Introduction
It has been three years since the Petroleum Industry Act ("PIA" or the "Act") was signed into law, and the implementation of the Act has come into full swing. Twenty-seven conversion contracts have been signed1 (as at today) which shows that many upstream companies have converted / renewed their existing licences / leases and began the application of the fiscal provisions detailed in Chapter V of the PIA. The Act replaced Petroleum Profits Tax (PPT) with Hydrocarbon Tax (HCT) for upstream companies (except those operating in the deep offshore and frontier acreages) and provides the basis for computing the tax payable on their crude oil profits. It also mandates the payment of Companies Income Tax (CIT) on the total profits of an upstream company.
Most companies with converted licences began to file their tax returns comprising the HCT (where applicable) and CIT computations, from May 2024. Although the Federal Inland Revenue Service provided information circulars to guide companies with the preparation of their returns, it was still an interesting period for taxpayers dealing with the complexities of interpreting and applying the fiscal provisions of the Act for the first time. The HCT computation involves the treatment of restricted costs, different tax rates depending on the licence types, amongst others. This article focuses on two provisions introduced by the PIA – the reasonability rule and the Cost Price Ratio (CPR) limit, and their impact on companies operating in the upstream sector of the Nigerian oil and gas industry.
The Reasonability Test
Section 263 of the PIA provides that "In computing the adjusted profit of a company in upstream petroleum operations related to crude oil for any accounting period, there shall be deducted expenses wholly, reasonably, exclusively and necessarily (WREN) incurred during that period...." (emphasis ours)
Under the provisions of the defunct PPT Act, there was no obligation for the costs to be reasonably incurred i.e. it only required the costs to be wholly, exclusively and necessarily (WEN) incurred. The WREN requirement was first detailed in the CIT Act. However, the draftsman has now extended the reasonability requirement to companies operating in the upstream sector.
The tax laws do not define "reasonable", but the general meaning available is a 'fair amount'. This aligns with the Black's Law Dictionary (8th ed. 2004)'s definition of 'reasonable' as "fair, proper, or moderate under the circumstances." To determine the reasonability of expenses under CIT in practice, they are typically benchmarked against payments made by similar companies in the same industry. For example, to determine if the personnel cost that an oil service company reported during a financial period was reasonable, the tax authorities would review the financial records of similar oil service companies to confirm the range of the personnel cost that they incurred during the period. Where they determine that the personnel cost that the company under review reported was 'overstated' compared to similar companies, the tax authorities would disallow the excess amount. This position usually results in dispute between the tax authority and taxpayers as there may have been extenuating circumstances that necessitated the taxpayer to incur costs that are beyond the usual industry practice.
Generally, it was believed that upstream companies were exempted from the reasonability test due to the peculiarity of the petroleum industry. The upstream sector is highly specialised and the players incur costs to ensure that goods and services used for their operations conform to global standards and best practices. They also incur various costs in their engagement and collaboration with relevant stakeholders which may differ depending on the oilfield area. In line with the high transparency requirement in the industry, a good portion of the costs that upstream companies incur are typically subject to review. Companies in Joint Ventures (JV) arrangements for instance have the Operating Committee (OpCom) which reviews and approves budgets for each JV. OpCom, in its review, benchmarks the budget of one JV with others in a bid to confirm the reasonability of the amounts stated amongst others. The JV Operators typically adhere to the budgets except for unplanned circumstances and the cost increase is defended to the parties. Therefore, the introduction of the reasonability test may result in disagreements during reviews by the tax authorities. How do the tax authorities intend to dispute the reasonability of pre-approved costs (that have already gone through a reasonability test for industry experts) which are critical for the company's operations and profits generation?
Section 264 of the PIA already disallows several costs such as all custom duties, bank charges, bad debts, interest on loans, costs incurred outside Nigeria, etc, for HCT purposes, thus, increasing the disallowed amounts based on the reasonability test may be detrimental to the tax payer and in effect, the image of Nigeria as an attractive destination for foreign investment in the oil and gas industry.
It would be interesting to see how this is applied by the tax authorities during their reviews.
