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Submission to the Review of Business Taxation
Discussion Paper 2
[FOR PUBLIC RELEASE]
Woodside Energy Ltd
CONTENTS PAGE Executive Summary
Description of Business Activities
The Impact of Taxation on Investment Decisions
Retention of the balancing charge provisions in the event of involuntary disposals
Case Study North West Shelf Expansion Project Australian Economic and
Who should be entitled to deductions?
Description of Business Activities
Woodside Energy Ltd (Woodside) is operator and major participant in the North West Shelf Ventures (NWSV). The company is responsible for all exploration, development and production of oil and gas reserves from the NWSV offshore exploration and production licence areas. Major products from the North West Shelf include natural gas, LNG. crude oil, condensate and LPG. Woodside also has extensive exploration and development interests outside the NWS, including the Laminaria oil field development in the Timor Sea which is due to commence production during the fourth quarter of 1999.
Woodsides discovery of the North Rankin, Goodwyn and Angel gas fields in the early 1970s led to the development of Australias biggest resource project the North West Shelf Gas Project. Sales of natural gas into the WA domestic market commenced in 1984. Exports of LNG to Japan commenced under long term contracts in 1989 and oil production from the Wanaea and Cossack oil fields commenced in 1995.
As operator on behalf of the NWSV, Woodside is responsible for the management of all offshore and onshore production assets, including the North Rankin A and Goodwyn A offshore gas drilling and production platforms, the Cossack Pioneer oil and gas production facility, a 134km subsea trunkline and onshore plant for the processing of natural gas, condensate, LNG and LPGs.
A Platform for Consultation
The Impact of Taxation on Investment Decisions
At a meeting of the Focus Group in respect of Wasting Assets that was held on 16 March 1999 in Canberra, representatives of the Review of Business Taxation suggested that the analysis of investment decisions should be undertaken on a pre-tax basis. In Woodsides experience, this is not the current practice. Such an approach represents a fundamental misunderstanding of the importance of taxation in establishing the commercial viability of projects, in valuing projects and in establishing the international competitiveness of projects.
The analysis of investment decisions is generally conducted using discounted (real value) after tax cash flows. The timing and magnitude of cash flows resulting from tax is critical to the analysis and investment decision. The use of a pre-tax discount rate, adjusted to take into account the rate of tax, is not an accurate substitute for the impact of the timing of deductions on cash flows and project value.
If project analysis is done on a pre tax basis there would be no argument about the merits of an accelerated depreciation regime versus an effective life depreciation regime. These differences are only reflected in an after tax analysis. The fact that such an argument arises is evidence of the use of after tax analysis.
The Benefits of GST for the Petroleum Exploration and Production Industry
The proposed introduction of a goods and services tax (GST) will potentially impact on the cost base of operations in the Petroleum Exploration and Production industry on two levels.
On the first level, and assuming that the GST does not impose an additional taxation burden on the industry, there is expected to be at best a very marginal reduction in the level of indirect taxation. As the relative share of indirect taxes is small (around 5% of the total value of tax payments), and recognising that the high cost indirect taxes that are incurred by the industry are to remain in place following the introduction of GST (ie tariffs), this first level of benefits is therefore expected to be very modest.
It also needs to be recognised that the nature of activities carried-out in the petroleum exploration and production operations are generally not land transport fuel intensive (particularly when compared with the mainstream onshore mining sector). The removal of diesel fuel excise, while potentially providing some avenue for cost reduction to the industry, again will only provide a relatively marginal benefit.
The second level of benefit associated with the introduction of a GST involves a possible reduction in the cost of business inputs as a result of a flow-through of lower taxes on supply activities. While it is recognised that some level of benefit may exist, the nature of activities in the industry may again dampen the overall impact. This is particularly the case due to the source of many of the inputs used in the industry, which are obtained from overseas supply points.
The full benefits associated with a reduction of business input costs can only be fully achieved for the Petroleum Exploration and Production Industry if there is a corresponding reduction in the level of customs and excise duties that currently apply to goods.
Woodsides judgement is also supported by the Department of Industry, Science and Resources (DISR). In comparing the oil and gas sector benefit with the coal industry, DISR advised that "..the upstream petroleum sector contribution to the figure (ie the net gain) is not as large as that of the coal industry where transport is likely to be a more significant component of costs."
Woodside strongly recommends against any attempt to justify the offset of any losses that may arise as a result from changes to the company tax systems against "perceived" benefits that are incorrectly believed to accrue from the introduction of a GST.
