Overview of the new natural gas market taxation - MSI Global ...

Overview of the new natural gas
market taxation

   1. Introduction:

In 2019, the Ministry of Mines and Energy, along with the Ministry of Economy, the
National Petroleum Agency ("ANP"), the Energy Research Company ("EPE") and
the Administrative Council of Economic Defense ("CADE"), launched the New
Gas Market project. It aims to promote the competition, attract domestic and
foreign investments, ensure the gas supply and reduce prices for the final
consumer. This is an improved version of the 2016 project “Gás para Crescer”
(“Gas for the Growth”).

One of the most significant challenges to be faced by this project is the need to
improve the poor position occupied by Brazil as one of the countries where the
gas price are the highest in the world, as well as the supplier of the most
expensive gas in Latin America, according to EPE. For illustration purposes, while
in Brazil gas the is traded for approximately US$ 14 per million BTU, in Europe -
where many countries do not even produce such commodity – the price range
from US$ 7 to US$ 8 per million BTU, and in the USA the price is as low as US$ 4 per
million BTU.

Given the essential nature of the energy sector for the industrial production, the
high cost of the natural gas impacts adversely the growth of the domestic
market.

As per such project, the government's primary commitments to this project is to
break the monopoly of state gas distributors. As a consequence thereof,
Petrobras undertook to divest its equity in the gas distribution companies
responsible for 19 of the 27 states of the federation, which in the past were the
exclusive concessionaires for the supply to the final consumer.

The creation of independent regulatory agencies and entities aiming to regulate
the free commercialization of the natural gas in similarity with the electric power
free market are revolutionary, such as the privatization of the state distributors

and the update on the regulation of the free consumers, self-producers, and self-
importers.

As regards taxation, the states of the federation entered into an agreement to
modify the Tax on the Circulation of Goods and Services - ICMS tax rules,
replacing the physical for the contractual flow of gas system thought
adjustments to the National Integrated Economic Information System - Tax –
SINIEF.

The present article has as purpose to highlight material aspects of the tax system
applicable to the natural gas market in Brazil vis-à-vis the expansion thereof and
the increasing complexity and multiplicity of service providers and agents
performing taxable transactions among themselves, which in the past were
executed, almost in its entirety, by Petrobras. Our analysis will address aspects of
Brazilian legislation related to the taxation of natural gas in the country focusing
on the main phases of its production and marketing chain.

   2. Tax Regime applicable to the Sector

The Brazilian tax regime applicable to the oil and gas upstream industry involves
the incidence of federal, state, and municipal taxes and the collection of
governmental and third-party participations. Since 2011, the legislation on the
matter establishes different systems for oil and natural gas exploration and
production (E&P), namely: the concession and production sharing systems,
which can be explained as follows:

A. Concession Regime

In the concession regime, the participant who offers the largest signing bonus to
the government for each block wins the bid. More recently, the level of proposed
Brazilian purchases (local content) has also been considered a relevant public
offer component.

Implemented in 1997 by Law No. 9,478, it is the model adopted since then in most
of the rounds already bid by the National Petroleum Agency (ANP).

Under the concession regime, the production is subject to the payment of the
following remuneration for the government, as per Law No. 9,478/1997 and
Decree 2,705/1998:

       • Signing Bonus: its minimum amount shall be established in the public bid
       notice and shall correspond to the payment offered in the proposal for
       the concession, to be paid upon the signature of the relevant concession
       agreement;

       • Royalties: to be paid monthly, in national currency (BRL – Brazilian Real),
       from the date the commercial production starts in each field, in an
       amount corresponding to up to 10% of the oil or natural gas production;

       • Special Participations: extraordinary financial compensation due by oil
       or natural gas exploration and production concessionaires, in case of
       large production volume or high profitability. Such compensation shall be
       paid, for each field in the concession area, as from the quarter in which
       the relevant production starts;

       • Payment for Area Occupation or Retention: the public bid notice and
       the concession agreement shall provide for the payment for the area
       occupation or retention, to be ascertained each calendar year, as from
       the date of the signing of the concession agreement, and paid every
       January 15 of the following year.

As regards the royalties for the natural gas, Decree 2,705/1998 provides that the
calculation thereof shall be based on the contracted price or, in lack of an
agreement, the natural gas reference price. Such prices consider the quality of
each field's gas, i.e., related to its respective calorific power.

B. Production Sharing Regime

In Brazil, the production sharing regime has been valid since 2010 for oil and
natural gas production in the pre-salt areas, as well as for other areas considered
as strategic. Unlike the concession regime, the Federal Government is
considered as the owner of the extracted oil and gas. Therefore, (i) the costs
incurred for the relevant operations are discounted from the total value
produced and (ii) the oil in excess is shared between the company or consortium
that exploits the area and the Federal Government.

