I INTRODUCTION

With a daily production of approximately 550,000 barrels per day, crude oil continues to be the most important export in the country, as it has been over the past four decades. Ecuador is an OPEC member.

In 2019, the Ecuadorian government has continued its efforts to recover and strengthen its hydrocarbon industry. The government expects to maintain a steady production of approximately 550,000 barrels per day and increase it up to 700,000 barrels per day by 2021. This effort will mandatorily include offering oilfields to private companies through public tender rounds, as well as continuing the improvement of operations of the state-owned company in charge of the exploration and exploitation of hydrocarbons in Ecuador, Petroamazonas EP (PAM).

Petroecuador EP is the state-owned company that is in charge of midstream and downstream activities. Petroecuador has a refining capacity of 175,000 barrels per day through three refineries, Esmeraldas (110,000 barrels); Shushufindi (45,000 barrels) and Libertad (20,000 barrels), that produce mainly gasoline, diesel and jet fuel among others.

II LEGAL AND REGULATORY FRAMEWORK

i Domestic oil and gas legislation

Ecuador has a civil law system, with its most recent Constitution approved on 20 October 2008 and amended in 2015. Pursuant to Articles 1 and 408 of the Ecuadorian Constitution, natural resources are the unalienable property of the Ecuadorian state and the government of Ecuador. Articles 313 to 315 of the Constitution establish that the state is responsible for the management of 'strategic sectors' through state-owned or state-controlled companies, and the regulation of these sectors through the corresponding public entities. Strategic sectors include, among others, energy in all its forms, non-renewable natural resources (including oil and gas, and mining) and hydrocarbons refining.

The Hydrocarbons Law regulates the Ecuadorian oil and gas industry. It contains the basic regulations for all the different types of contracts to be entered into with the state, including contract termination, state income and fiscal terms, transportation, commercialisation, exports, distribution, pricing and other provisions.

Furthermore, there are several specific regulations that regulate specific matters of the industry, for example, Regulations to the Hydrocarbons Law, Hydrocarbons Operations Regulations, Hydrocarbons Operations Environmental Regulations and other laws and regulations regarding environmental issues, taxation and accounting.

ii Regulation

The Ecuadorian state currently acts through: (1) the Ministry of Energy and Non-Renewable Natural Resources2 (the Ministry), which is in charge of carrying out hydrocarbons policies, and is responsible for executing, amending and administering areas and oil contracts, as well as the country's hydrocarbons resources; (2) the Hydrocarbons Regulation and Control Agency, which is in charge of regulating, controlling and supervising the technical, administrative and operative activities in the different stages of the hydrocarbons industry, including upstream, midstream and downstream activities; (3) the Ministry of the Environment, which is the national environmental authority in charge of applying environmental policies, and regulating, controlling and supervising all the environmental issues in all industries, including oil and gas; and, the Internal Revenue Service, which is in charge of taxation matters for all industries, including oil and gas.

iii Treaties

Ecuador is a party to the New York Convention, which has been in force since 1962.3 Additionally, Ecuador is a party to the Inter-American Convention on International Commercial Arbitration of Panama of 1975, in force since 1991. In 2017, Ecuador terminated all of the bilateral investment treaties to which it was a party. Finally, Ecuador has 18 double taxation treaties.

III LICENSING

The exploration and production of oil and gas resources shall be conducted directly and exclusively by the state through its state-owned companies. By exception only, the state may delegate these activities to local or foreign private, public or mixed-economy companies. Private companies with the required experience, and technical and economic capacity may enter into contracts with the state, awarded through a public tender process for certain oil and gas fields.

The Ecuadorian Constitution provides that the Ecuadorian state take in exploration and production contracts must be higher than the private contractors' take.

Pursuant to the Hydrocarbons Law, the state may award the following contracts to private, public or mixed-economy companies: (1) association contracts; (2) participation contracts; (3) risk service contracts for the exploration and production of hydrocarbons; or (4) other forms of delegation pursuant to Ecuadorian law.

Regarding the aforementioned types of contracts, Ecuador has traditionally implemented two types of contracts, namely participation contracts and service contracts, for the exploration and production of hydrocarbons with the Ministry.

More recently, Ecuador has also implemented another type of contract known as a specific integrated services contract with PAM.