A Platform for Consultation
In addressing the issues raised in the document A Platform for Consultation Discussion Paper 2, the following comments are provided.
Exploration is an essential element of conducting business in the Petroleum Industry. Exploration can cover a range of activities including regional surveys, geophysical evaluation, seismic operations, exploration drilling and field appraisal.
As an indication of the significance of exploration activities, data from the Australian Bureau of Statistics indicates that exploration costs incurred in petroleum exploration operations for 1997/98 totalled slightly less than $1 billion, or around 25 per cent of pre-tax operating expenditures.
The immediate and full write-off of expenditures associated with exploration correctly acknowledges the nature and importance of such activities. Such outlays are a direct cost of conducting the business and their immediate deductibility is appropriate.
The consequence of removing the immediate deductibility would be a highly distortionary disincentive to risk-taking that would ultimately reduce the overall exploration effort in Australia, particularly in those areas where risks are perceived to be higher. Exploration would likely be reduced in greenfields and frontier areas where the likelihood of success is more uncertain. This would clearly be at odds with general energy policy objectives of resource security and diversifying sources of supply.
Support for existing tax treatment of such costs has been extensive over the last two decades. In particular, the Industry Commission and its predecessors have strongly endorsed the continuation of the present provisions. Exploration costs are critical to the resource sector and any outcome other than immediate and full deductibility would be inequitable and distortionary.
Woodside recommends that the immediate deductibility for exploration expenditure should be maintained as it is entirely appropriate and indeed essential if the current level of activity is to be maintained.
Company Tax Reduction to 30 per cent
Woodside supports the Federal Governments objective of moving towards a 30 per cent rate of company tax. To maximise the benefits of the lower rate, the Government must ensure that it has a taxation framework that encourages investment. Specifically, the taxation system should not act as a bias against long term investment.
Policy Framework for Wasting Assets
Woodside strongly believes that a clear case exists for applying special rules to gas projects. The company tax system introduces a significant element of regressiveness which leads to gas projects becoming less profitable due to the depreciation provisions. This unsatisfactory outcome would be maintained under a lower company tax/effective life depreciation schedule regime unless additional value measures were put in place to achieve international fiscal competitiveness for gas projects.
Case Study: North West Shelf Expansion Project - Australian Economic and Fiscal Impacts
This section draws on results contained in a report by Access Economics produced in October 1997. The assumptions in the report reflect the then current conditions of market demand and energy prices, which have now changed considerably. None-the-less, the analysis still validly reflects the community benefits of a large-scale resource sector project, albeit that the profitability to the proponents is considerably lower than implicit in the case study. Community benefits will be delayed to the extent that the project timetable slips beyond that envisaged in the report.
Construction of a two LNG train export facility on the Burrup Peninsula in north-west Australia with some $6.5 billion of capital (1998 prices) being expended over the period from present to 2007. Capital is supplied largely (some 75%) by foreign investors and (for the purposes of conservatively modelling the community benefits) is assumed to be 100% debt financed. Additional revenues associated with 7 million tonnes p.a. LNG export are some $2 billion p.a.
Key economic results:
The report also makes the following points:
*Woodside extrapolation to 2022 based on Access Economics spot calculations to 2013.
A key measure of project viability is the after-tax rate of return expected by project owners. This is strongly influenced by both the company tax rate and by the rules governing depreciation of capital. Depreciation rules are especially important for capital intensive long-life projects such as LNG, where construction schedules of 3 - 4 years mean that depreciation deductions cannot commence until several years after expenditure (depreciation not permitted until start-up).
The chart below compares company tax rates and depreciation write-off periods applying to LNG projects currently operating or planned for development. It shows the competitive position of Australia against overseas LNG projects.
The chart shows that most competitors to Australian LNG (Malaysia, Indonesia, Qatar, Oman) enjoy low effective company tax rates and are allowed to depreciate capital over a 4 - 5 year period. In each competitor country, accelerated depreciation is recognised as an important concession to improve the viability of long-life capital intensive projects such as LNG. While Alaska is in the process of renegotiating applicable depreciation schedules for LNG (from 8 year to 5 year write-off), Australia is in danger of degrading its competitive position by lengthening depreciation schedules for LNG.
Impact of effective life depreciation on an LNG project
Our analysis shows that LNG projects are adversely impacted by a move from current depreciation schedules to a 15 - 20 year effective life for depreciation and that a company tax rate of 30% does not fully compensate for the reduction in NPV resulting from effective life depreciation.
