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THE DYNAMICS OF WINDFALL TAXATION SYSTEM

Article · July 2009

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 THE DYNAMICS OF WINDFALL TAXATION SYSTEM

GAURAV SHUKLA

ASHHAR MUSTAFA

(2009) Taxman mag. vol.178 page no.64

The term ‘windfall’ means an exceptional situation, good fortune and is primarily attributable to
gains in situation of ‘legacy’. The origin of windfall profits tax traces its roots to the United
States legislating an excise levy on the production of crude oil way back in the year 1980. It
denotes an unexpected profit, usually sizeable, which could be the result of sudden rise in stock
prices or increase in wealth consequent to, say, unexpected inheritance. This article makes a peep
into taxation system of windfall tax. The article concludes with a critical appraisal of this tax.

Introduction

1. Windfall gain denotes an unexpected profit, usually sizeable, which could be the result of
sudden rise in stock prices or increase in wealth consequent to, say, unexpected
inheritance. The term ‘windfall’ means an exceptional situation, good fortune and is
primarily attributable to gains in situation of ‘legacy’. Similarly, windfall tax represents a
levy on an unexpectedly large profit, especially one regarded to be excessive or unfairly
obtained. From the point of view of investment, it could be said to be one-off gain that
cannot be relied upon to recur. It is a gain or loss resulting from circumstance outside the
control of the recipient.1

Past few weeks have witnessed debate amongst policy makers, economists, and political
fraternity alike on justification for levy of windfall tax on oil and gas businesses. But the
demanded for such a tax has almost died down with the fall in international oil prices.
This by itself shows that a serious thought was not given to the economic, fiscal,
administrative and other issues concerning such a tax. Here it has been advocated that
whenever demands rise for its Legislature must necessarily examine the various
parameters of the issue prior to taking any hasty decision, since the precedents and
current situation suggest that it could be a ‘knee-jerk’ reaction.

Origin of the Concept

2. The origin of windfall profits tax traces its roots to the United States legislating an excise
levy on the production of the crude oil way back in the year 1980. The social and
economic environment permitting imposition of the windfall profit tax began developing

1
. Record Profit Mean Record Taxes, Investor’s Business Daily, February 12, 2008.
 almost a decade before this legislation. In the late 1960’s and early 1970’s, the supply of
petrochemical energy available in the United States began to noticeably dwindle.2 The
Arab embargo of the winter of 1972-1973 emphasized that point. During that period of
time, the Organization of Petroleum Exporting Countries, better know as OPEC, also
began to strongly influence the availability and supply of crude oil, resulting in the
United States initiating price controls on crude oil.3 When the decision was taken to lift
those controls over a period of time, many believed that significant ‘unearned’ revenues
would accrue to the oil industry solely because OPEC had been successfully in artificially
establishing the world price for the crude oil.4

Consequently, the President Carter signed into law the Crude Oil Windfall Profit Tax
Act, 1980 (‘the act’)5, which was intended to deprive the oil industry of a portion of this
alleged artificial increase in revenues6. Additionally, the act was indented to increase
Government revenues to fund various energy programmes7. The Act, first proposed by
the Representative Ullman on May 3, 1979, was debated by Congress for over ten
months. Debate on the act was primarily along regional lines with legislators from oil
producing States opposing the Act and those from non-producing States supporting it.
After all the debate on and controversy surrounding the Act, it is nevertheless misnamed.
The tax imposed by the Act is not a tax on profits. Rather, it is an excise or severance tax
applied to certain revenues from the sale of crude oil which were believed by some to be
a ‘windfall’.8
In brief, the Act established a tax in the difference between the sales price of taxable
crude oil and a base price, tied to the controlled price of the oil. The rate of tax varies
from thirty to seventy per cent, depending upon the category of crude oil being taxed.
The tax is imposed on producers of taxable crude oil removed from a property on or after
March1, 1980. However, the Act was later repealed on August 23, 1988, amid low oil
crisis, when the President Ronald Reagan signed P.L. 100-418, The Omnibus Trade and
Competitiveness Act of 1988.9

