Venezuela's new constitution gives rise to new legal issues on oil, gas investment

April 10, 2000
Whatever broader concerns may exist regarding the constitution of the Bolivarian Republic of Venezuela, investors in the Venezuelan oil and gas business may feel agreeably surprised.

Whatever broader concerns may exist regarding the constitution of the Bolivarian Republic of Venezuela, investors in the Venezuelan oil and gas business may feel agreeably surprised.

In our view, the constitution approved by the people on Dec. 15, 1999, is somewhat more favorable to private oil and gas investors than the constitution of 1961.

On the other hand, the new constitution gives rise to its own new issues of legal interpretation.

Hydrocarbon ownership

Article 12 of the new Venezuelan constitution states that fields "of minerals and hydrocarbons" existing in the national territory, in the territorial sea, in the exclusive economic zone, and on the continental shelf belong to the republic, are under the regime of public ownership, and hence give rise to inalienable and imprescriptible national rights.

This is a perfectly standard article. It is-outside the US-practically universal that governments own the rights to hydrocarbons in place in the reservoir or at least the right to produce such hydrocarbons. This kind of provision does not limit the government's ability to allow state or private companies the right to explore for and produce the state's hydrocarbons in return for a royalty and subject to all applicable regulations.

The important thing to note about Article 12 is that it talks about fields of "hidrocarburos" as being the property of the state. This word refers to all chemical hydrocarbons, from the lightest hydrocarbon (methane) to the lowest-gravity bitumen. "Hidrocarburos" clearly includes hydrocarbon gases, as well as liquid hydrocarbons and bitumen.

Petroleum activity

Article 302 speaks to how the state must manage "petroleum activity." The article, which is worthwhile quoting in full, is translated as follows:

"The state reserves, through appropriate Organic Laws and for reasons of national interest, the petroleum activity and other industries, exploitations, services, and goods of public interest and strategic character. The state will promote the national refining [or treating] of basic products derived from the exploitation of nonrenewable natural resources, with the objective of assimilating, creating, or innovating technologies; generating employment and economic growth; and creating wealth and public well-being."

This article has been much criticized based on the discretion it apparently gives to the state to define what "industries, exploitations, services, and goods" are of "public interest and strategic character," and that hence may be "reserved" to the state. This may be a valid criticism in general terms. However, from the standpoint of hydrocarbons, the article gives rise to little uncertainty: Clearly, "petroleum activity" is reserved-it is that simple.

This gives rise to two questions about the critical first sentence of Article 302. First, what does "petroleum activity" mean? Second, what does "reserved" mean? To us, it seems clear that "petroleum activity" is not the same as "hydrocarbon activity." The word "petroleum" probably refers to condensate and crude oil but not to hydrocarbon gases and bitumen.

In other words, the gas business, as covered by Decree 310 of Sept. 23, 1999,1 and-at the other end of the spectrum-Orimulsion, are probably excluded from "petroleum activity." We also believe that "petroleum activity" covers principally exploration, production, and perhaps also transportation, storage, refining, and treating. It may well be that the internal or external markets of petroleum products are not "petroleum activities."

To us, "petroleum activity" should be interpreted in accordance with considerations of "public interest and strategic character." The state arguably has strong public and strategic interests in the upstream petroleum business but less so in the midstream and downstream sectors. But the bottom line is that a future Venezuelan Congress and-in the event of a challenge, a future Venezuelan Supreme Court-will have to ponder and decide what the parameters of "petroleum activity" are.

The second question is just as important. On a superficial level, it is easy to read "reserved" as really meaning "can only be carried out by Petr

This conclusion is grounded in Venezuelan legislative precedent. For example, the 1973 Law on the Internal Market reserves the internal market on hydrocarbon products to the state, vests the right to carry out the business in the old Corp. Venezolana del Petroleo (CVP), and authorizes CVP to serve the internal market either directly or via contracts with third parties.

Thus, under this law, the fact that the business was reserved to the state did not imply an exclusion of private capital. The same principle applies here.