The company or consortium that exploits natural gas in the production sharing
regime shall pay royalties and signing bonuses, as provided for in art. 42 of Law
No. 12,351/10.

Under the terms of the relevant law, the royalties relating to the financial
compensation for the exploration of oil, natural gas, and other liquid
hydrocarbons shall be calculated based on a 15% rate.

The signing bonus, on the other hand, is not included in the oil cost (part of the
production corresponding to the costs and investments made by the contractor
in the execution of exploration, evaluation, development, production, and
decommissioning activities) and relates to a fixed amount due by the contractor
to the Federal Government, to be defined in the production sharing agreement
and paid upon signature.

3. Tax Incidence in Production

Regarding the incidence of state taxes, we emphasize that the gas extraction
(original acquisition), as well as flaring operations, personal consumption for
electric power generation, or reinjection, do not imply in transference of title.
Therefore, in our opinion, it should not be subject to the incidence of ICMS.

However, the State of Rio de Janeiro had passed the State Law No. 7,183/2015,
which provided that the ICMS would be collected on the oil circulation operation
- from the wells of its extraction to the concessionary company.

We are nevertheless on the opinion that such provision infringed the Federal
Constitution to the extent that the underground mineral resources belong to the
Federal Government, which grants to the concessionaires the original right over
the hydrocarbon ownership at the time of production. As a consequence, it
would not be appropriate to consider as circulation of goods the circulation of
gas between the reservoir and the production units. Rightfully, the referred state
legislation had its validity suspended by the Federal Supreme Court - STF through
the Direct Unconstitutionality Action (ADI) 3.019/2004.

Furthermore, the states and municipalities regularly institute, on a concomitant
basis, inspection fees on oil and gas research, mining, exploration, and
exploitation activities.

Not infrequently, such fees are have the mere purpose the collection of
additional taxes by overlapping the competence of the Federal Government,
who is the entity in charge of the granting of authorization for the exploration and
production activities, in addition to other unconstitutionalities.

As an example, Rio de Janeiro State Law No. 7,182/2015 -- which instituted the
Tax for the Control, Monitoring and Environmental Inspection of the Oil and Gas
Research, Mining, Exploration and Production activities (TFPG) -- aimed to
finance the environmental police power of the State Environment Institute (Inea)
on oil and gas activities in the State. This Law had stipulated the amount of R$
2.71 per equivalent unit of extracted gas to be collected,

Such law was nevertheless suspended by an injunction granted in 2016 by the
8th Civil Chamber of Rio. The law that established the TFPG has also been
challenged before the STF through two Direct Unconstitutionality Actions, ADIs
5480 and 5512, filed respectively by the Brazilian Association of Oil and Gas
Exploration and Production Companies (Abep) and the National Industry
Confederation (CNI).

Lastly, we point out that Repetro-SPED tax benefit is applicable in the acquisition
of equipment used in the natural gas production phase, given the express
prevision of Normative Instruction - IN 1,781/2017, pursuant to which the
interested parties can avail themselves of all the regimes contemplated by it.

4. Pipeline Importation

In this topic, we emphasize the importance of Decree 681/92, which internalized
the Partial Coverage Agreement on the Commercial Trade between Brazil and
Bolivia for Natural Gas supply.

As a result of this Agreement, the purchase and sale of gas between both
countries are exempt from import liens and export taxes and other non-tariff
restrictions. In this regard, Declaratory Act of the Federal Revenue Office - SRF
No. 21/2004 provides that such exemption also reaches the PIS/PASEP-Import
and COFINS-Import Contributions. However, such tax exemption does not cover
the ICMS, which is why the state tax that must be regularly collected.

The Bolivia-Brazil pipeline has its entry point in Corumbá/MS, discharging the gas
through city gates located mainly in São Paulo, Paraná, Santa Catarina, and Rio
Grande do Sul.

Therefore, there is a substantial legal discussion concerning which federative
entity would be competent to collect the tax, since the Federal Constitution
provides that the ICMS-Import will be due to the final recipient state.

Recently -- on October 22, 2020--, the Federal Supreme Court settled the dispute
through the Original Civil Action (ACO) No. 854, in which the understanding that
the legitimate collector of the ICMS-Import tax is the Member State in which the
importing establishment is located was consolidated.

5. Maritime Importation

Law No. 11,909/2009 (the “Gas Law”) regulates the importation of liquefied
natural gas - LNG, as well as the liquefaction and regasification activities.
Currently, such activities depend on mere prior authorization from ANP, dismissing
the need of a more bureaucratic public concession.

As it occurs in the activities related to natural gas flow and processing, in the
hypothesis that the importers themselves are owners or custodians of the
regasification infrastructure, we understand that there should be no incidence of
ICMS, as it characterizes a self-service hypothesis.

