Fixing Uganda’s tax rules on oil and gas licence transfers

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OPINION

By Denis Kakembo

Despite pessimistic narratives, most global outlooks paint a measured picture of the future of the oil and gas industry.

Rather than signalling an abrupt decline, they point to a sector responding to a complex landscape shaped by energy security and climate change concerns.

Widely cited outlooks suggest that oil and gas will remain integral to the global energy mix through the 2030s and beyond. Thus, as energy systems evolve, the growing role of renewable energy will temper oil and gas demand growth rather than drive a decline.

Continued investment in petroleum exploration and development, therefore, remains key as oil fields naturally decline and sustained output depends on replacing falling production over time.

Reduced investment now in the sector can create supply pressures before alternative energy systems are fully established, with consequences that are costly and difficult to reverse.

As Uganda gears up for its first oil, this reality comes into focus. Maintaining production will depend on continued exploration and development, typically enabled through the transfer or dilution of interests in petroleum licences to attract new capital and expertise.

This has been Uganda’s experience with CNOOC and Total entering the sector in 2012 by farming into licences previously held by Tullow Oil and, earlier, Heritage Oil and Hardman Resources.

While the current tax framework for oil and gas interest transfers is largely well developed, certain aspects continue to present challenges that require consideration if the framework is to align comfortably with Uganda’s otherwise strong petroleum regulatory regime.

A difficulty arises from the law’s failure to distinguish between two different situations. Applying the same tax treatment to both does not fully reflect how value is created in the oil and gas sector.

In the first situation, an incoming party acquires an interest in a licence by paying the existing holder amounts that reimburse or exceed costs already incurred.

Where those payments result in a gain on the transfer, the law properly treats that gain as taxable, and there is no difficulty with this outcome.

A second challenge is where an incoming party acquires an interest in a licence by agreeing to fund future exploration or development that the existing holder would otherwise have financed.

While this may be viewed as conferring an economic benefit on the existing holder, that characterisation is less convincing when assessed against how value is generated and realised in oil and gas operations.

In such arrangements, the incoming party’s funding is applied to future activities rather than paid to the transferor, which receives no cash or readily realisable value at the point of transfer, only a commitment to future expenditure at the incoming party’s risk.

Treating that commitment as taxable consideration risks taxing a promise to invest rather than realised value, creating liquidity pressures where no cash is received.

Where the incoming party bears the costs required to earn its interest, production may still accrue to the original licence holder depending on how the transaction is structured.

As those costs are not incurred by the original holder, no corresponding tax deductions are available, yet the resulting production income remains taxable. Imposing tax again at the point of transfer therefore risks taxing the same underlying economic value twice.

Previously, Uganda’s tax framework allowed an incoming party acquiring an interest in an oil and gas licence to recover the economic cost of that acquisition by deducting, against future production income, qualifying expenditure previously incurred by the original licence holder.

This reflected the commercial reality that the incoming party had, in substance, borne those historical costs as the price of entry into the licence.

Under the current framework, that acquisition cost is no longer deductible. The result is that production income is taxed on a gross basis, without recognising the capital deployed to generate it.

This departs from the principle of tax neutrality that underpins income taxation, which seeks to tax net profits rather than invested capital, and risks distorting investment decisions in the upstream sector.

As explained, limitations remain in the law governing the taxation of oil and gas licences. The government may recall that Tullow Oil’s proposed transfer of licence interests in 2017 partly collapsed because of some of these tax issues, resulting in the loss of tax revenues when the transaction was later restructured and completed in 2020.

It is apparent that aspects of Uganda’s oil and gas licence transfer regime, in practice, impose tax on funds committed to investment in the sector rather than on profits generated from that investment. This can make investment-driven licence transfers less attractive and will drive future tax disputes.

The writer is a Tax Lawyer, Cristal Advocates