And this position is fortified when one compares Article 302 to the very prejudicial Article 371 of the Constitutional Project of Oct. 14, 1999, which is translated as follows:

"The activities of exploration, production, transport, refining, and the internal marketing of hydrocarbons, except gas, are reserved to the state. Only in special cases, when in the national interest, and after approval by the National Assembly and always with state control, will contracts with private companies be executed [by PDVSA] to carry out these activities."

The Constituent Assembly then knew well how to exclude private participation from the reserved activities but declined to do so.

Article 302 seems to envisage a new Organic Hydrocarbons Law (the Ministry of Energy and Mines has already prepared a draft) that would preserve the state's dominant role in the oil industry but which would allow significant private participation. New private participation upstream will probably need congressional approval in most cases, but the story may be different relative to activities such as oil pipe- lines, refining, domestic marketing, and exporting, where state interests are not strategic.

The second sentence of Article 302, which seeks to encourage the refining of Venezuelan crude oil in Venezuela (implied through the use of private and state capital) further supports our liberal interpretation.

PDVSA's future

The next critical article of the new Venezuelan constitution is Article 303, which translates as follows:

"For reasons of economic and political sovereignty and national strategy, the state will remain the owner of all of the shares of Petroleos de Venezuela SA, or the entity created to run the oil industry-[but this disposition] shall not apply to the shares of the [PDVSA] affiliates, strategic associations, firms, or other entities which have been constituted or will be constituted as a consequence of the development of the business of [PDVSA]."

The original form of this article simply attempted to provide that the shares of PDVSA and (at least by implication) its affiliates could not be sold to the public.2 However, the view of many qualified commentators, including PDVSA Pres. Hector Ciavaldini, was that such a clause did not belong in the new constitution.

But instead of dropping the provision entirely, the National Constituent Assembly came to the surprising conclusion that the language should be modified to reflect that, while the shares of PDVSA must remain the property of the republic in perpetuity, this principle does not extend to the shares of PDVSA affiliates and mixed companies.

Article 303 does not mean that the state can, even if it is so minded (which it is presently not) sell shares in PDVSA Petr

However, Article 303 does open up the possibility of the state selling shares in entities such as PDVSA Gas SA or Carbozulia SA, which are not engaged in a reserved activities. And, clearly, a new Organic Hydrocarbons Law could alter Article 6 of LOREICH to allow for the privatization of other PDVSA affiliates.

Arbitration

The international arbitration clauses of the eight Exploratory Round Association Agreements (ERAAs) have been the subject of litigation filed by, among others, current Minister of Energy and Mines Al

"In contracts of public interest, and in cases where such a provision does not contradict the nature of the contract, there is considered to be incorporated, even when not expressly stated, a clause pursuant to which any doubt or dispute that may arise in connection with such contracts and which cannot be amicably resolved by the parties, shall be ruled upon by the competent courts of the republic, in accordance with its laws, without for any reason or cause giving rise to foreign claims."

The Supreme Court held that the exception language of Article 127 of the 1961 constitution enabled the national government, subject to the subsequent approval by Congress, to determine on a case-by-case basis-taking into account the circumstances of the negotiations-the suitability of including arbitration clauses in contracts of public interest. This decision was consistent with a line of authorities liberally interpreting the exception language of Article 127.

The National Constituent Assembly debated the elimination of the exception language of the old Article 127 in the new constitution.

But after a strong campaign in favor of international arbitration, the assembly decided to incorporate Article 127 of the old constitution into the new constitution on a word-for-word basis as Article 151.

While a future Supreme Court might interpret the new Article 151 more strictly than the same language has been construed in earlier jurisprudence, this is not very likely, as future major energy projects in Venezuela are likely to require international arbitration in order to be financeable. The new management of PDVSA has come out in favor of the continuing availability of international arbitration.

Municipal tax

Venezuela has a federal structure, with three levels of executive and legislative power.

First, there is "National Power." Secondly, there are the 23 states.3 Third, the states are divided into self-governing municipalities.