2
. Studies conducted by many petrochemical industry groups in this period showed the amount of proven reserves
falling. See generally American Gas Association, Inc., American Petroleum Institute & Canadian Petroleum
Institute, Reserves of Crude Oil Natural Gas Liquids, and Natural Gas in the United States and Canada (1972).
3
. See 6 C.F.R. Part 150, Sub-part L [1973]. For a detailed discussion of crude oil producer price regulations, see
Carroll, Department of Energy Crude Oil Producer Price Regulations: An Overview and an Update, XII NAT.
Resources Lawyer 327 [1979].
4
. See S. REP. No. 96-394, 96th Cong., 1st Sess. 132, 146, 160, reprinted in [1980] U.S CODE CONG. & AD.News
1008, 1135-36, 1148, 1161-62.
5
. See Pub. L. No. 96-223, 94 Stat. 229 [1980].
6
. See H.R. REP. No. 96-304, 96th Cong., 1st Sess. 4, reprinted in [1980] U.S. CODE CONG. & AD. News 1185,
1187.
7
. See S. REP. No. 96-394, 96th Cong., 1st Sess.8, reprinted in [1980] U.S. CODE CONG. & AD. News 1008, 1017.
8
. See H.R. REP. No. 96-304, 96th Cong., 1st Sess. 4, 7, reprinted in [1980] U.S. CODE CONG. & AD. News 1185,
1189, 1192.
9
. CRS Summary for H.R. 4848.
Factors Necessitating the Duo-enactments

3. Crude oil is the most important traded commodity and unlike other traded commodities
its demand and supply are subject to geo-political vagaries and, hence, inherently
susceptible to a prize variation. The added feature being that its availability is not as
widely scattered as other natural resources. The 1980 Act was essentially introduced on
increased profits that accrued following the deregulation of US price controls on crude
oil. The US Government enacted the legislation as part of compromise between the
Carter Administration and the Congress over decontrol of crude oil prices.10
(a) Factors motivating the enactment of Crude Oil Windfall Profit Tax Act, 1980
• The Congress believed that the projected huge redistribution of income from
energy consumers to energy producers would not be fair.
• The Congress also felt that industry was not paying its fair share of federal taxes
due to availability of two oil industry tax subsidies (incentives): the percentage
repletion allowance and the provision which permits companies to expanse
(deduct fully in the initial year) the intangible costs of drilling.
• Since the federal budget was in deficit between 1961 to 1979, the Congress’s
Joint Committee on Taxation projected that the tax would generate, from 1980 to
1990 additional gross revenues of approximately $ 393 billion.
(b) Factors motivating the enactment of the Repealing Act, 1988
• Congress was also consent that the tax had increased the nation’s dependence
on imported oil.
• The original forecast of revenues turned out to have been significantly over
estimated, reflecting over estimates of crude oil prizes from 1980 to 1990, the
tax generated gross revenue of about $ 80 billion or 80% less than the projected
amount of $ 393 billion.
• The tax also appeared to be a complicated tax to comply with and to
administered.
• The tax also may have distorted the way resources were allocated with in the
oil industry since the tax was imposed on oil production - i.e. upon its removal
and sale - extraction ( and other upstream operations) was penalized and other
aspects of the business (refining and marketing, the down-stream operations)
became relatively favored. Does it created financial incentives to shift
resources from exploration and drilling to refining and marketing.

Computation of Tax

4. The windfall profit tax is imposed only on the ‘windfall profit’ resulting from the
removal of taxable crude oil from the property from which it was produced during the

10
. Mukesh Butani, Windfall Tax Debate, Business Standard, New Delhi, July 28, 2008.
 each calendar quarter.11 The windfall profit is equal to removal (sales) price of a barrel of
oil reduced by the applicable adjusted base price and a severance tax adjustment.12 The
windfall profit on each barrel of oil is, however, subject to a net income limitation.13
The removal price with respect any crude oil is almost often the amount for which the
barrel is sold, but in certain cases it is the constructive sales price used for percentage
depletion purposes.14 On the whole, the adjusted base price is the average price for which
the category or tier of oil would have been sold in 1979 prior to the removal of price
controls and adjusted for inflation.15 Therefore, the base price for tier1 is the ceiling price
that would have applied to the oil under the Department of Energy (DOE) price
regulations if it had been sold in May, 1979 as upper tier oil,16 reduced by 21 cents.17 The
national average base price for tier 1 oil should be around $12.80 per barrel. The base
prices for tier 2 and tier 3 oil are currently determined under formulas set forth in the
temporary regulations pursuant to which the base prices for tier 2 and tier 3 oil will be
approximately $15.20 and $ 16.55, respectively.18 The base price is adjusted quarterly for
inflation to arrive at the adjusted base price.19 Additionally, the base price of tier 3 oil is
to be adjusted upward by approximately one-half per cent per quarter.20 The severance
tax adjustment is basically the difference between the States severance tax actually
imposed and the State severance tax which would have been imposed had the barrel been
sold at its adjusted base price.21 The tax payable with respect to a barrel of oil is
determined by multiplying the windfall profit by the tax rate applicable to the tier of oil
being taxed.22
An example of how the windfall profit tax is computed may be helpful in understanding
some of the Act’s provisions. Assume that (i) a single barrel of newly discovered oil (tier
3) is removed from a property during the calendar quarter, (ii) the barrel of oil is sold for
$ 35.00, (iii) its adjusted base price is $ 17.89 (base price of $ 16.55 multiplied by

