The explosion of exploration and VAT
07 April 2014
Posted by: Author: Mark Silver
Author: Mark Silver (Deloitte)
Mark Silver discusses recent amendments to the VAT system following increased interest in hydrocarbon reserves situated within South African territorial waters
It is no secret that there has been increased interest by multinational oil and gas companies ("entities”) in the hydrocarbon reserves situated in South Africa territorial waters. Certain features of this industry have posed some challenges to our VAT system and this article seeks to provide some detail and comment on these challenges and how SARS has sought to deal with them in the recent amendments.
The immediate issue faced by these entities is registration as vendors and in order to understand the issue it is necessary to briefly consider the process involved in the production of oil and gas. The process may be divided into the following four stages:
- Technical analysis
- Exploration and development
Reconnaissance involves the search for hydrocarbon reserves through geophysical, geological and photo geological surveys. It does not involve any drilling activities. In order to perform such reconnaissance the entity is obliged to apply to the Petroleum Agency SA (the "Agency”) for a permit which is valid for one year.
The technical analysis stage involves a desk top study of the sites and permits the entity to obtain existing seismic survey data from the Agency. The entity is obliged to obtain a technical co-operation permit from the Agency. This permit does not confer the right to access the area, but it does confer the exclusive right to apply for an exploration right in respect of the area to which it relates. The permit is valid for a year.
The exploration stage entails access to the site and the commencement of drilling in order to locate hydrocarbon reserves and in order to commence such activity, the entity is obliged to apply for an exploration right which is required to be registered at the Mineral and Petroleum Titles Registration office within 30 days of issue. The exploration right may be issued for a period of 3 years and is renewable for a maximum of 3 periods not exceeding 2 years each. These rights are transferable subject to Ministerial consent and any such transfer is required to be registered.
The final stage is the production stage, where the hydrocarbons are extracted for commercial purposes. The entity holding an exploration right must apply for a production right which confers on the holder the right to conduct any operation that relates to the exploration, appraisal, development and production of the petroleum and the right to remove and dispose of any petroleum. Production rights are valid for up to 30 years and are renewable for additional periods of up to 30 years. Production rights may be transferred subject to Ministerial approval and such transfers are required to be registered.
In order to apply for any of these permits, the applicant is obliged to submit prescribed supporting documentation which includes details relating to anticipated expenditure, proof of financial resources and proof of technical ability.
It should be clear from the above that these are long-term capital intensive projects with no guarantee of success even after extensive seismic analysis. Reconnaissance to production stage could easily take more than 10 years, during which period significant costs will be incurred.
In general, once the exploration rights have been granted, the rightholder commences setting up operations in South Africa in order to facilitate the drilling operations. In view of the significant costs attached to exploration (an exploration well can cost in the region of R1bn) one of the first transactions entered into by the rightholder is to identify another entity with whom it can share the exploration rights and costs.
Such agreement is typically referred to as a Joint Participation Agreement in terms of which the rightholder transfers portion of its exploration rights and the parties agree to share the costs of exploration and production in terms of a Joint Operation Agreement (JOA).
From a VAT perspective in many cases, the first significant transaction is the sale of portion of the exploration rights. These rights are extremely valuable and the amounts paid are considerable. In the absence of registration for VAT purposes, the transfer of these rights is subject to transfer duty which has to then be borne as an additional cost by the purchaser.
In order to avoid such additional costs, the parties would seek to register as vendors for VAT purposes. Prior to the 2013 Taxation Laws Amendments Act, section 23(3)(d) of the VAT Acr was relied on for these purposes. It allowed for registration where it is stipulated: "that person is continuously and regularly carrying on an activity which, in consequence of the nature of that activity, can reasonably be expected to result in taxable supplies being made for a consideration only after a period of time and where the total value of supplies to be made can reasonably be expected to exceed R50 000 in a period of 12 months.” (Emphasis added)
By virtue of the fact that there was no guarantee that these projects would result in the commercial production of petroleum these entities encountered difficulties in registering for VAT purposes. This caused considerable frustration on behalf of large multinational companies seeking to make significant investments in SA. Further, the Act provides no alternative mechanism whereby the matter can be placed before a senior SARS official who could exercise his or her discretion in registering such entities. The ruling route could be followed but this process usually takes several months.
SARS and Treasury recognised the above problems and sought to provide relief on two levels. In the first place, it was recognised that these entities needed to be able to import goods (survey vessels, offshore drilling rigs etc.) into SA without incurring import VAT. In this regard, regulations have been drafted which will align Schedule 1 of VAT Act to the Customs and Excise Act, exempting goods imported for oil and gas exploration from VAT. It is our understanding that these regulations will be promulgated shortly.