The participation contract is a production sharing agreement entered into by the state, pursuant to which it delegates to the contractor the right to explore and exploit hydrocarbons in the area designated in the contract. The contractor bears the risk for all investments and assumes all costs and expenses required for exploration, production and development. The contractor has the right to participate in the production, which is calculated taking into consideration the production volume and the sales price of crude oil. The sales of contractor's participation in production constitutes contractor's gross income, from which the contractor must pay all investments, costs and expenses, applicable taxes and profit sharing contributions. The participation in production may be received in kind or in cash, subject to prior agreement between the parties.

In line with Ecuador's constitution, the participation contracts includes a formula to adjust the contractor's take in the contract, in order to ensure that Ecuador's take of the contract (oil sales and taxes) is higher than contractor's take.

Under a service contract, the contractor is required to provide exploration and exploitation services, invest in equipment, materials and technology with its own economic resources and at its sole risk, in exchange for a fee per net crude oil barrel produced and delivered to the state at the measurement point. The contractor's fee considers an estimate of the amortisation of the investments, costs and expenses and a reasonable profit taking into consideration the risks borne by the contractor. The contractor is the sole and exclusive operator and will be entitled to the payment of a tariff per barrel of net oil produced in the contract area. The state takes 25 per cent of the gross income from the sales of the crude produced in the contract (the 'sovereign margin'). Variations in the international price of oil affect the payment of the contractor's per barrel fee. Payment to the contractor is made in accordance with the monthly 'available income' derived from the production of contract area. The available income is the value of the gross income of the crude produced in a certain month (barrels produced times the market price of oil) minus the sovereign margin (25 per cent of gross income) mentioned above, transportation and commercialisation costs of Ecuador and certain applicable taxes and contributions. If the available income in a given month is less than the per barrel fee payment, the contractor only receives the amount of the available income and the difference is accumulated in an accumulation account (the 'carry forward' account).

In 2012, Petroamazonas EP assumed the operations of all the fields and areas that were operated by Petroecuador at the time. Pursuant to a specific integrated services contract that Petroamazonas has implemented, the contractor agrees to carry out specific works, activities or services for PAM, which continues to be the designated operator of the field, providing the technology, capital and equipment or machinery necessary to perform its obligations, in exchange for a fee or remuneration in cash.

The specific integrated services contract is entered into to perform concrete, specific and particular activities. This type of contract is not a direct exploration and production contract or concession by the state, but rather it is a contract for the provision of services by the contractor, where PAM remains as the operator of the field and the contractor renders services to PAM. In this type of contract, the state generally retains the operational risks, and the contractor only assumes the risk of its own investments made to provide the services in exchange for a fee.

i Tender process for awarding participation and service contracts

When Ecuador decides to carry out exploration and exploitation activities, it may choose – following specific bidding regulations – private companies, associations or consortia with the required financial solvency and technical capabilities in the hydrocarbons industry.

The Hydrocarbons Bidding Committee (COLH) is in charge of conducting the bidding procedure and enacting the bidding terms. Once the winning bidder is awarded, the corresponding contract is entered into between the Ministry and the awarded company.

ii Special procedures for awarding specific integrated services contract with PAM

The state has conducted procedures to award specific integrated services contracts to international companies for the purpose of increasing the production of existing fields under the operation of PAM. Once the potential partners have been determined, the board of directors of PAM resolves to begin a process for the direct negotiations of the contract with the selected bidder.

iii Revocation and expiry of licences

With respect to the contracts entered into with the Ministry, the Hydrocarbons Law establishes several causes for which the Ministry may declare the unilateral termination of a contract, which is called 'caducity.' The effects of caducity are the immediate return of all assets and production to the state and calling up contractual bonds. Caducity may be declared for breach of contract, unfulfilled committed activities, suspension of activities, failure to deliver the state's share, and transfer of contractual rights without prior approval of the Ministry, among others. In order to declare caducity, the Ministry must comply with the procedure established in the law. In contrast, regarding contracts subscribed with PAM, termination causes will be indicated in the contract, including termination by mutual agreement.

IV PRODUCTION RESTRICTIONS

There are no restrictions on production or export of entitlements. Under participation contracts, the contractor is entitled to receive the agreed participation, and is responsible for the transportation and export of its share of production. Under service contracts with the Ministry and specific integrated services contracts with PAM, all production is delivered to the state at the delivery centre, and the state is responsible for the transportation and export of the production. There are no requirements for sales of production into the local market. Commercialisation of crude oil products is an activity heavily regulated by the state that includes subsidies for many products (gasoline and LGP, among others) and regulated prices. Price setting corresponds to the state-owned company Petroecuador.