11
. See I.R.C. § 4986(a).
12
. Temp. Treas. Reg. § 150.4988-1(a) [1980]
13
. See I.R.C. § 4988(b).
14
. See Temp. Treas. Reg. § 150.4988-1(b) [1980].
15
. See Temp. Treas. Reg. § 150.4989-1(a) [1980].
16
. Carroll, Department of Energy Crude Oil Producer Price Regulations: An Overview and an Update, XII
NAT. Resources Lawyer 327 [1979].
17
. Temp. Treas. Reg. § 150.4989- 1(b) [1980].
18
. Temp. Treas. Reg. § 150.4989- 1(c) [1980], as amended by, T.D. 7720, 45 Fed. Reg. 63,263 (1980) & T.D.
7721,
45 Fed. Reg. 64,574 [1980].
19
. See I.R.C. § 4989 (b)
20
. See § 4989 (b)(2). For the quarter ending September 30, 1980, the inflation adjustment was .0649 for tier 1 and
tier
2 oil and .0810 for tier 3 oil.
21
. H.R.REP. No.96-817, 96th Cong., 2d Sess. 104, reprinted in [1980] U.S. CODE CONG. & AD. News 1240,
1255.
22
. See I.R.C 4987; Temp. Treas. Reg 150.4987-1 [1980]. As noted earlier in the text, except for independent
producer oil, the tax rates is 70 per cent for tier 1, 60 per cent for tier 2, and 30 per cent for tier 3. Independent
producer oil in tier 1 is subject to a 50 per cent rate of tax and in tier 2 a 30 per cent rate.
 inflation adjustment of 1.0810), and (iv) the barrel is subject to a State severance tax
equal to 71\2 per cent. The windfall profit tax on such barrel of oil (without considering
the net income limitation) is $ 4.75, computed as follows:
Removal price $35.00
Less: Adjusted base price: $17.89
Severance tax adjustment:

The difference between the severance tax actually $1.29

Imposed ($35.00 X 71\2 per cent) and the amount
that would have been imposed if the oil sold at its
adjusted base price ($17.89 X 71\2%)
Total = $17.89 + $1.29 = $19.18
Thus, Windfall Profit Tax = Windfall Profit Multiplied by Tax Rate
= 30 per cent of ($35.00 - $19.18) = $4.75

If the amount of the windfall profit, not the windfall profit tax, on a barrel of oil exceeds
ninety percent of the net income attributable to that barrel, the tax is to be computed by
multiplying the applicable rate of the tax by a ‘profit’ equal to ninety percent of the net
income.23 Net income for the purposes of this limitation is the producer’s taxable income
from the property evolved, determined under section 613(a) of the code, with certain
adjustments, divided by the number of barrels produced from the property during the
year.24 In computing taxable income from the property, however, no deduction is allowed
for depletion, the windfall profit tax itself, intangible drilling and development costs
incurred on productive wells, or the cost of certain tertiary injectants.25

Precedents from other Jurisdictions

5. Since the repeal in 1988, the US Government is debating reimposition of tax and recently
the newly elected Presidential hopeful Obama has called for windfall taxes on oil.
However, with primary season in the US, the political debate can be highly pitched and
one need not take this debate at face value. In any case, the windfall tax on petroleum
refining goes against the grain of oil economics. The fact of the matter is that gross
refining margins do not necessarily fluctuate in the manner crude prices do. Given the
competitive nature of refining business and the fact that there is global shortage of
refining capacity (an important factor attributable to high crude and petroleum product

23
. See I.R.C. § 4988 (b); S. RHP. NO. 96-394, 96th Cong., 1st Sess. 58-59, reprinted in [1980] U.S. CODE CONG.
& AD. NEWS 1008, 1066.
24
. See I.R.C. § 4988 (b)(2). The definition of a property, for the purposes of the net income limitation is that
contained in Section 614 of the Code. S. REP. No.96-394, 96th Cong., 1st Sess. 52, reprinted in [1980] U.S.
CODE.CONG. & AD. NEWS 1008, 1059.
25
. See I.R.C. § 4998(b)(3)(B). The Act added section 193 to the Code which requires the deduction, for income-tax
purposes, of the costs of certain tertiary injectants, A producer, though, may elect to capitalize and amortize these
costs for purposes of the windfall profit tax net income limitation.
 prices), improvements of margins is attributable to enhanced productivity and
efficiencies.26

Besides US, wherein the debate has not gathered momentum, UK as a major oil
producing nation has history of imposing of a supplementary charge of 10 percent only
on the ring fence profits. In the past, UK has attempted windfall tax on very specific
businesses and targeted privatized utilities.

