Constitutional Insights #3

Oil, Natural Gas and Other Fluid Hydrocarbon Royalties
under Brazilian Law

By Luis Fernando Priolli

The Brazilian Supreme Federal Court (STF) held hearings on May 6 and 7 regarding the Direct Actions of Unconstitutionality (ADIs) 4916, 4917, 4920, 4918, and 5038, respectively filed by the Governors of the States of Espírito Santo, Rio de Janeiro, and São Paulo, the Board of Directors of the Legislative Assembly of the State of Rio de Janeiro, and the Brazilian Association of Municipalities with Maritime, River, and Land Oil and Natural Gas Loading and Unloading Terminals (ABRAMT). The cases, reported by Justice Cármen Lúcia, challenge amendments introduced by the Royalties Law (Law No. 12,734/2012).

This law seeks to amend Laws No. 9,478 of August 6, 1997, and No. 12,351 of December 22, 2010, in order to establish new rules for the distribution among the entities of the Federation (Federal Government, States, and Municipalities) of royalties and special participation fees arising from the exploration of oil, natural gas, and other fluid hydrocarbons (“Oil Royalties”), as well as to improve the regulatory framework governing the exploitation of these resources under the production-sharing regime.

During the 1987–1988 Constitutional Assembly, the constituent legislators established that oil and its derivatives would be subject to a special ICMS tax regime. In other words, ICMS would not be collected in the producing state (at the origin), but rather in the destination state (where consumption occurs), contrary to the general taxation rule.

Since this would clearly cause losses to producing states and municipalities, the 1988 Federal Constitution (“CF/88”) guaranteed financial compensation for exploratory activities to producing states and municipalities, municipalities affected by exploration activities, and municipalities adjacent to offshore production areas, as provided in Article 20, Paragraph 1 of the Constitution, through Oil Royalties and special participation fees on oil and natural gas exploration.

To properly understand the intended purpose of this so-called financial compensation, it is important to analyze the records and debates of the 1987–1988 National Constitutional Assembly, the prevailing interpretation of the STF and constitutional legal doctrine.

Under the general ICMS interstate taxation rule, taxation normally benefits the state of origin. However, in the case of oil and its derivatives, the decision was made to tax consumption at destination (currently Article 155, Paragraph 2, Item X, “b” of the Constitution). This removed revenue from producing states. As a political and financial counterpart, the mechanism provided in Article 20, Paragraph 1 was created.

In the judgment of Writ of Mandamus No. 24,312/DF before the STF, reported by Justice Ellen Gracie on December 19, 2003, Justice Nelson Jobim — who had also served as a constituent federal congressman and played a key technical and political role in drafting the final constitutional text — provided the following historical reconstruction of the negotiations held during the Constitutional Assembly, describing the political agreement concerning ICMS and royalties:

“There was extensive discussion during the Constitutional Assembly as to whether ICMS should be levied at origin or destination. An issue arose involving electricity and oil. Oil-producing and electricity-producing states intended to maintain ICMS collection at origin. São Paulo, naturally, preferred destination taxation because it is a consumer state. The political solution was as follows: ICMS collection was removed from the origin state and financial compensation was created for producing states. That is how Paragraph 1 of Article 20 of the Constitution came into existence.”

In another portion of the same debate, Jobim added:

“It was established that ICMS would not apply to operations involving oil, including lubricants, liquid and gaseous fuels derived therefrom, and electricity destined for other states. In other words, ICMS incidence was removed from origin. Thus, the following solution was adopted: ICMS was removed from origin and states were granted financial compensation for the loss of such revenue.”

And further:

“I am attempting to reconstruct the historical issue of the Constitutional Assembly. This is not federal revenue that the Union is generously transferring to the states; rather, it is revenue originally belonging to the states, as financial compensation for the exploitation within their territories of an asset not subject to ICMS.”

The principal purpose of this constitutional provision was therefore to compensate producing states for the loss of tax revenues caused by destination-based ICMS taxation on oil. However, because the constitutional text also incorporated the idea of “compensation for the impacts and risks of exploration,” it opened the possibility of including environmental, infrastructure, and socioeconomic impacts and risks within its scope.

Thanks to the expression “financial compensation,” it also became legally acceptable to associate royalties with (a) territorial degradation; (b) environmental risks; (c) pressure on public services; and (d) the finite nature of natural resources.

Although the STF did not establish a binding precedent in this judgment stating that royalties exist exclusively to compensate for ICMS revenue losses, the Court formally recognized in MS 24.312 that royalties have the constitutional nature of “participation” or “financial compensation,” and that they originally belong to the beneficiary states and municipalities.

The summary of the judgment itself also references another rationale based on compensation for the economic, social, and environmental damages resulting from oil exploration activities.

Historically, therefore, the issue may be summarized as follows:

1. During the 1988 Constitutional Assembly
   1. The predominant political purpose was to compensate for the loss of ICMS revenue at origin;
   1. Especially for Rio de Janeiro and other producing states.

The constituent debates consolidated the political solution later reflected in:

• Article 155, Paragraph 2, Item X, “b”
  • ICMS on oil and electricity would be levied at destination; and
• Article 20, Paragraph 1
  • Financial compensation/participation for resource exploitation.

It is precisely because of this connection that Justice Jobim stated that “Article 20, Paragraph 1 must be read together with Item X of Article 155.”

• In subsequent legal developments
  • The thesis of compensation for the environmental, economic, and social impacts of exploration activities also became consolidated.
• Therefore, royalties today have a dual foundation
  • A federal-taxation rationale; and
  • An environmental/economic compensatory rationale.

This point became especially important in later disputes concerning the redistribution of pre-salt oil royalties, when producing states argued that the Constitution had established a specific federal pact in exchange for the loss of ICMS revenues. This understanding supported Justice Cármen Lúcia’s vote declaring unconstitutional the law that altered the rules governing the distribution of oil royalties, on the grounds that Law No. 12,734/2012 went beyond a mere revision of percentages and ultimately disrupted the federal balance by changing which entities are entitled to the financial compensation provided for in the Constitution.