The P53.1-B peso Shell v. Philippines arbitration case : What You Need to Know

CURRENT INVESTMENT CONCERNS
Elpidio V. Peria
22 July 2016

MALAMPAYA GAS

The Malampaya Natural Gas Project, in Palawan (from http://www.shell.com.ph)

My friends at the EU-ASEAN FTA Philippines network recently circulated the news that Shell Philippines Exploration B.V. (SPEX) has requested arbitration with the Philippine government over the company’s Php53.1 billion peso (US$ 1.1B) tax liability which was affirmed as something that the company has to pay by the Commission on Audit (COA) last 6 April 2015. The case was just referred to the International Center for Settlement of Investment Disputes (ICSID) this July 20, 2016 and has already a title and case number, Shell Philippines Exploration B.V. v. Republic of the Philippines (ICSID Case No. ARB/16/22), though no documents about the complaint or referral were made available at the site as this blog is being written.

Instead of going up to the Supreme Court which is the usual recourse of litigation lawyers in these cases, the company, which currently operates the Malampaya natural gas fields in Palawan, chose the arbitration route, which means it will be decided by an arbitration panel or an outside group of lawyers, equally chosen by the parties to the case and it seems information from my friends said that former Philippine Supreme Court Chief Justice Reynato Puno was chosen by the Philippines to be part of the panel, but not its lawyer.

The company alleges some breaches of the Netherlands-Philippines Bilateral Investment Treaty (BIT), which will surely become one of the biggest challenges to be faced by President Duterte’s legal team to date, which may be similar in impact to the South China Sea ruling.

Checking the COA website for a background of the case, we were able to download the Decision of the independent constitutional body, dubbed as COA Decision No. 2015-115, dated 6 April 2015. News items refer to another May 11, 2015 ruling, but there is no such thing in the website.

The COA or Commission on Audit is an independent constitutionally-created body by the 1987 Philippine Constitution and it has the authority, and duty to examine, audit, and settle all accounts pertaining to the revenue and receipts of, and expenditures or uses of funds and property, owned or held in trust by, or pertaining to, the Government, or any of its subdivisions, agencies, or instrumentalities, including government-owned or controlled corporations with original charters.

Details about the COA Decision

From the narration of facts by the COA, this case stems from an interpretation of Service Contract (SC) 38, entered into by then President Corazon C. Aquino, through then Office of Energy Affairs (OEA), with Occidental Philippines Inc. and Shell Exploration BV – the predecessors-in-interest of SPEX, PNOC-EC and Chevron – the contractors.

The contractors undertook to execute all operations in connection with searching for and obtaining petroleum in commercial quantities in the contract area, in Malampaya off the coasts of Palawan. The contractors were to furnish the necessary technology and financing, including the required services for petroleum operations, and assume all exploration risks without being entitled to reimbursement even if no petroleum in commercial quantity is discovered and produced.

As alleged by Department of Energy (the successor agency of the OEA), from the start of commercial operations of SC 38 in 2002 up to 2009, the government’s share of 60 percent of the net proceeds included the corporate income taxes of the contractors.

Upon post-audit in 2004, the Supervising Auditor (SA), DOE, noted that the corporate income taxes of SPEX were deducted from the government’s share and thus, the SA opined that the inclusion of corporate income tax from the government’s share for January 2002 to November 2003 resulted in the understatement of the government revenue in the amount of of P2.63 billion. In the Annual Audit Report (AAR) for CY 2004, the understatement amounted to P4.8 billion.

There were several pleadings exchanged between the DOE and the contractors with the government auditors, including the Office of the Government Counsel, but in the Annual Audit Report for 2009 of DOE, the under-collection of the government’s share totaled P53,140,304,739.86 for the covered years, and understated the account due to the National Treasury (Business Income Account) by P10,562,146,395.26 for 2009 and by P42,578,158,344.60 for prior years.

Notwithstanding the 11 arguments raised by the company and the DOE, the COA reduced the issue to the following :

whether or not the sourcing of payment for corporate income taxes of contractors in the MNGP (Malampaya Natural Gas Project) from the 60 percent government share has legal basis

In other words, the COA sought to find out whether the SPEX’s claim that they don’t have to pay the corporate income tax since that tax is already included in the 60% share of the government taken from the income of the Malampaya natural gas fields, is valid and supported by the relevant law on the matter.

The COA, led by Heidi Mendoza, a career bureaucrat who led several audit investigations of well-known personalities and exposed their anomalous transactions particularly Vice-President Jojo Binay when he was Makati City Mayor, after which she was later appointed by President Noynoy Aquino to head the COA, denied the SPEX claim, finding the consortium liable to pay the amount of P53,140,304,739.86 and making the following key findings to debunk the SPEX’s assertion that the corporate income tax is already included in the government share of 60% :

There is no provision in the law which specifically provides that the income taxes of the contractors will be part of the share of the government

The DOE argued that Section 18(b) of Presidential Decree or PD 87 (the law that governed the service contract for the Malampaya gas exploration) unambiguously provides that Petitioner DOE may enter into service contracts whereby the revenue of the Government shall include all taxes paid by or on behalf of the contractor and that Section 1(a) of PD 1459 likewise provides that the share of the government shall include all taxes.