In recognition of the registration issue, section 23(3)(d) of the VAT Act has in terms of the Taxation Laws Amendment At 31 of 2013, been replaced with the following: "that person is continuously and regularly carrying on an activity of a nature set out in any regulation made by the Minister in terms of this Act, and in consequence of the nature of that activity is likely to make taxable supplies only after a period of
time.” (Emphasis added)
Two issues arise from this amendment. It is unlikely that the Minister will be able to anticipate all situations where, by virtue of the nature of the enterprise, there is a significant lead time between the incurral of expenditure and the generation of taxable supplies. If such activity is not listed in the regulations it will not be able to register. Thus the issue may have been addressed for listed activities (subject to the comments below), but any activities which are not listed will have no basis for registration in terms of the amended legislation. In other words if an entity cannot show that it will generate taxable supplies within a period of time and it does not conduct a listed activity, it will not be able to register as a vendor.
"By virtue of the fact that there was no guarantee that these projects would result in the commercial production of petroleum these entities encountered difficulties in registering for VAT purposes. This caused considerable frustration on behalf of large multinational companies seeking to make significant investments in SA”
The second issue relates to the use of the phrase "likely to make taxable supplies”. How different is this from "reasonably be expected to result in taxable supplies”? Both tests would seem to envisage a better than even chance that the activity will result in taxable supplies. We have dealt with the obstacles to registration above, but another issue is who must register and in particular, whether the Joint operation must register as a vendor.
Section 51 of the VAT Act provides as follows: "where any body of persons, whether corporate or unincorporated (other than a company) carries on or is to carry on an enterprise.
(a) such body shall be deemed to carry on such enterprise as a person separate from the members of such body.”
It is clear from section 51(2) that a partnership falls within the above definition. In its glossary to the VAT 404 Guide, SARS includes a "partnership/joint venture” under the definition of a "person” without indicating what is meant by a "joint venture” and whether or not it is distinguishable from a partnership in this context.
In any event, the statutory description of a "body of persons” is fairly broad and could conceivably cover two persons pooling their resources for the purposes of achieving a common objective. This leads to the question whether two or more persons who enter into a cost sharing arrangement constitute a "body of persons” which is required to register separately from its members?
It is submitted that even if in the broadest sense, such cost arrangement constitutes a "body of persons” such body of persons is only obliged to register separately where it conducts "an enterprise”. Following this, a pure cost-sharing arrangement does not constitute "an enterprise” as costs are shared but it is only the individual members who make supplies. The position may be different where the arrangement is that the body of persons shares costs and also makes sales to third parties.
Thus in the case of Binding Private Ruling 086 where SARS was of the opinion that the joint venture conducting mining operations was required to register separately, it was clear that the joint venture would conduct the production and sales and share the profits between the parties.
The JOAs typically provide for the conducting of joint exploration and production activities and the sharing of cost in proportion to the parties respective exploration and production rights but include statements to the effect that they are not partners and that each party has the right and obligation to take and separately dispose of its share of the production. In other words, they agree to jointly produce but do not agree to sell jointly. Each party sells under its own brand and account. The parties may indeed be competitors at the retail stage.
It is submitted that in such arrangements, even if there is a body of persons acting in concert for the purposes production only, such activity conducted by the body of persons does not constitute an "enterprise” and does not accordingly, fall within the ambit of section 51 referred to above. In such event it is the two entities that are eligible for registration (subject to the provisions of section
23 discussed above). This in turn introduces its own complexities where one of the parties incurs and recovers the costs of the production from the other party. Generally an agent is not entitled to claim the VAT on expenditure incurred on behalf of its principal. This would mean that in the absence of a ruling from SARS, it would only be entitled to claim the VAT on its share of the expenditure irrespective of who initially incurs such expenditure.
An illustration of the above would be a group of advocates who each practise for their own account but who share resources and the costs of running their respective practices. In terms of General Ruling 74 (now withdrawn) SARS provided the following view on how the expenditure should be dealt with:
"...one of the registered members would have to be appointed as an agent for the group and receive all the tax invoices from suppliers in respect of supplies made to the group, they would then advise the other members of the amount of input tax which they will be able to claim after having apportioned the expenses. In terms of section 54(3) he will also have to keep sufficient records to enable the name, address and registration number of each advocate to be ascertained”.
Although this ruling has been withdrawn it is submitted that it illustrates the principle which has not changed.
Finally it should be noted that the amendments only became effective on 1 April 2014. This poses a problem for those entities that have already incurred expenditure and have paid either VAT or transfer duty. In order to recover such costs they will either have to request that SARS register them retrospectively or rely on the change of use adjustments contained in section 18(4)(b) of the VAT Act. Where the goods in question consist of exploration rights which constitute "second-hand goods” then section 18(4)(c) of the VAT Act will have to be relied on.
This article first appeared on the March/April edition of Tax Talk.