Brazil is aiming to double its production of oil and gas to more than four million barrels per day by the beginning of the next decade. With the vast majority of this additional production coming from the huge “pre-salt” reserves and other deep water fields off the Brazilian coast, Petrobras alone requires an another 32 floating production facilities by 2020; not to mention the drilling rigs, pipe-laying vessels, shuttle tankers, platform supply vessels, tugs and the like that will be needed to support this unprecedented exploration and development effort.
This is a colossal task by any measurement. However, it has been made harder by uncertainty regarding the applicable tax regime and by recent assessments by the federal tax authority, which could make the offshore oil and gas industry liable for billions of dollars in back taxes.
Existing rules and practice
Shortly after the liberalisation of the Brazilian oil and gas sector in 1997, Federal Law No. 9.481/97 provided that amounts remitted abroad as payment for the charter or leasing of vessels would be taxed at a zero rate with respect to withholding income tax. This position is repeated in Article 691, Item I of the Brazilian Income Tax Regulation Codex (Decree No. 3.000/99).
In 1999, the ‘REPETRO’ special admission regime was introduced, which allows the supplier of vessels or other goods to the oil and gas industry to benefit from the suspension of federal taxes that would otherwise be due upon importation in certain circumstances. REPETRO also allows Brazilian suppliers to take advantage of this favourable tax regime, by allowing the fictitious export and re-importation of goods.
It has become common practice to combine these benefits, by splitting agreements into two separate contracts, to be performed simultaneously: (i) a bareboat charter between a foreign vessel owner and a Brazilian oil company; and (ii) a services contract, under which a Brazilian entity (usually an affiliate of the foreign owner) provides vessel operation and maintenance services to the Brazilian oil company. Total contractor remuneration is split between the two contracts and is usually distributed heavily in favour of the charter contract (which generally accounts for 80-90% of the total price), as the services contract attracts a higher rate of tax than the charter.
Over the past few years, the federal tax authority has been challenging such tax structures, issuing several tax assessments against oil and gas companies. These challenges are mainly based on the arguments that: (i) the zero tax rate should only benefit the charter of vessels that are employed in the transportation of cargo or passengers, so that floating platforms and drilling rigs, for example, should not be considered vessels for these purposes; or (ii) the splitting of the contractual scope between the two separate contracts is artificial and arbitrary, especially in those cases in which the Brazilian services provider operates at a loss.
Several such tax assessments have been made in recent years, but they have all been challenged by the oil companies involved and are still being discussed in the lower Brazilian courts. The tax authority has prevailed in some cases at first instance, but no clear trend has yet emerged and it is still unclear whether these challenges will be upheld.
However, the risk to the industry is serious. It has been reported that Petrobras alone has proceedings against the federal tax authority for R$13.7 billion (£3.7bn) in back taxes and that, in late July 2014, Petrobras sent letters to its charter and vessel services providers stating that it would pass on to them any withholding income tax, fines and interest for which it is held liable in relation to their contracts. Some of Petrobras’ suppliers have already indicated that they would challenge any such pass through. Although Petrobras contracts usually include a ‘change in tax law’ provision, Petrobras would presumably argue that this is not a change in law and that the supplier is responsible for taxes that should have been withheld in respect of its income.
Now other private oil and gas companies, who have hired charter and operation services in accordance with widespread practice and legislation, are also being assessed by the Federal Revenue. Industry organisations (such as ABESPetro and IBP) are seeking to address the issue and to provide the tax authority with materials to support the legality of the split structure.
Although the federal tax authority has denied changing its position, some media have reported that the authority has changed its interpretation and will now treat the split structure as a single contract for the provision of services. They have linked this with the recent issue of Normative Instruction No. 1.455/14, which expanded the definition of technical services that would be subject to a 15% withholding tax.
That view does not seem to be fully supported by a Consultation Response issued by the Brazilian Federal Revenue in August 2014 (Solução de Consulta n. 225/2014). This consultation related to a drillship, which was being provided under a split contract structure where, unusually, the vessel owner and operator were not part of the same economic group (although there were cross-shareholdings). This decision confirmed that the parties were free to structure their business as they think fit, with a view to optimising operations and maximising profits, although it stressed that there were limits to freedom, imposed by the law. The decision confirmed that, in this case, the charter payments would be free from withholding tax. However, it stressed that the difference in ownership between vessel owner and operator was important, because shared ownership of these two companies, when associated with other factors, such as disproportionality between the agreed remuneration and the absence of a business purpose, could indicate an abusive tax planning and be challenged by the tax authority.
The scope of this Consultation Response is limited to its facts, and it expressly did not consider whether semi-submersible rigs would benefit from the same treatment. However, the industry should welcome its acceptance that a split contract structure may be justified. The reasoning of the decision seems to support this position even where the owner and operator are part of the same economic group, provided that the split of remuneration between the charter and operation agreements are justifiable and serve a legitimate business purpose.
Although vessel owners and oil companies may prefer to avoid tax assessments altogether, they should be able to live with a tax regime in which the rules of the game are clear and objective. It is easy to understand why the Brazilian tax authorities cannot accept a system in which overseas companies make large profits on charter income, while their Brazilian subsidiaries operate at a loss and pay no tax at all.
It is feasible to identify costs associated with the provision of the vessel itself, including capital expenditure, financing and registration costs etc., and those associated with its operation, including staff costs and consumables. Once these have been budgeted, and a profit margin applied to each, it should be possible to arrive at a justifiable split of remuneration between the two contracts. There may be some contentious areas, such as responsibility for insurance and the cost of replacement parts, but if the industry can work together with the tax authorities and other branches of government, they should be able to formulate the clear rules necessary to give investors certainty and sustain growth in the Brazilian oil industry.
The current uncertainty threatens this investment at a critical juncture and, if the Brazilian tax authority were able to impose the back taxes it is claiming, it risks killing the goose that lays the golden egg. It should not be forgotten that Brazil stands to gain much more from sharing in the oil and gas and revenues that its operators will eventually produce, than in taxing an essential input for this production. It is to be hoped that ongoing tax assessments can be settled or dismissed, so that oil companies and their suppliers can focus instead on what they do best.