Aldyen Donnelly: How the Canadian Government should respond to the PetroChina deal

(February 11, 2011) Aldyen Donnelly argues that the Canadian Government should use the PetroChina deal as an opportunity to revisit punitive tax and royalty frameworks at the Federal and Provincial levels.

A client recently asked me the following question:

What do you think the Government of Canada response to the Proposed PetroChina investment in western Canadian shale gas reserves should be?

I think there is an elegant highly conditional approval for the PetroChina investment that can be both vote-getting while it, at the same time, can totally change the lay of the land for Canadian resource rents in a way that is absolutely necessary for Canada to secure any future investment in domestic value-adding capacity.

In my view, the barrier to investment in Canadian resource value-adding capacity and the threat to long-term Canadian taxpayer returns on our public resources is not foreign ownership of Canadian resources.  The problem is that the combination of provincial royalty and provincial and federal income tax regimes fail to protect Canadian taxpayer interests in our public resources and deliver an artificial financial windfall to investors who can get raw resources out of Canada and into foreign (including US) processing plants, as quickly as possible.

Before tax and royalty considerations, it always costs less to produce finished products closer to the point of raw resource extraction.  That is because it costs more, per tonne of finished product, to ship feedstock and other key processing inputs to distant refineries than it costs to ship the resulting finished products from the refineries that are located close to the feedstocks point of origin to final consumers.  The only reason it is currently more economic for market participants to build long pipelines to ship raw feedstock to distant refineries, or to invest $15 billion in very long gas pipelines when the same amount of gas would have access to many more markets (with lower transmission-related product losses) with an $8 billion LNG terminal and shorter gas pipeline investment, is because our existing provincial and federal royalty and tax regimes drive capital to the less efficient supply chain strategy that places value-adding capacity closer to the end-use market and far away from the original point of feedstock production. As long as large foreign investors can by Canadian resource assets at low prices relative to the long-term value of those assets and then legally price crude resource feedstock transfers to their sister companies at well-below market prices, it will remain impossible for Canadian governments to secure a fair return on Canadian resource depletion for Canadian taxpayers.  It also will continue to make no sense for foreign investors to develop value-adding capacity in Canada, when global corporate returns are maximized by getting crude feedstock out of Canada for processing anywhere else (including in the US).

The situation is bad in Canada.  At this time, even Sweden–with no domestic fossil fuel reserves — has more petroleum refining capacity than western Canada.  US refineries are now net exporters of both gasoline and diesel fuel, having shifted to a net export position entirely at Canadian refineries’ expense–over a period that Canada became a net importer of both of those finished products.

In my view, Norway’s response to the economic bleeding that resulted from the impact of foreign control of Norwegian resource assets in the late 1960s and 1970s was most effective and has proved efficient.  In my response to my client, I included the bolded remarks below.

If I was in Tony Clement’s position, I would rule that the PetroChina investment could only meet with the government of Canada’s approval if/when the government of BC modified the provincial royalty and corporate income tax regimes in such a manner as would ensure that Canadian taxpayers are guaranteed a minimum 70% long-term share of the revenues that would be derived from the sale of natural gas by the new entity at spot market prices for the commodity.  Minister Clement could offer a commitment that Finance Canada would be willing to work closely with the provincial government(s) to develop modifications of the federal tax treatment of income from raw resource extraction and export to compliment any decisions made by BC.

If this deal was proposed in Norway it would not be approved. After a few years of being ripped off by foreign oil companies (in Norway‘s history the bad guys were BP and Shell), the government of Norway ruled that private companies (domestic or foreign-owned) could not develop oil or gas reserves other that in partnership with a state-owned entity (StatOil or NorskHydro). At this time, Norway‘s state-owned entities own 66% of the equity shares in oil and gas developments on the Norwegian continental shelf.

Norway also figured out–about 15 years ago–that it was impossible to get the design of royalty regimes right, when “right” means fair to both the taxpayers who own the resource and the private investors who put their capital at risk when invest in partnership with the state. So in 1996 Norway started to phase royalties out of the resource regime, with royalties fully phased out by 2006. Now, Norway‘s tax rate for corporate income from resource production and processing is 77% (compared to a 28+/-% tax rate for other corporations). State-owned corporations pay income taxes just like the private companies. The first 50% of the cash in Norway’s sovereign wealth fund comes from state-owned corporation dividend payments to the taxpayer/investors, and most of the rest of the revenue for the sovereign wealth fund comes in the form of income tax payments, where the difference between the taxes the companies would pay at a 28% rate and what they do pay at 77% is deposited into the sovereign wealth fund. Even back in the early 1990s when Norway still had a royalty regime, royalty revenues accounted for less than 30% of the deposits into Norway‘s sovereign wealth fund.

Another key is that Norwegian oil and gas producers’ profits are calculated, for purposes of determining how much income tax is owed, as if every barrel of oil and mcf of gas sold was sold at a daily reference price that reflects public spot market prices for the commodities. So foreign companies may well–and do–produce and they ship crude oil and LNG to offshore refineries outside Norway‘s boundaries at “transfer prices” which are much lower than the actual market prices. This is legal and common practice. But it is not the low transfer prices that determine the companies’ income tax payable to Norway. It is the full market price. This ensures that the people of Norway lose no economic rents when foreign investors sell Norwegian resources to their offshore sister companies at below market rates.

In theory, Cdn royalties and income taxes are calculated assuming products were sold at market and not transfer prices. In practice, however, their is little clarity, consistency or common discipline regarding how “market prices” are to be estimated to determine provincial or federal royalties and income taxes payable under Cdn royalty and income tax regimes. Royalty and tax obligations for transfer-priced sales are regularly “negotiated” by the corporate taxpayer and tax departments, which negotiations are required due to ambiguity in royalty and tax rules.  The Canadian way generally allows foreign investors to effect a much greater wealth transfer from Cdn taxpayers to offshore refineries/processors/energy customers than would be allowed if the Norwegian approach to taxing income from resource extraction was in place in Canadian policy.

Please note that in 2006 the UK Parliament amended royalty and corporation income tax laws to move part way from an old-fashioned royalty and low income tax rate regime to a lesser dependence on royalties and an income tax rate hike for corporations that develop oil and gas in the UK’s offshore asset base.  Since 2006, the tax rate for corporate income derived from the extraction of oil and gas in the UK offshore is 55% (where income is calculated on the basis of the assumption that all resource sales are priced at Brent sea spot market prices, even if sales are actually transfer-priced), and royalty rates were reduced (but not eliminated).

I have not noticed that this shift from royalty to income tax basis for securing public resource rents has in any way inhibited private investment in either Norway’s or the UK’s oil or gas sectors.

Aldyen Donnelly

Read more of Aldyen’s blog posts here.



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