a reduced borrowing capacity may be relevant even for a company which is presently not “tax optimised” according to the “thin capitalisation rule”.

Another possibility is that the company has a high share of non interest-bearing debt on the liability side of the balance sheet. In this case it may be profitable to have even more debt than 80 pct. of the total balance, even though deductible interest expenditures are scaled down. This would reduce the effect of increased deferred taxes, although a substantial part of the difference between the direct economic gain and the net effect would still remain.

In general, the effects mentioned above could only make the reduction in the direct effect smaller. They could never add to the direct effect.

Summing up, the Ministry of Finance would conclude that approximately 1,4 pct. of the investment cost is the best estimate of the net economic gain for the companies of the accelerated depreciation scheme. One cannot however rule out that the net effect may differ from this estimate, and several possibilities have been discussed in the text above. A theoretical maximum would occur for a company using a high discount rate (set at 10 pct.) on approximately risk free cash flows, and at the same time assigning no value to the reduced debt capacity within the provisions of the “thin capitalisation” rule. In this case the net effect of the accelerated depreciation scheme is estimated to be approximately 8 pct. of the investment cost. With a considerable margin, the 8 pct. figure is therefore a theoretical upper limit to the effect of the accelerated depreciation scheme.

2. Economic consequences for the Snøhvit project

The general economic consequences which are calculated in section 1 clearly apply to the Snøhvit project. In the following we show the direct economic consequences of the accelerated depreciation scheme for the Snøhvit project.

The starting point of the calculation is the net present value of the companies’ expected yearly investments in the Snøhvit project with different discount rates, cf. table 1 and the net present values cited on pages 3-4 in the letter from the Royal Ministry of Trade and Industry to EFTA Surveillance Authority of 30 April 2002. Furthermore, the expected yearly investments in table 1 in the letter of 30 April 2002, make it possible to calculate the yearly depreciation figures for the accelerated and ordinary depreciation schemes respectively. Taking the difference between the yearly depreciation figures under the two schemes, multiplying with the marginal tax rate (78 pct.) and discounting gives the direct economic gains of the accelerated depreciation schemes for different discount rates. The results are given in table 3:

Table 3. Direct economic gain for the Snøhvit project with different discount rates

The results for the Snøhvit project are in accordance with the general figures in table 1 in this letter. Similar results confirming to the general figures in table 2 in this letter might have been produced for the net economic gain for the Snøhvit project, cf. row 2 and 4 in table 2 in the letter from the Royal Ministry of Trade and Industry to EFTA Surveillance Authority of 19 April 2002.

Yours sincerely,