The fiscal impediments to expansion of Australia's LNG industry under the current fiscal regime have already been flagged as part of the LNG Action Agenda process. A change to the tax system that achieves no better than NPV neutrality with existing fiscal terms does nothing to improve Australia's competitive position with regard to LNG. LNG projects require internationally competitive company tax rates and depreciation schedules (or equivalent value measures) to stand a chance of meeting the investment hurdle rates required by investors.
The chart below shows that the breakeven depreciation life is some 12 years for a greenfield LNG project1. The chart also shows how the project return can be improved by a move to internationally competitive fiscal terms including a 4 - 5 year write-off period for LNG capital (or equivalent value measures).
Viability of projects - Australian impact
According to Access Economics2 some $190 billion of mining and resource-processing investment is forecast for the period 2001 - 2011. Some of this pool of investment will represent projects, which may not proceed if overall taxation conditions deteriorate from those currently available. Our analysis shows that for a range of discount rates, long-life marginal projects are likely to be worse off with effective life depreciation, even with a lower company tax rate of 30%. These projects, although offering marginal returns to investors, will provide substantial community benefits if they proceed.
To estimate the effects of some projects not going ahead if accelerated depreciation is eliminated (i.e. without substitution of equivalent value measures), a hypothetical suite of long-life projects was postulated, based on a typical long-life capital-intensive project such as LNG. The following assumptions were made:
Results, shown below, indicate that, at a hurdle rate of 10% real, a significant fraction (some 5% or $10 billion) of the portfolio of long-life investments may well become uneconomic if a 20 year effective life and 30% tax rate replaces current tax treatment. Conversely, a significant fraction (some 10% or $20 billion) of currently sub-economic projects could become economic if the existing accelerated depreciation regime was maintained in a low tax environment. The chart also shows that similar results are likely to apply over a range of commercially relevant hurdle rates.
The economy-wide benefits of a major investment long-life project going ahead greatly exceed the cost of maintaining accelerated depreciation for that project ($6.5 billion project, $400m NPV cost of accelerated depreciation, $9800 million NPV increase in government revenue). Applying these values to the portfolio of projects means that the "revenue-neutral" trade-off of tax rate with effective life depreciation puts some $14 billion NPV of Government revenue at risk. Conversely, by maintaining existing depreciation rates in a low tax environment for the entire portfolio of projects at a cost of some $12 billion NPV, additional government revenue NPV of some $30 billion could be expected.
The balance of trade implications of long-life major-investment projects such as LNG also needs careful consideration. With Australia's current account deficit heading towards record highs it is important to consider the implications of discouraging such export oriented investment by removing accelerated depreciation. Other things being equal, an unsustainably high current account deficit reduces national wealth by lowering the exchange rate, putting upward pressure on interest rates thereby dampening economic growth. These threats to economic welfare can be reduced by appropriate policy settings which encourage export industry, namely a lower company tax rate whilst maintaining accelerated depreciation (or introducing equivalent value measures).
State-by-State economic impact of losing accelerated depreciation
A quick-look study undertaken by Access Economics3 shows that the costs of losing accelerated depreciation fall disproportionately on WA, Qld and Vic whereas the benefits of a lower company tax rate are more evenly spread amongst the States. While a revenue-neutral outcome may be achieved across Australia, the outcome for states such as WA is far from neutral. Maintaining accelerated depreciation (or introducing equivalent value measures) in a low tax environment could alleviate the adverse impact on WA and on regional Australia.
The table below shows the outcome for WA and for Australia if accelerated depreciation is removed in exchange for a 30% company tax rate.
Table: Annual impacts and net present value calculation ($million)
Note - Year refers to year ending June of the year given.
Woodside recommends that the competitiveness of Australias taxation system be improved by lowering the company tax rate to 30% whilst maintaining the current depreciation schedules (or introducing similar value measures) for long-life projects such as LNG. The increased level of investment attracted by an internationally competitive fiscal environment for LNG encompassing a lower company tax rate and attractive depreciation schedules (or equivalent value measures) will generate superior community benefits to an outcome that trades off depreciation schedules against a lower company tax rate.
Woodside supports a change to the current depreciation provisions in accordance with Option 1 that provides for the person who incurs the expenditure on the asset to claim the deduction.
1. Data depicting "low return LNG project" supplied by APPEA
2. Access Economics, private communication 12/3/1999, representing forecast investment by industry 2001/02 to 2010/11 in "Mining" and "Resource processing", nominal dollars.
3. "State Impacts of Proposed Changes to Company Taxation", Access Economics, March 1999