Maritime imports are subject to AFRMM (Additional Freight for the Renewing of
the Merchant Marine), which covers cargo freight unloaded in ports outside the
North and Northeast regions. On the other hand, the PIS and COFINS contribution
rates were reduced to 0% on LNG imports.

However, in case of a back-to-back transaction -- defined as the sale of the
acquired cargo before entering Brazil--, PIS and COFINS will be levied on the total
amount of the transaction, without the right to offset the relevant credits. In this
respect, offshore operation tax planning may constitute a valid alternative to
reduce the tax impact depending on the specific case.

We also highlight that, should the LNG import operations involve related parties,
they will be subject to the transfer price rules foreseen in Law No. 9,430/96 and IN

RFB No. 1,312/2012. The referred IN requires the mandatory use of the Import
Quotation Price (PCI) method, defined as the daily average values of the goods
quotation or rights subject to public prices as per the internationally renowned
commodities and futures exchange entities.

Furthermore, the LNG importer that does not have its Regasification Terminal and
therefore needs to hire the regasification from third parties must comply with
Article 3 of IN No. 1,282/2012 to obtain the "cargo use availability." After this step,
the agent will be able to issue a delivery note for regasification.

6. Outflow

The outflow activity, which is currently not regulated by the national legislation,
consists of natural gas circulation between the production field and the
treatment units.

In this activity, the producers themselves may be the owners or custodians of the
outflow infrastructure. As it constitutes a kind of self-service, there would be no
incidence of the Tax on Services - ISS. On the other hand, in case a third-party
infrastructure for gas flow is contracted, the taxation will follow the established at
the relevant agreement, depending on whether it is related to the capacity
release, service rendering, etc.

It should be emphasized the occurrence of advances in this sector that are being
implemented by the New Gas Market.

Among such advances, we highlight the Agreement signed on September 30,
2020, between Petrobras and Petrogal Brasil, Repsol Sinopec Brasil, and Shell
Brasil, which foresees the sharing of the natural gas flow and processing
infrastructure, originating the Integrated Outflow System-SIE.

The Agreement contemplates the physical interconnection and sharing of flow
capacities on routes 1, 2, and 3 (the last one owned by Petrobras and currently
under construction). In the future, other natural gas producing companies may
adhere to the existing agreements, provided their provisions are duly complied
with and that there is available flow capacity in the system.

Concerning the above-mentioned SIE System, it should be highlighted ICMS
Protocol 18/2017, according to which the system corresponds to a set of
infrastructure assets that, while integrated, enable the natural gas flow produced
in territorial waters bordering the states of Rio de Janeiro and Sao Paulo.

Furthermore, the relevant Protocol provides that only one Electronic Invoice (NF-
e) shall be issued monthly for the natural gas output operations, which is likely to
simplify the compliance with ICMS accessory obligations between the producing
fields and the treatment units.

Moreover, ICMS Protocol 18/2017 established the deferral of the ICMS levied on
the internal transfer operations of unprocessed natural gas, carried out at the
same taxpayer establishment, to the moment of the product's removal.

Taxpayers that perform the outflow through the SIE System shall execute, on a
monthly basis, a withdrawals report by each taxpayer (producer), indicating: (i)
the amount of natural gas moved through the SIE, per platform, (ii) the amount
in stock and (iii) the Operating Differences, in millions of British thermal units
(MMBTU), in addition to the methodology for calculating the stock in the gas
pipelines that form the SIE System.

It is also important to mention that, according to the ICMS Protocol 18/2017, the
operational differences will not be subject to ICMS, as long as they remain within
the minimum tolerance rate established by a statistical study carried out by the
competent State Treasury Offices.

7. Treatment

As it occurs with the outflow, the natural gas treatment process is not regulated
by national legislation.

As regards the treatment of natural gas, the producers themselves may be the
owners or custodians of the outflow infrastructure, which, by constituting a self-
service, should not be subject to ISS taxation.

On the other hand, in the case of contracting a third-party infrastructure for the
gas outflow, the taxation will follow the established in the relevant agreement,
depending on whether it relates to capacity release, service rendering, etc.

There is a discussion on whether third parties’ gas treatment should result in the
collection of ISS or ICMS: if the activity would be considered a service (related to
an obligation to do) or a manufacturing to order (operation on raw materials or
intermediate products relevant to obtaining new products).

In a manufacturing to order scenario, it is worth pointing out that STF considers
that if the sale occurs to whoever promotes the circulation of goods, the ICMS
should be payable. If the buyer is the final consumer, the preponderance
between the "obligation to give" and “obligation to do” should be evaluated by
verifying the industrialized elements. ISS should be payable when the "obligation
to give" prevails over the "obligation to do."

