Royalties

Royalties are the price that the owner of a natural resource charges a private company or consortium for the right to develop this resource.

The right of governments to levy royalties from oil and gas companies derives from their ownership of natural resources. Through royalty payments, governments are compensated by oil and gas companies for the extraction of public natural resources.

In most jurisdictions around the world, governments own and manage resource development on behalf of their citizens. In Canada, for example, provinces own the natural resources found on public lands. (The exception is offshore oil and gas, which is a federal responsibility or, in the case of Nova Scotia and Newfoundland and Labrador, a joint federal-provincial responsibility. There may also be revenue-sharing agreements as part of land claim agreements with First Nations.) Provincial governments are therefore entitled to collect royalties from oil and gas companies. They can clarify this right through legislation, regulations and contracts.

Governments generally use of one of two systems: (1) a concession system where regulated royalty rates apply to all producers equally; or (2) a system of Production Sharing Agreements (PSAs) with producers, where rules and rates may vary from contract to contract. In a PSA, a government collects an agreed share of profits from oil and gas production – some PSAs stipulate that royalty payments must also be made. This Practice Guide is more relevant for the audit of concession systems, but many of its sections may be useful for planning performance audits of PSAs (compliance audits are also common for PSAs).

Royalties apply once production has begun at a new site. There are different types of royalties, the main ones being:

• Volume-based (or specific) royalties: a regulated price per unit of production. This type of royalty requires controls to monitor production and to ensure there is no illegal (unrecorded) extraction.
• Value-based (ad valorem) royalties: based on the value of the extracted commodities. The value is volume multiplied by price (set by the market), so the difficulty of establishing price (which varies day to day) is added to the difficulty of establishing volume.
• Profit-based royalties: based on a company’s profits. While this is in many ways similar to an income tax, it is an additional charge for the extraction of public natural resources. Like an income tax, this type of royalty requires government departments with strong financial, technical, and administrative capacity to regulate and collect the royalties while minimizing the risk of tax evasion. (Transfer mispricing is a common example of tax evasion in the natural resources sector) The challenge is substantial because many extractive companies are global market players that are not regulated by any single government.

Oil and gas companies pay royalties in addition to their regular income taxes. However, royalty payments are deductible for income tax purposes in many jurisdictions.

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