Last Wednesday the initial findings of the Sheshinski Committee were published on how to tax oil and gas exploitation in Israel. This followed the discovery of large quantities of gas in the Mediterranean off Israel’s coast.

The committee’s work has aroused much controversy, prompting the finance minister to say some harsh things in his own press release accompanying the above publication: “I want to praise the committee not only for its professional thorough work, but also for the exemplary way it withstood more than insignificant pressure from the day it was formed; in particular, the pressure and scare tactics that were directed personally against the chairman of the committee, Prof. Sheshinski, and his family are to be condemned.... The time has come for the State of Israel, its citizens, the Knesset, the Government to decide: are we a modern state that takes care of its citizens, or are we a state where scare tactics and threats... prevent it from acting as such.”

What’s all the excitement about?

Israel’s present oil-tax regime is contained in two and a half pages in the Income Tax Regulations (Deductions from Income of Oil Rights Holders) 1956 and a few provisions in the Oil Petroleum Law, 1952. These are similar to US tax regulations at that time. They do not even cover gas. For many years, nothing happened until the recent massive gas discovery led the government to appoint the Sheshinski Committee to review and compare oil and tax policy in Israel and the rest of the world.

In view of the importance of the subject, we published an open letter to the Sheshinski Committee in The Jerusalem Post on August 10 (“Can Israel tax offshore oil and gas finds?”) and submitted a slightly longer version to the committee a few days later (on the Finance Ministry website).

The proposition is that the government ought to collect more revenues on behalf of Israel’s citizens, just like in other countries – the UK, US, etc. The counter-proposition is that oil and gas exploration is a very costly and risky business, and it should not be retroactively penalized when it succeeds.

What does the present tax regime provide?

Very briefly, the present Israeli tax regime imposes a 12.5 percent royalty on oil revenues. Then for income tax purposes, the regime allows the taxpayer to deduct a depletion allowance from profits – amounting to 27.5% of revenues but no more than 50% of profits. Alternatively, the taxpayer may deduct a depletion allowance based on the estimated quantity of oil reserves used up during the year. The depletion allowance is effectively an exemption for such amounts.

In addition, the present regime allows the taxpayer to choose between treating exploration expenses as an ordinary expense for income tax purposes, or as a capital expense. Any land acquired for onshore drilling may be amortized over the holding period. Upon any abandonment, any undepreciated assets may be written off for tax purposes.

What does the Sheshinski Committee propose?

The Sheshinski Committee proposes a new regime for oil and gas exploitation that aims to assure the continuation of gas development, accompanied by the receipt of reasonable consideration for the public, while giving fair incentives to operators in the sector.

First, under the new regime, the Sheshinski Committee proposes to leave the 12.5% royalty unchanged.

Second, the Sheshinski Committee noted the 12.5% royalty and depletion allowance largely balance each other out, which is illogical. Furthermore, the oil being depleted does not actually belong to the oil operator. Therefore, the committee proposes to abolish the depletion allowance for income-tax purposes.

Third, the Sheshinski Committee proposes to impose an oil and gas levy on profits (revenues minus current expenses), but only after recovery of 150% of the amount invested in exploration and developing a project. This is referred to as a recovery factor (R-Factor) of 1.5.

The rate of the levy would start at 20% if the R-Factor is 1.5 (recovery of 150% of amount invested) and range progressively up to 60% of the R-Factor reaches 2.3 (recovery of 230% of amount invested).

The levy would be imposed on each field separately; this is known as ring fencing. Depreciation would be allowed. Export installations may apparently be exempt from the levy. The levy would be treated as a deductible expense for income-tax purposes. It is estimated that the levy would only kick in after about eight years of production in the case of a medium to large field, or after about 15 years in the case of a small field.

It is estimated that after implementing these measures, the total Government Take (GT) would amount to about two-thirds during the life of a profitable project.

Next steps

The Sheshinski Committee is inviting the public to comment on its draft report. The committee will them submit its final report to the government by the end of the year. After that, we will need to see what the Knesset legislates and when.

Some comments

The committee’s draft report will need to be digested. It remains to be seen whether the expected legislation will resolve a variety of issues, including: the geographical extent of Israel’s taxing jurisdiction in the Mediterranean; the applicability of transfer pricing rules within groups of companies; what about supplies by air and sea to the oil/gas rigs; what about pipelines for shipping the oil/gas ashore; will employees be taxable; will they pay and benefit from National Insurance Institute payments (social security); will Israel’s tax treaties prevail where relevant; what about customs duty and VAT; accounting and tax administration; and many more issues.

As always, consult experienced tax advisors in each country at an early stage in specific cases.

leon@hcat.co

Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.

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