V ASSIGNMENTS OF INTERESTS

Transference of interests in service contracts and participation contracts requires prior approval from the Ministry. Failure to obtain approval is cause for termination under caducity. The transference of interests approval procedure is regulated, and requires the Ministry to determine that the assignor is technically and financially capable to conduct the operations under the contract. The transference requires the assignee to pay a fee equal to: (1) US$5,000 per participation interest assigned or (2) 0.001 times the net profits obtained in the year preceding the transfer or assignment. The assignor has to pay a fee equal to US$5,000 per participation interest assigned. Ministry authorisation is mandatory, whether or not the transference involves a change in control. The Ministry usually takes from eight to 12 months to issue the authorisation.

VI TAX

Ecuador's take (in addition to crude sales income) also comes from the following taxes and contributions: (1) 25 per cent income tax rate; (2) 15 per cent profit-sharing (15 per cent of net profits before income tax); (3) 12 per cent value-added tax; (4) 5 per cent currency remittance tax; (5) municipal taxes; and (6) other fees and contributions levied by hydrocarbons and other authorities.

In the Ecuadorian tax system, foreign and domestic sourced income is subject to income tax, which applies to all industries, including oil and gas. Companies operating through locally incorporated companies or a subsidiary are subject to pay annual income tax on the net profit of each year at a rate of 25 per cent. Companies are required to make a prepayment of income tax, following the rules set forth in the law.

Dividends paid after the payment of annual income tax are exempt, provided that: (1) the final beneficiary is not an individual with permanent tax residency in Ecuador; and (2) the Ecuadorian company complies with the shareholder's annual annex report to reveal the final effective beneficiary of the company. Dividends paid to individuals who are tax residents are subject to income tax withholding at a rate that ranges from zero to 35 per cent, depending on the amount distributed.

i Withholding taxes

According to Ecuadorian legislation, all payments or crediting on account, whether directly or indirectly, considered as taxable income for the recipient, are subject to withholding taxes. Therefore, remittances of income from an Ecuadorian source to non-residents are subject to withholding taxes. The tax is withheld on the gross amounts remitted, with no deductions allowed. The taxpayer of these withholding taxes is the non-resident beneficiary. However, the local taxpayer is considered as a withholding agent, and as such, is jointly and severally liable.

Almost all types of payments made abroad are subject to income tax withholdings, at a 25 per cent rate; however, this percentage can be reduced through the application of double taxation treaty benefits. A 2 per cent withholding tax applies to payments made to local beneficiaries for the provision of services, and a 1 per cent withholding tax is applied to the acquisition of goods. Income tax withholding at a rate of 35 per cent, applies to payments made abroad to recipients in tax havens, low taxation jurisdictions or preferential tax regimes.

Interest payments and financial fees are generally subject to 25 per cent income tax withholding; however, if the loan has been granted by a foreign financial institution, specialist non-financial institution or an international organisation, no income tax withholding shall apply on the interest payments, provided that additional requirements are met. It is noteworthy to mention that thin capitalisation rules are in force in Ecuador, establishing a ratio of 3:1 foreign debt to equity.

ii Remittance tax

All Ecuadorian taxpayers that remit currency abroad are subject to a 5 per cent tax on the amount transferred, regardless of whether the transaction is made through a financial institution or if the financial resources are not located in Ecuador. Dividends distributed to foreign residents shall be exempt from remittance tax to the extent that the recipients of the dividends are not domiciled in a tax haven or a lower tax jurisdiction. Remittance tax payments may be considered income tax credit for five fiscal years in some cases.

iii Transfer prices

Ecuador follows OECD rules, complying with the arm's-length standard.

VII ENVIRONMENTAL IMPACT AND DECOMMISSIONING

The Ecuadorian Constitution provides a responsabilidad objetiva regime of strict liability for environmental damage. Article 396 of the Constitution sets forth that 'liability for environmental damage is strict'. Strict liability, within the context of the Constitution, means that for the oil operator to be liable, the state shall only establish that environmental harm exists, and that the harm was found in the areas where the oil operator undertook petroleum activities referred to in the Constitution. It is worth emphasising that, under the Constitution, strict liability is a liability 'without fault'. Thus, the state does not need to prove the existence of a causal link between the action or omission and the environmental damage found in the areas where the oil operator conducted operations. In order to be exempt from liability, however, oil operators must establish that the damage arises from (1) force majeure; (2) actions or omissions of the party affected by the damage; or (3) actions or omissions of a third party. This strict liability requires full restoration of the ecosystem to its original state, in addition to the obligation to compensate affected third parties, as well as the respective fines that may be applicable.

