DON'T ALLOW TAX COMPLEXITIES TO HAUNT NELP BIDDERS

The seventh round of New Exploration Licensing Policy (NELP VII) has generated a lot of interest in India’s upstream oil and gas sector. Offer of 57 blocks under this round, the largest till date, is big enough to stir the interest of a number of foreign and domestic players. For starters, E&P companies are subjected to a specialised regime offered under production sharing contract (PSC) executed with the government. A significant aspect in the assessment matrix drawn up by the E&P companies to firm up their bidding strategy is the tax cost on such operations. While the taxation and regulation in the E&P sector has been evolving under NELP, various complexities still remain. E&P firms have been offered an ‘undertaking’ specific income-tax holiday for seven years starting from the year in which they begin ‘commercial production’ of ‘mineral oil’. However, there has been considerable debate on the aspect of when such commercial production can be said to have begun. In the initial stages, oil companies often start producing oil/gas in small quantities, which may not be commercially marketable and may not, therefore, qualify as ‘commercial production’. As determination of commencement of tax holiday on the basis of such production may result in denial of benefit of the holiday in subsequent years, this aspect needs to be clarified. Since the term ‘mineral oil’ has not been specifically defined in the tax holiday provisions, it calls for clarity as regards whether the same includes natural gas for the purpose of tax holiday. There also exists a difference of opinion on whether each production well or a cluster of such wells within a block constitute separate ‘undertakings’ such that their tax holidays can run independently. A natural corollary to this issue is the ring fencing of the costs, including exploration, development and production costs, where more than one block is operated by a single entity. For cost recovery purpose, such ring fencing restricts set-off of costs of one block against revenue streams of another. For tax purposes, there is no dispute as regards unsuccessful ‘exploration costs’, which are permitted to be set-off against income from producing contract areas. But clear tax policy for similar adjustment of ‘development costs’ needs to be formulated. Another ambiguity that needs to be addressed pertains to farm-out transactions through which a participant exits a block by assigning its interest therein to a third party. The existing provisions, which provide for tax treatment of excess/deficit of transfer proceeds over the unabsorbed expenditure, deal with simple farm-out transactions. However, complex structures of farm-out transactions, involving annuity payouts, carried interest, etc, need to be specifically addressed by policymakers. From indirect tax perspective, supplies in relation to E&P operations are exempt from Customs and excise duties. However, ambiguities exist with respect to certain conditions attached to the Customs exemption notification, specifically with respect to requirement of re-export of equipment on completion of the project. Further, there is a restriction on foreign exchange remittance, in case imports are made by a foreign company or on their behalf. This restriction does not apply in case of imports made by an Indian company and hence becomes onerous for foreign companies. There has been considerable debate on applicability of service tax on services provided by drilling contractors to E&P firms. The government has tried to put this debate to rest by introducing a broader category of taxable services, namely ‘mining services’, w.e.f. June 1, 2007, which seeks to cover the entire gamut of services provided by oil field service providers. Since the service tax charged by service providers becomes a cost for the E&P companies, the government has been urged to grant an exemption of service tax to the sector, in line with Customs and excise incentives being offered at present. Other significant concern of the E&P firms is frequent changes in the Indian tax structure, which could alter the expected economic benefits factored by these companies at the time of bidding. It is interesting to note that PSC provides for necessary adjustments and revisions to the contract, in case of any material change in the expected economic benefits accruing to the parties due to change in tax laws. However, in practice, this provision has not been often enforced and hence does not provide requisite comfort to the operators. – www.economictimes.com