Israel Could Lose Millions on Natural Gas Discoveries Due to Lack of Export Policy

Israel still hasn't set a taxation policy for exported natural gas, even though exports could total $300 billion and the state could stand to take in $70 billion of that, according to the Tzemach committee's projection.

The cabinet is scheduled to meet soon to decide if and how Israel should export any of the natural gas discovered in offshore reserves over the past four years. But the ministers' decision, expected within the next month, won't be accompanied by any projections of how much the state will earn from exports - and that's not only because no export contracts have been drafted. The reason is that no one has any idea what the state stands to receive.

A moment before this fateful decision, it turns out that Israel still hasn't set a taxation policy for exported natural gas, even though exports could total $300 billion and the state could stand to take in $70 billion of that, according to the Tzemach committee's projection.

The Sheshinski committee, appointed three years ago to recommend new fiscal policy regarding natural resources - namely natural gas - did indeed lead to a change in the state's taxation policy regarding natural gas, but only regarding the gas sold for Israel's local market. That committee did not thoroughly address the complicated tax issues that arise regarding exports.

And no one has addressed these issues since then - no official entity has even conducted any comparative international research to see how other countries handle the matter.

Yet the government isn't waiting when it comes to setting export policy. But the moment that it states that the companies mining the local gas fields are eligible to export part of their finds, the government will find itself under extreme international pressure from parties interested in doing away with the uncertainty and creating a "comfortable" taxation policy. And it will likely have to settle for setting policy without a public committee, without public hearings and without interim reports, in an expedited process designed to prevent multibillion-dollar contracts from falling through or even a fallout with Israel's allies.

Currently, Israel has three mechanisms for taxing natural gas. The first one is royalties, as set in a 1952 bill. Companies mining gas in Israel pay royalties equal to 12.5% of total sales. This applies both within Israel and abroad. The second mechanism is the surtax on profits, set based on the recommendations of the committee headed by Prof. Eytan Sheshinski. These taxes are to kick in only once the companies have recouped their investment - via exploration, drilling, building infrastructure and the like.

Three mechanisms

For most gas fields, the companies are entitled to earn back their investment plus another 50% before they start paying a tax equal to 20% of profits. The maximum taxation eventually reaches 50% of profits, once the companies have earned back 230% of their initial investment. For the Tamar gas field, the partners received a benefit under which this tax kicks in only after they've earned back 200% of profits, and not 150% as in all other cases. The third mechanism is corporate tax and income tax.

These three mechanisms are supposed to give the government between 50% and 62% of revenues from all gas sales - presuming the gas is sold within Israel. But what if it's sold abroad?

The Sheshinski committee addressed this, but only in brief. Its base assumption was that the state should not help fund investments for exporting gas, and thus investments for export purposes - liquefaction and transportation facilities, for instance - would not be considered expenses for calculating the Sheshinski surtax. The obvious reason is that these expenses are likely to total billions of dollars. But on the other hand, it did not mandate that the surtax be paid on full profits from export. Instead, it stated that companies would be taxed on export based on the Israeli "market price."

And herein lies the problem. What's to keep the companies from inflating expenses? How do you define the local market price? And what if profits from exports are significantly higher than those within the local market? The government is poised to approve exports, while these questions and more remain open.

These questions not only bear billions of dollars in significance, but they could determine whether exporting is financially worthwhile altogether. In order to settle this, the Tax Authority faces three main issues.

The first issue involves setting a minimum price for exports for taxation purposes. This is the so-called transfer price - a tool commonly used in international taxation in order to ensure companies aren't using creative tax planning in order to avoid paying taxes. For instance, this is relevant if, say, the Tamar partnership were to sell gas at a reduced price to a liquefaction company, and the liquification company were to sell the gas onward at a higher price. Thus, the Tamar partnership would pay the Sheshinski tax on the lower sales price, while the more lucrative sale would be passed over.

The Sheshinski committee recommended that the transfer price be set based on the price of gas in the local market, global gas prices, the theoretical price of the gas in a reserve and the accepted returns on gas transport (downstream ) installations. Yet it has not been set.

There is a great deal of variance in contracts signed within the local market so far. The Tamar reserve has signed a contract to sell gas to the Israel Electric Corporation for a base price of $5 per million BTU. It's selling gas to private power utilities for $6, and to other factories for $8-$10. Each contract has a different mechanism for updating prices.

And this doesn't address some other forms of tax planning. For instance, the Tamar partnership has signed an initial contract with Korean company Daewoo and Norwegian company Hoegh LNG, under which the two foreign partners will build a liquefaction and transport platform. In the meanwhile, those two partners have been negotiating to sell the gas to the Russian company Gazprom. So how should the price be calculated in this situation? This deal is shaping up to be a barter whereby Tamar sells gas at a reduced price in exchange for the construction of that processing platform. The Tax Authority needs to address this.

The second issue is determining which expenses should be recognized for tax purposes, while the third issue is determining how to tax excess profits from exports. Let's say one of the partners signs a contract with a Japanese company at a price of $18 per million BTU, while the transfer price is set at $6. What part of that $18 will be considered the cost of exporting gas all the way to Japan? And how should the remainder be taxed? All these questions are still open. Most likely the ministers will need to include a clause in their decision stating that all future export contracts are dependent on a to-be-determined tax mechanism.

Albatross