The Hindu Business Line : Lowdown on windfall tax

There has been increasing demand from a section of political parties that we in India need to levy windfall tax on oil companies which are seen to have made excess profits with recent changes in global oil prices.

There were serious debates on this issue amongst the political parties, with demands that the Export Oriented Unit (EOU) status extended to private sector refineries be revoked. There are no easy solutions to an issue such as this under the current laws; EOU status cannot be revoked so long as the conditions prescribed have been fulfilled.

For the time being, it looks like this matter has been put to rest, with the Government stating that such a levy may not be a good idea as the rise in oil prices is a global phenomenon and not peculiar to India. Given this backdrop, let’s analyse the background and discussions on this issue.

Definitions

‘Windfall tax’ is a tax imposed by a Government on companies making excessive profits and causing social and environmental damage. The UK levied such a windfall profit tax as a ‘one-off tax’ on certain companies on the excess profits they made, more specifically a privatised utility companies.

This levy was introduced by the Labour Government in 1997 and the legislation came in specifically from their election manifesto. It was aimed to balance the levy by these utilities companies on the customers and to bring in parity with other larger taxpayers.

This levy was specifically utilised by the Labour Government to fund the welfare of the programmes, which sought to tackle the long-term employment issue and capital grants for schools and universities in the UK.

This levy of tax was calculated by means of applying a Price Earning Ratio (PE ratio) using a multiple of nine times, whereby the average post-tax profit in the four years after privatisation was multiplied by nine to give the value for purpose of levy of this tax. The difference between this value and the total market capitalisation based on the companies’ stock price was subjected to a 23 per cent windfall tax, which was the corporate tax rate applicable at that time.

One-time levy

The tax so charged on the companies was payable in two instalments on December 1, 1997 and December 1, 1998. This tax was levied on number of companies such as British Telecom, British Gas, British Energy, Centrica, National Power, Power Gen, Regional Electric Companies and other privatised utility companies like water and sewerage.

This tax was a one-time levy and thankfully was never continued. Quite interestingly, this debate, we have in India, has re-surfaced in the UK and it is now reported that the UK Cabinet is considering a proposal for levy of windfall tax on energy companies in view of the perceived excessive profits made by these companies!

In the 1980, the US enacted the Crude Oil Windfall Profit Tax Act as a part compromise between the Carter administration and the Congress after the decontrol of oil prices. This tax was primarily intended to recover the profits earned by oil producers as a result of sharp increase in the oil price brought by the OPEC embargo.

Even though this tax was named as a profit tax it was more in the nature of an excise tax imposed on the difference between the market price of oil and the statutory base price, which was adjusted for inflation and State taxes. This levy was later repealed by the Ronald Reagan administration on August 23, 1988.

Since then, this tax was not re-enacted, but it is understood that some in the Congress is looking to bring in such a levy.

The Venezuela Government was mulling over this levy of tax in 2004 by the then President Hugo Chvez to extract more money from foreign oil companies. However, this proposal never got through as there were numerous representations made to the Government that such a levy would prove disastrous to the whole Venezuelan economy.

Also it is a given fact that Venezuela is one of the more aggressively taxed countries in the world.

Is it a good idea?

Experts defer on this subject, but the consensus seems to be that levy of windfall tax on oil companies would not be a good idea in the larger interest of the economy and here are some of the reasons:

Elimination of tax loopholes: Some of the countries still give massive subsidies in the form of tax breaks for offshore and onshore oil producers and these tax breaks run into hundreds of billion dollars. The experts’ view is that such tax breaks are not required and instead the oil companies have to be treated on equal footing like any other industry. As far as India is concerned, we did provide for tax break in the law, Section 80IB by way of 100 per cent deducted on profits for a period of seven consecutive years from the date of commercial production.

However, this provision has been amended by the Finance Act of 2008, by way of a restrictive amendment and this is available only to wholly-owned public sector companies or any company, which has a substantial public sector holding of, say, 49 per cent or more. Also such oil companies have to begin operation prior to March 31, 2012.

We also have separate provision for EOUs by way of Section 10B, which gives a tax break on the export profits, which is now available up to March 31, 2010. In addition, we have the SEZ scheme, which gives export profit deduction for a period of 15 years on a graded basis — Section 10AA, that is, 100 per cent profit deduction for the first five years, 50 per cent for the balance five years and 50 per cent for a further five-year period, subject to creating a specific reserve to be used for the purpose of the SEZ undertaking.

Misallocation of capital investment: As mentioned earlier, subsidy favoured by the Government on one industry over other industry shifts capital investment. A levy such as a windfall tax, if made on energy companies would then move away capital from investment in the energy sector and thereby can make oil prices even go much higher!

Return of capital: If one would see return of capital (RoC) as a measure to see whether oil companies do have a higher return of capital in comparison with other companies, statistics do not show such an analogy. It is a fact that energy companies deploy huge capital as this is a highly-intensive capital sector. If you take a RoC on the capital employed, the quantum would look larger; but in contrast, on an average the return would be no different from any other industry.

Investment cycle: Energy companies need to invest heavily in tangible assets and, therefore, need to deploy huge capital. In any developing country, the energy sector is the backbone to economic growth and there has to be an encouragement to augment capacity and make fresh investment in this sector. Any step which does not encourage such investment, would have a serious effect on the whole economy.

Risky proposition

There is an old saying that ‘you can’t get something for nothing’. It might sound an attractive proposition to tax oil companies by introducing a windfall tax, but international wisdom tells us that one would be at serious risk by creating such a situation, which would have unintended consequences. The other issue to consider specifically for India is that we need serious investments in the oil and gas sector and such as proposal would clearly steer away any investment to this sector. To give an example, the recent NELP awards did not attract any sizeable private sector investment.

Also, we should not forget that the energy sector is among the most capital intensive and exploration, development, refining and distribution is a risky business.

In fact, the better way would be to have a re-look at all the fiscal subsidies given to the sector, including tax breaks, and bring in a level-playing field, so that there is no fiscal distortion.

(Illustration by R. Rajesh)

(The author is a Bangalore-based chartered accountant.)

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