Under the 1961 constitution, the states had less powers that either the National Power or the municipalities, and that situation is not significantly different under the new constitution. Critically, the states' powers to tax are very limited.4

On the other hand, the municipalities, under both the former and current constitution, have the general power to levy taxes on industrial, commercial and service activities. In practice, municipalities have levied this tax on gross income arising from economic activities within their areas. There is no specific constitutional or legislative provision that serves to cap rates of municipal tax.

The municipalities' ostensible pow- er to levy taxes on gross income is a major problem for private companies involved in the oil industry.5 Oil and gas companies, which often engage in operations that occur in a number of municipalities, face aggressive tax rates (which function like royalties). Every municipality needs to be dealt with as a separate jurisdiction. Neither are there clear apportionment rules. Any disputes between taxpayer and municipality must be resolved in local courts. In light of all this, if oil and gas companies can avoid being subject to municipal taxes, this is a major positive factor.

We believe that the new constitution probably achieves this positive result, for companies involved in "hydrocarbon" activities.

In the exploratory round decision, the Supreme Court held that private investors that had won the eight areas bid for under the terms of the 1996 exploratory round, are not obligated to pay municipal taxes.6 The court reached its conclusion on the basis that the exploratory round investors had been authorized by the Venezuelan Congress to carry out hydrocarbon activities pursuant to LOREICH, Article 5, Unique Paragraph. And under the Venezuelan constitution of 1961, Ordinals 8 and 10, it is stated:

"It is within the competence of the National Power...:

8. The organization, collection, and control of taxes on income, on capital and successions and donations...on mines and hydrocarbons and the other taxes and charges not granted to the states and the municipalities by this constitution and the law...

10. The regime and administration of mines and hydrocarbons..."

Because the hydrocarbon business, in particular the taxation of the hydrocarbon business, was under "the competence of the National Power," the court reasoned that the municipalities had no power to levy taxes on such activities.

The new constitution contains very similar provisions regarding the competence of the National Power. In this respect, Article 156 states:

"It is within the competence of the National Power...:

12. The creation, organization, collection, administration, and control of taxes on income, on successions, donations, and other related things, on capital, on production, on value added, on hydrocarbons and mines, on the import and export of goods and services, of taxes which fall on the consumption of liquors, alcohols...cigarettes and other tobacco products, and all other taxes and charges not granted to the states and the municipalities by this constitution and the law...

16. The regime and administration of mines and hydrocarbons..."

In this respect, Article 156 of the new constitution is slightly more favorable to oil and gas companies than Article 136 of the former constitution, because Ordinal 12 states that "the creation, organization, collection, and administration of" and not just "the organization, collection, and control of" taxes on hydrocarbons is subject to the National Power. And under Article 156, Ordinal 12-as under Article 136, Ordinal 8-it appears that the powers to tax granted to the National Power are those taxing powers "not granted to the states and the municipalities by this constitution..."

It is likely that future courts will interpret Article 156, Ordinals 12 and 16, in accordance with prior decisions of the Venezuelan Supreme Court interpreting Article 136 of the 1961 constitution, including the exploratory round decision. Under the terms of both the 1961 and 1999 constitutions, the term "hidrocarburos" clearly covers natural gas, as well as petroleum.

A favorable interpretation of Article 156, Ordinals 12 & 16, will probably exempt from municipal tax PDVSA and its affiliates, all private companies carrying out hydrocarbon activities under LOREICH, Article 5, Unique Paragraph, and companies involved in most if not all of the activities covered by Decree 310. It seems obvious that, as a policy matter, the municipalities should have no power to tax or interfere with Venezuela's strategic national industry.

On the other hand, some commentators question whether a favorable interpretation of the new constitution following the reasoning of the exploratory round decision will be forthcoming, given the wording of Article 180 of the new constitution, which states:

"The taxing power of the municipalities is distinct and autonomous from the regulatory powers which this constitution or the laws attribute to the national or state power regarding specific matters or activities.

