Month: August 2010

1. Accelerated capital cost allowances
2. Depletion Allowances
3. Interest Deduction Rules
4. Loss Carry Forward
5. Tax Holidays

In Israel there is a special tax regime for oil and gas production, which includes tax benefits for oil and gas exploration expenses and tax benefits on revenues. The revenues stem from the Tax Authority Regulations (regulations to calculate tax on holdings and sales of participation units in petroleum exploration partnerships)-1988 (hereinafter: the regulations). The regulations distinguish between “petroleum exploration partnerships” that are defined as partnerships registered that have been approved by the Tax Authority Director and whose main expenses are related to petroleum exploration. According to the tax authority, the partnership is not liable for tax vis-à-vis the tax authority and its financial activities are related to the general partner based on his share and to the owners of the participation units according to their relative share in the partnership. According to the regulations, such a partnership is entitled to two tax benefits as specified below:

Offset for capital expenses during the current year: according to the tax method used in Israel, capital expenses are deducted over a number of years. According to the regulations, the owners of participation units are permitted to offset their capital expenses during the course of the current year from their income in other spheres of activity as though these were current business losses. This represents a tax benefit that signifies a postponement of tax payment (such as in the case of accelerated amortization . The deduction that a such an owner is entitled to relate to his income will not be greater than the sum he invested to purchase the participation unit, minus deductions from previous years (namely a person cannot buy a participation unit for 100 NIS and then claim that his part of the deduction is 500 NIS, as this would convert all his investment into a tax shield) . This is thus a type of “erection of a screen” between the owners of participation units and the partnership (in fact from the legal point of view, there is no screen between the partner and the partnership and therefore there is no need to “erect a screen”. The term is borrowed from the field of companies’ law, which is better known, where there is indeed a “screen” that distinguishes between two separate legal entities: the shareowner on the one side and the company on the other) which enables the holder to enjoy the acceptance of the partnership’s expenses already during the period of holding the participation unit in the partnership. Different to company losses, where the shareholder in a company does not “enjoy” benefits from company losses whilst holding shares. On the matter of equity profit, it has been determined in clause 88 of the income tax regulations that should the holder have offset his expenses from the value of his holding, then from the calculation of his equity profit it will not be possible to again take into consideration the original expense (in order to avoid double benefit). It is pointed out that over the last few years that significant amounts of natural gas has been discovered in Israel, and that the tax authorities and courts have yet to debate the various issues in this field. For example, lately there have been disagreements between the companies dealing in oil and gas exploration and between the tax authorities regarding the framework of approval of expenses and specifically what is included in the term “expenses for oil and gas exploration”. Finally, the tax authorities decided that this benefit will also be binding on infrastructure and production costs (such as the construction of an offshore pipeline and an onshore processing terminal) and not only on the exploration and drilling expenses.

Lower corporate taxes due to depletion allowances. Clause 3 of the regulations relates to the limited economic unit in the partnership. According to the regulations, there is a tax benefit known as amortization deduction. Thus the tax deduction is done by the method of the oil and gas field depletion (אזילה ) – each year the assets are reduced at the rate of the amount of oil and gas that was produced that year from the remaining reserves based on experts’ estimate. The regulations include a number of ways to calculate the deductions, with the main manner is t determine a rate of deduction of 2.5% from the total partnership volume up to a ceiling of 50% from the total net revenues (namely, the highest between the two). This deduction in fact brings about a lessening of the tax burden of the partnerships. The meaning of this benefit for the partnerships is a lower corporate tax at a rate of a multiplication of the deduction (27.5%) of the tax rate (25% as of 2010) (such a deduction as an expense, is deducted from the total of revenues when the calculation is done on the profits for tax purposes).

Common manner of funding large projects or for small oil and gas companies. Usually it is possible to deduct the interest on the loan from the taxed income as an approved expense. Even interest within the company can be deducted from the taxable income, when they are calculated in a fair manner.

Assets are deducted in a different manner throughout their lifespan. The main methods of are:
• Direct line amortization (constant annual amortization)
• Surplus amortization (direct line amortization calculated for the surplus value of the asset each year)
• Amount of remaining years (the ratio between the number of remaining years of the asset and the number of years that the asset is due to be used)
• Production units (equity cost of the equipment, after amortization of the accumulative amortization and of the remaining value, multiplied by the ratio between the total annual production and between the remaining recoverable reserves at the outset of any particular tax year.

IRR is the discount rate at which the net present value (NPV) of future cash flows from a capital investment equals zero. Capital expenditure is the primary factor in determining a market’s IRR, along with incentives and operating expenses. Put simply, it provides an apples-to-apples metric for investors to compare demand and project growth across disparate markets.

In a competitive market with no excess profits, the IRR will equal the risk adjusted discount rate.

If a project has an NPV greater than zero, the project creates value and should be undertaken. One can provide in a gas project the breakeven gas price (BEP), which represents the gas price needed to ensure that a project’s NPV is zero, and as such that it is the price needed for the project to be value neutral. If the realizable price is above the BEP, then the project will create value and should be pursued. If not, then the project would destroy value and should not be undertaken.

In the calculation of investments for offshore oil and gas drilling in Israel, economists often take a risk adjusted discount rate of 9%. Insofar as the IRR applies to rate of return on a project, it is sometimes referred to as the project internal rate of return