The rational being subsequent deregulation has given rise to windfall profits. Insofar as
Canada is concerned, experts believe that it would be a political suicide. In the 70’s an
attempts to change energy taxation (but no windfall tax) met with criticism and to
whisper in Calgary (Canadian centre for oil and gas) would be viewed as disaster. In May
2008 Venezuela, a major oil exporting nation approved law on special contribution paid
by companies exporting or transporting natural or upgraded liquid hydrocarbons.
Indonesia, in turn, has not considered any proposal to levy tax. Hence, current global
regime even in most oil producing and exporting nations does not favor such levy.27

Economics of oil production in India

6. No policymaker will deny our serious attempts to attract private investments in the
hydro-carbon sector. Our production sharing contracts (PSC) – an agreement between
Indian government and oil entrepreneurs provide for inbuilt mechanism to deal with any
significant upside in oil prices and/or oil reserves. Take for instance, the PSCs that India
has signed with private and public sector oil companies.
Under the sliding scale formula, the government gets a higher share of profit oil on the
basis of investment multiple achieved by the entrepreneur. To illustrate, if the investment
multiple is less than 1.5, the government is entitled to 25 percent and the entrepreneur to
75 percent of petroleum profit. Similarly, as the investment multiple increases to 3.5, the
Government’s share is enhanced to 50 percent and entrepreneur’s share reduced to 50
percent. The investment multiple expressed by dividing net income by net investments.
Hence, as crude oil prices continue to soar investment multiple moves up and so does the
Government’s share in profit. Hence, the government is extracting its pound of flesh
under the current PSC regime. Not to forget, the royalties levied by the Central and the
State Government under PSC are on ad valorem basis.28

Now to levy a windfall tax seems unreasonable besides, reneging on contractual

obligation. All PSC’s besides being placed before both the houses of Parliament are

26
. What is a ‘Windfall’ Profit ? Wall. St.Journal, August 4, 2008.
27
. Idid.
28
. Supra note 10.
 ‘grandfathered’, which tends to protect the interest of an entrepreneur from any
subsequent levies. Hence, even if such tax is levied, the entrepreneur would pass the cost
to the Government by way of reduced profit petroleum (Government’s share of profit). It
can be said that a combination of reduced profit petroleum and sliding scale formula
ensures that the Government will collect from the right hand and pay from the left hand.29

A Critical Appraisal

7. To say that the recent rise in crude oil would result in windfall to producers is probably
not fair, unless India was a net exporter. At best the rewards could be attributed to high
risks assumed by investors. Why are we ignoring the fact that high crude oil prices means
increased share of Government profit, higher rate of federal, State and local taxes and
royalties ? If commodity price variation is subject to windfall levy, we should consider
similar levies for other commodities like iron, steel or gold; although this would result in
an absurd situation from tax economics perspective.
In a note, prepared in response to first the Left and now the Samajwadi Party leader Amar
Singh’s demand for windfall profits tax, the Ministry has given five reasons why such a
tax defies logic. These are:
• India is neither a major oil producer nor Indian companies have gained much from the
rising global prices of oil.
• The Government is bound by the contract of the production sharing agreements as part of
the NELP (New Exploration Licensing Policy).
• As a part of the profit sharing plan, the Government is already a beneficiary of the rise in
profits of oil companies, besides 35 per cent corporate tax on such profits.
• WPT on the basis of revenues in discovered blocks ignores the huge risks, investments
and poor changes of discoveries.
• WPT will discourage long-term investments in oil industry.30

One of the unfortunate fall outs for such levy could be the effect of reducing domestic supply of
crude oil below what the supply would have been without the tax. So far as India is concerned
the tax would enhance production cost, possibly reduce domestic production, enhance
dependence on imports and the final nail in the coffin, discourage domestic and foreign
investment in hydro-carbon production and refining capacity.

India is in a decontrolled environment insofar as marketing of petroleum products is concerned.

The Government has the ability to juggle with fiscal levies and determine final price of
petroleum products to meet the dual objectives of fiscal discipline and political acceptance. So,
we need to be watchful enough about probable pitfalls in the Indian system and, thus, what other
energy starved economies are doing. Singling out this industry will further lower the investors,
29
. Ibid.
30
. R. Prema, 5 Reasons Why windfall profit tax is wrong ? New Delhi, July 16, 2008.
Available at http://www.rediff.com/money/2008/jul/16spec.htm.
 confidence and frustrate them, as is borne out from the recent response by bidders for oil
concession.

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