"Tax immunities against the taxing powers of the municipalities, in favor of the other political powers [the national and state powers] only extend to those juridical persons created by such political powers, but not to concessionaires or other contractors of the National Administration or of the states."

The view of these commentators is that paragraph one of Article 180 means that the "taxing powers" of the municipalities are not affected ("distinct and autonomous") by the specific regulatory powers explicitly granted by the constitution or the laws to the national and state powers. These would include the "regulatory" powers granted to the National Power by virtue of Article 156. The second paragraph of Article 180, according to this view, is complementary, in that it states that, to the extent that the national or state powers create juridical entities, only these entities will enjoy immunity from municipal taxation, and this immunity will not extend to "any concessionaires or other contractors."

We reject this argument. First of all, Article 180 refers to the "taxing power" of the municipalities." These taxing powers are elaborated under Article 179, which studiously avoids giving the municipalities the power to tax any distinct activity (including hydrocarbons) mentioned in Article 156 as being under the competence of the National Power. However, Article 179 gives the municipalities the following limited but still ample power to raise "taxes on economic activities of industry, commerce, services, or other activities of similar nature, within the limitations established in this constitution."

"The limitations established in this constitution," in our view, are principally those established in Article 156, Ordinal 12, which gives the National Power the right to "create, organize, collect, administer, and control" taxes on hydrocarbons and many other distinct economic activities. In our view, the taxing powers attributed to the National Power under Article 156, Ordinal 12, are not "regulatory" within the meaning of Article 180.

In addition, Article 183, Ordinal 1, of the new constitution prohibits the municipalities and the states from levying taxes on the "revenue-producing activities under the competence of the National Power." A similar provision existed under Articles 18 and 34 of the 1961 constitution. Article 183, Ordinal 1, clearly envisages an exclusion of municipal tax competence relative to the revenue-producing activities under the competence of the National Power under Article 156, including hydrocarbons. This understanding is made clearer by the fact that Article 183 goes on to say that municipalities can tax only the activities of agriculture, animal raising, fishing, and forestry subject to a (forthcoming) national law that will stipulate if and how such a tax shall be levied. Article 156, Ordinal 25, merely reserves to the competence of the National Power, "the national policy" for these four industries. This language in Article 183 thus provides for an exception to the general rule that the municipalities may not tax.

The citation of revenue-producing industries listed under the competence of the National Power and covered under the second paragraph of Article 180 refers to the fact that juridical entities formed by the national or state powers are, like those powers, themselves immune from municipal tax. The second paragraph then states that neither "concessionaires nor other contractors of the National Administration or of the states" share this immunity. As we have seen, Article 156 does not make companies involved in hydrocarbon activity "immune" from municipal tax.

The best interpretation is that Article 156, Ordinal 12, serves to exclude the municipal taxing power. The municipalities do not have the power to tax such activities and there is hence no question of immunity.

However, in any event, private companies authorized to conduct hydrocarbon activities under LOREICH, Article 5, Unique Paragraph, and licensees and permittees under Decree 310 are neither "concessionaries or other contractors." Instead, "concessionaires" may well refer to public concessionaires under the Law of Concessions. Neither are such private oil and gas companies "contractors," as they are not "contracted" to do anything but instead have independent rights to carry out hydrocarbon activities without governmental compensation of any type.

Distribution potential conflict

One of the few cases where "gas" is explicitly mentioned in the constitution is Article 156, which reads, in part, as follows:

"It is the competence of the National Power...:

29. The general regime of public services to private houses and, in particular, electricity, drinking water, and gas..."

We believe that, in this instance, the reference to "public service" of domestic "gas," is to the distribution of methane by gas distribution networks. This reference may have been included because the scope of the "administration and regime...of hydrocarbons" under Article 136, Ordinal 10, has generally not been considered to extend to the distribution of methane.