The Organic Environmental Code establishes the general environmental guidelines and environmental policy of the state. This law sets out each of the environmental authorities and their duties, and establishes the environmental management system. Private investments in projects that might impact the environment are required to obtain an environmental licence through this system, for which an environmental impact assessment must be carried out. Without the environmental licence, no activities can be performed. For oil and gas activities, the environmental licence must be obtained by the operator. Additionally, throughout the life of the contract, the operator must carry out environmental audits according to the corresponding environmental impact assessment.

The Environmental Regulation to Hydrocarbon Operations contains specific provisions pertaining to the exploration, production, storage, transportation and industrialisation of hydrocarbons. All activities that could have an impact on the environment are contemplated in this regulation. Under this regulation, operators must deliver an annual programme of environmental activities to the Ministry of Hydrocarbons by the first of December of every year. Operators must also deliver an environmental budget for the following year for evaluation and approval on the basis of the pronouncement of the Undersecretary for Environmental Protection. Additionally, the operator must provide an annual environmental report due by the first of January of each year.

Regarding decommissioning, the contractor must perform the final environmental impact assessment audit. Additionally, all tax and labour matters arising during the term of the contract, as well as all pending obligations with subcontractors, must be liquidated.

VIII FOREIGN INVESTMENT CONSIDERATIONS

i Establishment

A branch of the foreign company or a local subsidiary must be created to enter into a contract. It is not necessary that the branch or the subsidiary be set up in Ecuador during the tender process, but it is mandatory once the contract has been awarded.

The following is required to establish a foreign branch in Ecuador: (1) the company's by-laws should allow for establishment of branches in foreign countries; (2) a legal existence certificate granted by the corresponding government authority; (3) resolution from the shareholders, board of directors or any other duly authorised body or official, authorising the establishment of a branch, assigning a minimum initial capital of at least US$2,000 and appointing a legal representative in Ecuador; (4) issuance of power of attorney granted to whoever is appointed as the company's legal representative of the branch in Ecuador; (5) Ecuadorian consulate certification that the company exists; and (6) a corporate bank account in Ecuador with at least US$2,000.

The procedure to establish a branch is the following: (1) submit a petition to the Superintendence of Companies that includes the documents listed above; (2) the Superintendence of Companies will issue a domiciliación resolution approving the registration and the power of attorney; (3) the resolution must be registered in the Mercantile Registry; and (4) after the resolution is duly registered, a local tax ID number and the patente – for commercial operation tax – in the corresponding municipality must be obtained. Upon completion of this procedure, the branch is ready to operate.

The procedure to incorporate a company is the following: (1) the issuance of a public deed of incorporation from a public notary; (2) registration of the public deed of incorporation in the Mercantile Registry; (3) once the incorporation is duly registered, it must be notified to the Superintendence of Companies in order to take note of the incorporation; (4) after the registration in the Mercantile Registry and the Superintendence of Companies, the local tax ID number and the patente for commercial operation tax must be obtained in the corresponding municipality. Upon completion of this procedure, the company is ready to operate.

Additionally, in order to subscribe a hydrocarbons exploration and exploitation contract, the company must get registered in the Hydrocarbons Registry of the Ministry.

It may take up to six weeks to complete the entire procedure. The costs for setting up a branch or incorporating a company will not exceed US$5,000, plus legal fees.

ii Capital, labour and content restrictions

Capital

Ever since the establishment of the US dollar as the legal currency in Ecuador, there are no restrictions on capital movements abroad, other than the remittance tax, or access to foreign exchange of currencies.

Labour

Below are some general considerations regarding the Ecuadorian labour regime:

  1. minimum wage for 2019 is US$394.00 dollars per month;
  2. two additional mandatory pay cheques, commonly referred to as the thirteenth and fourteenth salaries are required. The thirteenth salary must be made in December, while the fourteenth must be made by March (Coast Region) or August (Highlands or Amazon Region);
  3. from the thirteenth month onwards, a payment, corresponding to 8.33 per cent of the employee's salary, must be made to the reserve fund;
  4. the employer must pay 12.15 per cent of the employee's salary to social security, on a monthly basis;
  5. normally, contracts are signed with an employee for an undefined duration. If the employer wants to terminate the contract, the employee must be indemnified;
  6. employees have the right to 15 days of vacation each year, plus one additional day per year worked over five years for the same employer;
  7. employees are required to work eight hours per day, and 40 hours per week. By mutual agreement, the employee may work extra hours for overtime pay. However, in the oil and gas industry, special working schedules can be used with prior approval of the labour authority; and
  8. the company must have internal regulations regarding safety and healthcare for the employees.