It seems that corporate income tax is already referred to in these provisions, but the COA held that the phrase “all taxes” in both provisions pertains only to the manner by which it can be determined if the government received its 60 percent minimum share. There is nothing therein that would suggest that the government cannot receive more than 60 percent. Thus, no law would be violated even if the government’s entire share, including all taxes, would exceed 60 percent. In this case, the government’s share ultimately became less than 60 percent as a result of the supposed “tax assumption”, in clear violation of the provisions of PD 87 and PD 1459.

The payment by the government of the income tax increases the 40 percent share of the contractors and reduces the 60 percent share of the government in the net proceeds.

The COA came up with a table in its decision analyzing arithmetically the result of SPEX’s claim and found out that if SPEX will prevail, allowing the deduction of the CIT and BPRT from the 60 percent government share increased the actual take of the contractors from 40 percent of the net proceeds to 65.97 percent. This is contrary to the provision of sec. 8 (2) of PD 87 which says that the Service Fee of a contractor shall not exceed 40 percent. Besides, COA noted that computing the 60 percent government share from after-tax income of the project would mean that the government is taxing itself, which is inconsistent with the principles of taxation and the provisions of law.

• Sourcing the payment of income taxes of contractors from the 60 percent government share is tantamount to tax exemption which is not provided or allowed by applicable laws

COA cited clear provisions of PD 87 that service contractors are subject to income tax (sec. 8) and are not exempt from income tax (sec. 12). It also pointed out that if the government will pay what should be paid by SPEX, in effect the government is giving the SPEX a tax exemption and by law and jurisprudence, COA said that a tax exemption cannot be made to arise from a vague inference, it must be clear and unequivocal.

•  With the inclusion of income tax in the 60 percent government share, contractors effectively became immune from the application of amendatory income tax laws.

The COA referred to an Affidavit by Marcos-era Finance Minister Cesar Virata who mentioned a conversation with then BIR head Efren Plana who said that including the contractor’s tax obligation on the 60% Government share provided stability to the fiscal terms that were stipulated in the service contract.

COA debunked this and this stipulation would most likely play among the issues that will eventually be tackled in the arbitration case, the COA said :

the inclusion of income tax in the 60 percent government share practically placed the contractors beyond the reach of legislative authority. Since the government will always pay on their behalf whatever amount of income tax is due anyway, the contractors will not in any way be affected by tax laws providing for changes in income tax rates. This practice cannot be countenanced. It is a basic constitutional doctrine that no irrepealable laws shall be passed. In addition, granting incentives to attract foreign investors should not result in impairment of legislative power. For this reason, the alleged legislative intent, which is to “protect” the contractors from tax issues, cannot be appreciated for being unreasonable and violative of public policy.

 

Key Provisions of the Netherlands-Philippines Bilateral Investment Treaty (BIT)

The treaty, signed in 1985, is a straightforward 6-page document consisting of 12 articles.

Perhaps, and this is purely speculative as we haven’t seen the pleadings of the Parties, what may be involved is the interpretation of what is meant in the opening sentence of Article 5, which reads

Investments or earnings of nationals of either Contracting Party shall not be subject to expropriation or nationalization or any measure equivalent thereto in this article, all such measures are hereafter referred to as ‘expropriation’, except for public use, in the public interest, or in the interest of national defence and upon payment of just compensation.

Maybe the SPEX will argue that the COA ruling is tantamount to a “measure equivalent” to expropriation or nationalization, though if one reads the full sentence on which this legal anchor is based, “public use”, “public interest” or “in the interest of national defence” are arguments which may be used by the Philippine government to excuse itself from the claim.

The counter-argument of the Philippines could be that the corporate tax payment is not part of the 60% share of the Philippine government and this is in the public interest and supported by the Constitution, the Marcos-era decrees and the service contract which allowed such natural gas exploration to take place.

Another issue that may be raised by SPEX here is the issue of “fair and equitable treatment” in article 3.2 of the BIT and here, SPEX may hope to find other similar exploration companies that were able to get a favorable treatment from the Philippine government than what SPEX got and SPEX can use that case to say that they did not get “fair and equitable treatment” in their tax liabilities.

For its part, the Philippines may argue that the ICSID has no jurisdiction on the issue since the case involves a purely tax matter, which appears not to be within the scope of the Netherlands-Philippines Bilateral Investment Treaty (BIT) signed in 1985 except in a limited manner in article 4.2 of the BIT when a third party that may be benefited from a tax arrangement with the Philippines and the Netherlands wishes to seek the benefits of the most-favored-nation clause that the Philippines and the Netherlands give to each other. Art. 25 of the ICSID Convention also states that the jurisdiction of the Centre shall extend to “any legal dispute arising directly out of an investment” and being purely a tax manner, the Philippines may assert this is not such legal dispute within ICSID’s jurisdiction.

Anyway, there is no point in further speculating what may be the other arguments of the Parties to the case given that their pleadings are not yet available, but at least the reader will now have an overview of what this case is all about.

The Biodiversity, Innovation, Trade & Society (BITS) Policy Center, Inc., through this blog, will continue to monitor this case as it develops and will post updates and analysis of the case as they arise.

oOo

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