We also point out that Liquefied Petroleum Gas (LPG) produced from natural gas
(Liquefied Natural Gas - LNG) are subject to different tax treatments regardless
of the fact that they are similar products.

8. Transportation

ANP regulates natural gas transportation, whose activity is defined through
public calls. Under the terms of Article 30 of Law No. 11,909/2009, the gas
pipelines are considered public interest goods, being their economic
exploitation subject to authorization by the Federal Government.

We emphasize that the activity is subject to the collection of fees regulated by
Resolution ANP No. 15/2014, establishing the criteria for calculating the natural
gas pipeline transportation fee.

The fee may not imply on discriminatory or preferential treatment between users.
However, the above-mentioned Resolution provides that the fees may be
distinguished depending on the service and carrier type and must consider
factors such as cost for efficient service rendering, the distance between entry
and delivery points, volume and term, and the liability of each carrier.

According to ANP Resolution 16/2008, natural gas odorization shall occur in the
transportation and distribution stages, aiming to ensure the gas quality.

ANP Resolution 15/2014 provides the methods to be adopted to calculate the
transportation fees applicable to the Firm Transportation Service. Such fees will
be composed, at least, by the following:

      I – Entry Capacity Charge: destined to cover the investments on the
      inbound capacity, the Firm Transportation Service costs and the fixed
      expenses;

      II – Transportation Capacity Charge: intended to cover the investments on
      the Transport Capacity;

      III – Exit Capacity Charge: intended to cover the investments on the
      delivery capability

      IV – Circulation Charge: intended to cover the costs and variable
      expenses with gas circulation.

Regarding the compliance with tax ancillary obligations in gas transportation,
SINIEF Adjustments 03/2018 and 17/2019 introduced a significant advance under
the New Gas Law. It considered that the issuance of tax documents relating to
circulation operations and pipeline transportation services would be established
based on the quantities of natural gas effectively measured at the points of entry
and exit, according to a contractual provision, as requested by forwarders and
recipients and confirmed by the natural gas pipeline transportation agent.

Such rules replaced the old principle of physical flow of the natural gas, which is
not compatible with the new scenario -- that ended the monopoly in the sector
and allowed more investors to access the market – in which is not possible to
define the effective owner of the gas that is being transported.

Furthermore, the SINIEF Adjustments provide for the institution of an Information
System - SI, which allows the taxpayer to promote the adjustment between the
physical and contractual parameters of the gas transported for taxation
purposes. The Cotepe Act 56/2019 approved the SI, according to which the
forwarders and recipients should issue to the transportation service providers, on
a daily basis, the logistic schedule provided for in Sinief Adjustment 3/2018.

9. Distribution

The gas supply for captive consumers is featured as the sale of natural gas with
the provision of the necessary infrastructure by the distributor.

Despite this operation contemplating two objects, namely, circulation of goods
and rendering of services, the ICMS taxation is calculated over the total price.

Besides that, a circulation fee for free agents has been defined by the Gas Law
as an activity of "operation and maintenance," which would be subject to the
ISS.

However, the legislation is silent as regards the distributing services that trespass
the municipality's territorial limits. Thus, observing the specific characteristics of
the operation and pertinent local rules, we understand that the ISS would be
levied when the gas circulates within the same municipality and ICMS would
apply in case of interstate distribution.

ANP Resolution No. 51/2011 regulates the registration of the natural gas self-
producer and self-importer, as follows:

       I – a company or consortium that has signed an agreement with the
       Federal Government for oil and natural gas exploration and production,
       with a declared commercial discovery and development production
       plan approved by ANP;

       II – a company, directly or indirectly controlled by other companies that
       are producing natural gas, as well as the controlling shareholders of the
       producing company; and

       III – related companies of a natural gas producing company

ANP Resolution No. 52/2011 regulates the registration of free consumers, self-
importers, and self-producers for natural gas commercialization within the
Federal Government sphere of competence. This regulation provides for the
authorization of all companies or consortiums constituted under Brazilian Law,
with headquarters in the country.

It provides restrictions for purchasing and selling natural gas to the transporter,
except regarding the volumes necessary for the transport facilities' self-

consumption and operational stock as well as for maintenance purposes.
Therefore, a legal separation of the activities has been established so that the
transporter is prohibited from commercializing natural gas.

Finally, we emphasize that the ICMS Conventions 18/1992 and 100/2014 instituted
the ICMS tax base reduction benefit, corresponding to the taxation of 12% on
internal natural gas output. The states of Amazonas, Bahia, Mato Grosso do Sul,
Paraíba, Paraná, Rio de Janeiro, Rio Grande do Sul, Santa Catarina, and São
Paulo have adhered to the referred Convention.

Creuza Coelho and Rafael Fiuza