Outsourcing employees is prohibited. However, oil and gas companies are allowed to contract complementary services or technical and specialist services under civil regulations instead of labour regulations, if these activities are not directly related to the company's primary business activities.

As of May 2018, the Organic Law for the Integral Planning of the Amazon Region has been in force, establishing the preferential employment right, which means that companies carrying out their activities in the special jurisdiction of the Amazon Region shall hire no less than 70 per cent of local residents, to perform non-skilled activities, save the cases where qualified skilled labour does not exist.

Additionally, the Hydrocarbons Law establishes certain limitations for hiring local and foreign workers, which must be observed. Finally, in accordance with immigration legislation, all foreign workers must obtain a visa.

iii Anti-corruption

The Constitution and the Organic Criminal Code are the primary laws that criminalise corruption-related crimes. Thus, the Constitution sets out prohibitions and liability warnings for public officials when performing their duties, as well as when handling public goods and resources. The aim is to prevent them from being involved in bribery, extortion, influence peddling, embezzlement and unlawful enrichment. Other laws, such as the Organic Law on Public Service, the Public Procurement Law, the Organic Law on the Transparency and Social Control Branch and the Organic Law on the Council for Citizen Participation and Social Control also set forth anti-bribery rules. Additionally, Ecuador is a signatory to the Inter-American Convention against Corruption of 29 March 1996. Finally, in 2005, Ecuador ratified the UN Convention against Corruption.

Despite the general legislation described above, Ecuador does not have specific anti-corruption rules for the oil and gas industry. Nevertheless, the Ministry is working on new anti-corruption rules that will be applicable to state-owned oil companies.

IX CURRENT DEVELOPMENTS

The participation contract model was used by Ecuador from the early 1990s to 2010 when Ecuador, pursuant to new reforms in the national oil industry, switched to the service contract model. Ever since 2010, it has been the policy of the government of Ecuador to award services contracts for the exploration and production of hydrocarbons, and not to award participation contracts. However, in 2018, the participation contract was reinstated by the government of Ecuador in the latest oil and gas round (Intracampos 1), through which seven oilfields were awarded to private investors.

It is expected that a new Round, 'Intracampos 2,' will be launched late in 2019 under very similar conditions, using the same model of the participation contract used in the previous round.

PAM also carried out an oil and gas round in 2018 in order to select private investors for the provision of integrated services with contractor financing for the development of several oilfields operated by PAM. Three oilfields were awarded in this round.

In an interesting judicial development, in 2019, the Waoranis, an indigenous ancestral native community in the Ecuadorian Amazon Region, achieved a victory in the courts, with a ruling that declared the violation of their collective right to self-determination and prior, free and informed consultation regarding non-renewable resource exploitation projects on their lands. The ruling prevents oil exploitation in part of their ancestral territory and orders the prohibition of any type of exploitation on 180,000 hectares within Block 22, which has not been granted to any company yet. As an integral reparation measure, the court ordered the Ecuadorian state to conduct a prior, free and informed consultation in the Waorani community, applying the Ecuadorian Constitution and the standards established by the Inter-American Court of Human Rights and the Constitutional Court of Ecuador.

Finally, the government has decided to merge Petroecuador EP and Petroamazonas EP, in order to have – again – a single state-owned company in charge of all phases of the hydrocarbons activity in Ecuador.


Footnotes

1 Sebastián Cortez Merlo is a partner, Francisco Larrea Naranjo is a director and María Elena Sanmartín is an associate at Noboa Peña & Torres Abogados.

2 Executive Decree 399, dated 18 May 2018, ordered the merger of the Ministry of Hydrocarbons, Hydrocarbons Secretariat, Ministry of Electricity and Ministry of Mines, creating the Ministry of Energy and Non-Renewable Natural Resources, which succeeded all their rights and obligations.

3 Ecuador subscribed the NYC with the following reservations: (1) application only to recognition and execution of award rendered in states parties; and, (2) application only to awards derived from legal relations, contractual or not, considered as commercial, according to the internal legislation.