After a trial of a value-based resource production tax launched in June 2010 in Xinjiang, north-west China, the government has announced that oil and gas production will be based on value, rather than on weight or volume, across the whole country. This step brings China in line with the rest of the world.

The taxation of resource production can be based on the unit of resource produced (weight or volume) or on the value. Such taxes are commonly known as royalties. Until the second half of the twentieth century, most royalties were based on the unit of resource produced. More recently, most countries have shifted to a royalty based on value. The primary advantages of charging royalty based on value rather than on unit of production are that the royalty rates do not need to be adjusted every time the resource price changes, that the government receives more revenue at times of higher prices, and that the financial burden on the companies is reduced at times of low resource prices.

 

Further, some governments have developed ways to tie the royalty rates more closely to profitability by introducing sliding scales based on such parameters as production rate, annual operating profit, or cumulative net revenues. The aim is to make the royalty more economically neutral.

 

Since Liberation in 1949, the production of oil, gas and minerals in China has been tax on the basis of the volume or weight of the resource produced. In recent years, these rates have been:

·       RMB Y 8.00-30.00 per tonne of crude oil (US $ 1.00 = RMB Y 6.35);

·       RMB Y 2.00-15.00 per thousand cubic metres of natural gas;

·       RMB Y 0.30-5.00 per tonne of coal.

 

With crude oil selling at prevailing international rates of above US $ 80 per barrel (about US $ 550 per tonne), producer prices for natural gas of between US $ 100-200 per thousand cubic metres, and coal at prices about US $ 100 per tonne, the Chinese companies are paying royalties of less than 1% of the value of the resource produced.

 

This approach to resource taxation may have been appropriate in the times of planned production, fixed prices and non-commercialised resource companies. But in today’s world of high and fluctuating prices and of commercialised resource companies, it results in the further enhancement of the profits of the resource companies and in a loss of revenue to government. The profitability of these majority state-owned resource companies was further supported by the reluctance of the government to require these companies to pay dividends to the state until recently. Throughout this period, most foreign oil companies operated in China under production sharing arrangements with royalty arrangements based on value, with sliding scales based on production rates, following international practice.

 

In June 2010, the government launched an experiment in the resource-rich Xinjiang Autonomous region of north-west China. This involved a royalty levied on oil and gas production of up to 5% by value, the actual rate varying by field. The revenues flowed to the government of Xinjiang. The result was a massive increase in the revenue from resource production from RMB Y 370 million in the first half of 2010 to RMB Y 2.3 billion in the first half of 2011.

 

In early October 2011, the government announced that it would apply this new method of royalty payment for oil and gas across the entire country, and that the royalty rate would range between 5% and 10%. A slightly later announcement stated that the rate would initially be set at a uniform 5%, but would probably be increased in later years. Although this new system will require significantly higher royalty payments from the companies, it contains no sliding scale to capture higher royalties from the most productive fields.

 

The royalty payments for coal will continue to be based on unit of production, though coking coal will have a special higher rate of RMB Y 8.00-20.00 per tonne. The rate for conventional coal will remain unchanged. Rare earth element ores will face a royalty of RMB Y 0.40-30.00 per tonne, with the more valuable, heavy rare earth’s facing the higher rates.

 

The official explanations for the introduction of the new royalty system emphasise the conservation of resources and protection of the environment. If these were indeed the main drivers, the reform could have been carried out many years ago. Instead the timing of the change suggests that raising revenues for indebted provincial governments is the principal objective. These measures will also address popular anger at the high level of profits of China’s national resource companies. Analysts have projected earnings declines in 2012 of up to 11% for both PetroChina and Sinopec.

 

Whilst such a tax reform is long overdue, the risk of a ‘flat rate’ of 5% across all oil and gas fields is that economically marginal oil and gas fields become commercially unviable and that the companies stop production from these fields. It is likely that shale gas and shale oil will be taxed under a separate regime.

This is just a first step in a long and complex process of resource tax reform. We should expect further adjustments to the new systems for oil and gas taxation arising from pressure from the oil companies and from possible reduction in production volumes. The government is likely to be more cautious in extending value-based taxation to the coal and metals sectors for a number of reasons: these resource companies are generally less profitable than those in the oil sector; they are greater in number and therefore the tax administration is more complex; and higher costs in these sectors will feed more directly into inflation.