The intent may have been to dispense with any possible regulatory power that the municipalities may have had over methane distribution and to prevent them from attempting to tax distribution companies. If so, it would have been much better to have specified that all distribution of methane is subject to the competence of the National Power, as it is not possible to have two regulatory authorities with jurisdiction over a single distribution system (distribution networks typically serve both domestic and commercial customers).

However, a further problem is occasioned by Article 178, which provides, in part:

"It is within the competence of the municipalities the governing and administration of their interests and the management of the matters assigned to them by this constitution and the national laws, as respect to local life, in particular the ordering and promotion of economic and social development, the giving and providing of domestic services to private residences...the improvement, in general, of the conditions of life of the community, in the following areas:

"6. Distribution of drinking water, electricity, and domestic gas..."

Article 178, Ordinal 6 appears to give the municipalities competence over areas (provision of drinking water, electricity, and domestic gas) that are declared by Article 156, Ordinal 29, to be within the competence of the National Power. Some commentators suggest that Article 178, Ordinal 6, can be read to give the municipalities only the power to "promote or uphold" the distribution of "drinking water, electricity, and domestic gas."

While this attempt at harmonization may be plausible, we suggest that Article 156, Ordinal 29, should be amended to put "the distribution of methane to all users" within the ambit of the National Power, and Article 178 should be amended to take away any regulatory or fiscal authority of the municipalities.

Conclusion

During the election year of 1998, private oil and gas investors in Venezuela watched the triumph of Hugo Chávez Frias with some measure of alarm.

In many respects, Chavez's election campaign was a campaign against the oil apertura (opening) of former PDVSA Pres. Luis Giusti. However, once in office, more pragmatic considerations have held sway. Last year has seen promising gas and electricity legislation that will allow for unprecedented private investment in the Venezuelan energy business.

The new constitution envisages a new and, it is hoped, more liberal Organic Hydrocarbons Law and confirms that the state can sell shares in PDVSA affiliates. In addition, hydrocarbon activities, including gas activities, will probably be exempt from state and municipal tax. International arbitration will likely remain available, even in contracts of public interest.

The Fifth Republic has turned out to be surprisingly benign for the private oil and gas business, especially given the charged atmosphere of 1998.

References

  1. Official Gazette No. 36,793 of Sept. 23, 1999.
  2. Article 372, which was the predecessor of current Article 303 in the Constitutional Project of Oct. 14, 1999, simply stated: "The state will retain ownership of all of the shares of Petróleos de Venezuela SA or the entity created to manage the national oil industry because of considerations of political and economic sovereignty and national strategy."
  3. The 23 states cover almost all of Venezuela's land area. However, in addition, there are a number of small federal territories (mostly offshore islands) and the capital district.
  4. Under Article 167 of the new constitution, the power of the states to tax is very limited and, for purposes of this analysis, is simply discounted.
  5. LOREICH, Article 7, specifically exempts PDVSA and all of its affiliates engaging in reserved activities from paying state or municipal tax. However, companies functioning under the operating agreement modality of LOREICH Article 5, are engaging in normal commercial (not hydrocarbons) activity and are hence subject to municipal tax.
  6. Supreme Court Decision of Aug. 17, 1999, File No. 812-829.

The Authors

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Uisdean R. Vass is a partner in Macleod Dixon, an international law firm whose head office is in Calgary, Alberta, also with offices in Caracas, Moscow, Almaty, and Toronto. Vass is based in the Caracas office, Despacho de Abogados miembros de Macleod Dixon SC. Vass holds the LL.B (Honors) from the University of Edinburgh Faculty of Law in Scotland, and the LL.M (with specialization in Oil & Gas Law) from Louisiana State University Law School in Baton Rouge, La. Vass is licensed to practice law in Scotland and Louisiana, and holds a special permit to practice international law in Venezuela.

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Leopoldo Escobar is a junior associate with Despacho de Abogados miembros de Macleod Dixon SC. He holds a law degree from Universidad Católica Andrés Bello and is currently pursuing postgraduate studies in tax law at Universidad Central de Venezuela. He is admitted to practice in Venezuela and is a member of the Caracas Bar Association.