Bashir Karim Vakil April 15 2013 Division of royalties causes friction between states Karim Vakil & Cruz Vizaco Advogados | Energy & Natural Resources - Brazil Bashir Karim Vakil Energy & Natural Resources IntroductionDivision of royaltiesRevised billCommentIntroductionThe word 'royalty' was historically used to imply the payment of compensation to the monarch or other member of the nobility in relation to activities carried out on their lands (eg, fishing or hunting), the use of their infrastructure (eg, bridges or mills) or the extraction of natural resources (eg, wood, water or minerals). Over time, the term has been gradually adapted to include the compensation due to a government for natural resources within that country.For a federative republic such as Brazil, it would be logical to conclude that royalties should be evenly distributed among all the country's states and cities, since their original beneficiary would be the federal union. However, the Brazilian Constitution provides oil-producing states and municipalities with the right to receive a larger share of such compensation as indemnification for allowing potentially hazardous activities to be carried out in their jurisdiction.This has led to imbalances between the share of royalties attributable to each Brazilian state and municipality and caused entire cities to be built and developed using the proceeds from oil and gas royalties. In 2011 Rio de Janeiro alone received nearly R5 billion (approximately $2.5 billion) in royalties.Division of royaltiesUnder the Petroleum Law (9.478/1997) the royalties and the special participation fee (an additional tax, ranging from 0% to 40%, which is levied on high-yielding or profitable fields) were distributed as follows.5% royalties (levied on high exploratory risk areas)5% to 10% royalties (levied on lower exploratory risk areas)Special participation feeProducing states30%22.5%40%Producing municipalities30%22.5%10%Municipalities affected by exploration and production activities10%7.5%-Non-producing states and municipalities10%7.5%-Federal union20%40%50%The 2007 discovery of huge oil and gas reservoirs in the pre-salt layer offshore Brazil - especially in the states of Rio de Janeiro, Espirito Santo and Sao Paulo - shook up the oil industry and potentially placed Brazil among the world's leading oil and gas producers.The combination of huge reservoirs, higher quality oil and a lower exploratory risk led to a new legal framework being drafted for the pre-salt area that enabled the government to keep a larger proportion of pre-salt profits, as detailed in the Pre-salt Law (12,351/2010).However, with the topic in the headlines of every newspaper in Brazil and gaining recognition abroad, the non-producing states began to question the fairness of the royalty distribution regime, eventually forcing their representatives in Congress to embrace the cause.Revised billIn 2011 the Senate drafted Bill 448, which aimed at correcting the imbalance in the distribution of royalties and special participation fee. Under this new regime, which was intended to be effective retroactively, there was to be a significant increase in the proportion of royalties and special participation fee destined for the federal union and the non-producing states and municipalities.However, in the face of the potentially overwhelming losses that could result from the bill (eg, in 2009 Rio de Janeiro received approximately $2.5 billion; in 2013 it would receive approximately $50 million if the bill is passed), the oil-producing states exercised political pressure on President Dilma Rousseff, who was eventually left with no option but to veto partially the draft bill. A revised version of the bill was passed in December 2012, approving the new distribution only for royalties paid in connection with exploitation rights granted after the bill was passed.Following much criticism of the bill in Congress by representatives of the non-producing states, on March 7 2013 the legislative houses decided to overturn the veto. The producing states immediately contested this version of the bill in the Federal Supreme Court. Judge Carmen Lucia conceded a preliminary injunction on March 18 2013 that would suspend provisionally the effectiveness of those sections of the bill that had previously been subject to the presidential veto (ie, the applicability of the new royalty distribution to the contracts executed before its enactment). The court is expected to release a final decision on the case at an unspecified date in the future.Under Law 12.734/2012 and Provisional Executive Order 592/2012, the royalties and special participation fee will be distributed as follows.15% royalties (for blocks in the pre-salt and strategic areas)10% royalties (for blocks in the remaining areas)Special participation feeProducing states22%20%Decreasing from 32% in 2013 to 20% in 2020Producing municipalities5%Decreasing from 15% in 2013 to 4% in 2020Decreasing from 5% in 2013 to 4% in 2020Municipalities affected by exploration and production activities2%Decreasing from 3% in 2013 to 2% in 2020-Non-producing states and municipalities49%Increasing from 42% in 2013 to 54% in 2020Increasing from 20% in 2013 to 30% in 2020Federal union22%20%Increasing from 43% in 2013 to 46% in 2020CommentAlthough the oil-producing states are hopeful that the Supreme Court will prevent the entry into force of the vetoed provisions, they are already seeking alternatives to compensate their losses should their case be unsuccessful. The state of Rio de Janeiro recently passed a draft bill creating an additional tax to be levied on exploration and production activities. However, this draft bill was vetoed by State Governor Sergio Cabral.The existing developments are merely the first stages in the royalties saga and further change is expected. The oil industry would like the dispute to be settled before the next bidding round, scheduled for May 14 and 15 2013, as such political instability and legal uncertainty is not well received.Although this uncertainty may be of concern to foreign investors, the federal union is unlikely to allow an argument between producing and non-producing states to affect the tax burden on oil and gas companies. In principle, settling this matter should be a question of merely how to share the proceedings from taxes that are already in existence and should not involve the creation of new taxes.For further information on this topic please contact Bashir Karim Vakil or Carlos Campos Neto at Karim Vakil & Cruz Vizaco Advogados by telephone (+55 21 8151 0018) or email ([email protected] or [email protected]).