Taxation in the Upstream Oil and Gas Sector

By Geoffrey Muchiri

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26th May 2012 is a date that will forever remain etched in the minds of Kenyans as it is the day when the announcement was made that vast quantities of oil had been discovered in Turkana County. Commercial viability of those discoveries had not been determined but from that date Kenya became a new petroleum province of great interest to all in the global oil and gas industry. It is in the context of this discovery that Kenya’s numerous oil blocks are seeing a renewed interest from International Oil Companies(IOC) (be they: small independents or the oil majors/seven sisters and their successors in title) or National Oil Companies from other countries.

The exploration and production of oil and gas is a very expensive capital intensive undertaking as the preliminary shooting of seismic and the drilling of exploratory wells in an oil block in accordance with the work programme agreed with any Government in any country may cost between US$1 million to over US$ 15 million and Kenya is no exception (this is coupled with the attendant risk that there is always a great possibility that the oil(if any that is found) may not be in commercial quantities). The development and production phase may involve the construction of the infrastructure necessary to transport the oil from the wellhead to the port of Mombasa or Lamu and may cost hundreds of millions of dollars.

For that reason any IOC that  seeks to sign a Production and Sharing Contract (PSC) with the Kenyan Government in respect of the available oil and gas blocks (be they onshore or offshore) would like to ascertain up front what taxes if any are applicable during the exploration phase as well as the production before the IOC can proceed to make any contractual commitment by signing and sealing the PSC. This accords with what Lord Mansfield stated in 1774, that in all mercantile transactions the great object should be certainty. This aphorism holds true to this day especially in the oil and gas sector.

The taxes applicable to the oil and gas company undertaking exploration and production of oil in Kenya are as follows:

  1. Corporation tax on the profits during the production phase (with an allowance being given for amongst others: production costs (recovered from the cost oil within a period of between 4 and 5 years), intangible drilling costs, payments to the government under the PSC, executive and general administrative expenditure incurred in Kenya ( as well as outside Kenya with special exception in the sense that those expenditures although incurred outside Kenya relate to Kenya), management fees, interest paid on loans(provided tax on the interest has been deducted and paid). The corporation tax rate is 37.5% for non-resident companies and 30% for resident companies.N/B: Since many IOCs which happen to be oil majors are vertically integrated there is a likelihood they may sell oil to their subsidiaries involved in marketing and for that reason there are rules that govern and ensure that such sales are done on an arms- length basis.
  2. A tax on any transfers of any interest in the property and/ or shares of an oil company was introduced in This attempts to cover: take-overs and farm-outs as well as outright sales of the whole interest. This tax was introduced as a result of a battle that the Kenyan Government lost when it tried to call for its share of taxes when an international take-over of a company had the effect of resulting in the acquisition of stakes in some oil blocks in Kenya.
  3. Government share of profit oil is also a tax from the IOC’s. The Government share of profit oil is calculated on a sliding scale with the government share increasing dependent on how many barrels of oil are produced from a particular oil block (akin to the sliding scale that applies to an individual person’s income in Kenya whereby the government take/tax increases with  each  increasing level of income). The Government share of profit oil is a negotiable variable and this is a factor which ought to be taken into consideration as one engages the Government in  negotiations leading up to the signing of a PSC.
  4. Windfall profits tax may be included in some concluded Production Sharing however, in light of the continued sharp price decline in the global oil prices. This might not be a very attractive tax model.

Ring-fencing is applicable to the upstream oil and gas sector in Kenya. This means that losses from one oil block cannot be used to reduce the taxable income in respect of another profitable oil block.

The Kenyan Government is currently at an advanced stage of concluding the preparation of new legislation that will govern the upstream oil and gas sector in Kenya.