Cost Price Ratio
Another key introduction by the PIA is the Cost Price Ratio limit in Section 266(2) and the Sixth Schedule to the Act which provide that the total cost allowable for tax deduction is limited to 65% of the gross revenue at the measurement points. However, it excludes expenses incurred on rent, royalties, and any amount contributed to the establishment of the HCDTF, Environmental Remediation Fund, Niger Delta Development Commission, and other similar contributions (hereinafter referred to as "excluded costs") and petroleum allowance, from the restriction. This means all other allowable costs including capital allowances and unutilised losses would be subject to the CPR limit. The PIA also makes provision for companies to carry forward the cost disallowed (i.e., the 35%) to subsequent years provided that the cost does not exceed the 65% in those years. However, the amount carried forward is not deductible for purpose of calculating HCT upon the termination of upstream petroleum operations.
The introduction of the CPR rule means that incurred costs would undergo a two-step review process before they can be offset against a company's income. First, the costs would be reviewed based on the provisions of Sections 263 and 264 of the PIA (i.e., to determine if the costs qualify as allowable for HCT purposes) and thereafter the allowable cost would be subjected to the CPR limit. The impact of the two-step process on the profits of companies may be significant.
One of the possible reasons for the introduction of CPR limit is to aid the government in its revenue drive as it ensures that companies always have a chargeable profit that would be subject to tax. The limit indirectly connotes that there is a minimum tax threshold for HCT purposes, however the threshold will vary per company depending on the quantum of its production allowance and the excluded costs. While the Act was in its draft stages, the Petroleum Industry Bill had subjected all costs to the 65% limit. This position was met with objection from taxpayers as it meant that the minimum tax threshold was 35% and companies would need to pay the computed hydrocarbon tax irrespective of the profitability status. This is in addition to the CIT that is payable on the total profits by the same company. However, based on the PIA, the exclusion of some costs when determining the CPR limit should significantly reduce the 35% threshold. Nevertheless, the introduction of the CPR limit is still significant for the Federal Government because a chargeable profit amount is assured especially as the PIA has repealed the Investment Tax Credit and Investment Tax Allowances.
There is also the possibility that companies may be unable to fully recover the costs incurred during the life of the project. The PIA allows for companies to carry forward the unutilised costs indefinitely, however, for a company that has incurred huge capital expenditure and costs compared to its gross revenues, it may be unable to ever recover these costs. The limit also applies to unutilised losses carried forward from the PPT regime, thus, these losses may continue to be warehoused for extended periods. Investors typically prepare feasibility models to evaluate their profitability levels before venturing into such businesses. Where they determine that the taxes payable as well as cost recoverability would be unfavourable, they may be unwilling to invest unless there are other commercial factors to "sweeten the deal". Oil profits from deep offshore and frontier acreages are not liable to HCT, thus, investors may set their sights on investments in those areas of the sector as we have seen with most International Oil Companies who have been divesting their interests in onshore / shallow water acreages to focus on deep stream assets.
Another impact of the CPR limit may be to elicit cost efficient production in the upstream industry. Operators may take the issue of operational efficiency more seriously.
From our research, CPR limitation is not a common phenomenon in calculating oil revenue-related taxes in other jurisdictions. Cost recoverability under production sharing agreements / contracts (PSC / PSAs) are more common. However, it is a contractual provision and does not impact the taxes calculated. It specifies the portion of the cost incurred that a contractor would recover as cost oil from the oil produced by the asset. Nigeria also applies this in its PSC / PSAs but interestingly, most companies with signed PSC / PSAs operate in the deep offshore and are not liable to HCT. Therefore, it might be important to review the impact of this provision on companies and investments in the sector after a few years.
Further, the principle of recognising the temporary differences of assets and liabilities of upstream companies in their deferred tax computations will be significantly altered by the CPR limit. Where a company has deferred tax assets, its deferred tax computation must consider the impact of the costs that were subject to the CPR limit and when they will be recovered.
Conclusion and recommendation
The fiscal framework of the PIA has introduced some beneficial provisions such as lower tax rates and production allowances. However, it also includes provisions that may be difficult to assess at this point. The reasonability test as well as the CPR limit appear to fall under this category. It is important that all parties continue to review the impact of these provisions and put in place a dynamic process for change where necessary that ensures that Nigeria continues to be a key destination for oil and gas investments across the globe.
Footnote
1 CONVERSION CONTRACTS – Nigerian Upstream Petroleum Regulatory Commission
The opinion expressed in this article is solely personal and does not represent the views of any organization or association to which the authors belong.
