Sheshinski: Gas tax producing enormous revenues

Eitan Sheshinski

The head of the Sheshinski Committee asserts that the tax instituted in 2011 has dramatically increased the government take from Israel's natural gas reservoirs.

The op-ed article by Avishai Ovadia on January 9 ("Tamar Partners Haven't Paid a Single Shekel Tax on Profit") gives the impression that the tax law passed in 2011 made no significant change in the government take (GT) from profits on Israel's natural gas reservoirs. The legal GT at the time was 25% - the lowest in the world. What did the law do?

According to the Accountant General, NIS 459 million from the Sheshinski tax was accumulated by the end of 2017. In the coming years, tens of billions of dollars more will be accumulated in the fund for taxes from the owners of rights in the Tamar, Leviathan, Karish, and Tanin reservoirs.

In the Tamar prospect, for example, the partners paid the Ministry of National Infrastructure, Energy, and Water Resources over NIS 4 billion in royalties in 2013-2018, plus large additional amounts in income tax. Starting in 2020, the Sheshinski tax will also be added to GT, thereby increasing GT to 59% of the total profits from the reservoir during all of its years of operation. The projected GT rate from the Leviathan reservoir, which will begin producing gas towards the end of this year, is 62% of the accumulated profits. Conclusion: the 2011 tax law dramatically raised Israel's tax revenues from the gas reservoirs to the average OECD rate from gas production.

Ovadia's article made the following errors, in addition to others not listed here:

1. The super royalties paid to the general partner cause profits to be transferred to it at the expense of the minority partners.

The legislator was aware of the existence of super royalties, through which a general partner, or anyone with an agreement with the gas partnership (a geologist, for example) can withdraw a proportion of the partnership's revenue or profit, thereby reducing the share of the other partners (mainly holders among the public of participation units) in the remaining profits. The law therefore took note of these super royalties:

The law does not allow deduction of super royalties for the purpose of calculating the tax. Not deducting super royalties increases tax payments to the state. Furthermore, the law establishes a mechanism that benefits the public. According to this mechanism, if the gas partnership pays tax, the general partner and anyone who received super royalties will first make a payment on account for the tax applying to the partnership, before the partners and the public holding participation units pay their share of the tax. The amount of tax applying to receivers of super royalties is the total super royalties received in a year, multiplied by the tax rate applying to partnership in that year. For example, profits - 200, tax rate 50%, tax = 200 x 50% = 100; super royalties for the general partner - 120, tax paid by the general partner - 120 x 50% = 60. Tax paid by the partners: 100 - 60 = 40. Balance of profits for distribution: 200 - 40 = 160. The owners of participation units will therefore be left with larger surpluses for distribution.

2. Raising the tax rate on the income and royalties of the gas partnerships would have been more profitable for the state and preferable to a complicated tax mechanism.

This is incorrect. The advantage of the royalties is indeed their simplicity and uniformity, and they were therefore left unchanged by the tax legislation. The royalty rate was not increased, however, because this would have had a negative impact on the viability of investment in exploration and development of gas reservoirs, and would have created negative incentives on the volume of production in the sector and the number of companies in it. Another disadvantage of royalties is that they are regressive, meaning that the percentage of royalties from the profits will decrease as the profits increase.

In contrast, the tax mechanism stipulated in the law is progressive, so that the tax increases as profit increases. The tax adjusts itself to the level of profit in each reservoir. For very profitable gas reservoirs, on the one hand, the mechanism encourages large investments by the developers, such as deep-water drilling (through a return on the investment with the addition of a normative profit before payment of the tax begins); on the other hand, the mechanism collects the proper share from the developers in economic rent.

3. The partnerships promote exports because there is no tax on them.

The statement is incorrect. The tax also applies to gas exports. Only the revenues component arising from transporting the gas for exports is tax exempt. On the other hand, the capital-intensive investments in constructing the pipelines and facilities for transporting gas for exports are not deductible in calculating the tax, and therefore do not reduce the tax or postpone it.

4. The Tamar venture can deduct payments for exploring another gas field in the license area.

The statement is incorrect. The legislator wanted to provide an incentive for additional exploration in the areas of the gas leases, because any commercial quantity of gas found in them and sold will increase the tax payments from the prospects. The law therefore permits deduction of payments for additional gas exploration. In contrast to the assertion in the article, payments for drilling outside lease area are not deductible in calculation of the tax.

5. The tax law grants factors for investments that reduce and postpone the tax.

The rationale behind the factor for gas exploration investments is to provide an incentive for exploration, because such investments are high-risk; there is no certainty at the exploratory stage that gas will be discovered. The rationale behind the factor for construction of gas production facilities is recognition of normative financing expenses on investments in construction, as a substitute for allowing the deduction of financing expenses, which are not deductible in calculating the tax. Deduction of payments for financing expenses is not allowed in order to avoid distortion of considerations by owners of rights in the venture about whether to finance through shareholders' equity or foreign capital. The normative financing expenses calculated according to an interest rate of LIBOR plus 3% do not increase the investment each year, as asserted in the article, but only during the gas venture's setting-up period.

Additional comments and corrections in the article:

* In calculating the tax, proceeds are also linked, not just payments, as asserted in the article.

* The period from the enactment of the tax law until the beginning of tax payments from Tamar will be 8-9 years, not 10-11 years, as asserted in the article. The relevant date for calculating the number of years is from the beginning of gas production at Tamar (the end of March 2013), and the period from then until tax payments begin is only seven years.

* In contrast to what is stated in the article, there was no revision of the law in 2015 concerning payments for exploration of another gas field in the same license.

To sum up, the article by Avishai Ovadia made a mountain out of a molehill, while the Sheshinski tax generated a mountain of revenues for the state treasury.

The authors of the above article are Prof. Eytan Sheshinski, head of the Sheshinski Committee appointed by then-Minister of Finance Yuval Steinitz to consider taxation on the oil and natural gas discoveries in Israel - the committee issued its final conclusions in January 2011 - and Shlomi Philipp, CPA, senior manager for legislative costs in the Israel Tax Authority Planning and Economics Division.

Avishai Ovadia writes in response:

The response of Prof. Sheshinski and Shlomi Philip to my article of January 9, "Tamar Partners Haven't Paid a Single Shekel Tax on Profit," shows me that they are evading the facts. A large proportion of their response concerns other matters, not the tax itself that constitutes the core of the law. Their response refers to the total payment by the partnerships (I never said that the payments would not increase - the partnerships found gas, so the state will obviously receive more).

They do comment on the super royalties for the general partners, which is the real problem. They only demonstrate, however, that the distribution of profits between the general partner and the holders of participation units (most of whom are from the public) is disproportionate.

I still think that the Sheshinski tax formula leaves a great deal of room for interpretation (and so do the gas partnerships, by the way); it is too complicated and includes large discounts for the gas partnerships - that's just arithmetic. I still think that something simpler and easier should have been devised for taxing the partnerships. I still believe that charging tax from 2020 onwards (at best, if at all) is ridiculous.

Beyond this, the fact that Sheshinski and the Israel Tax Authority think that they will succeed in collecting a large amount through the tax unfortunately does not mean that they will actually do so. Things may seem simple from the ivory tower, but reality is a tougher nut to crack.

Published by Globes, Israel business news - en.globes.co.il - on January 10, 2019

© Copyright of Globes Publisher Itonut (1983) Ltd. 2019

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Eitan Sheshinski
Eitan Sheshinski
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