BRASILIA (Reuters) - Brazil's Congress overturned a presidential veto on parts of an oil royalty bill on Thursday, setting up a prolonged legal battle with producer states and prompting oil-rich Rio de Janeiro to order the suspension of payments on the state's obligations in protest.
Rio's state government, which calculates a loss of 3.1 billion reais (1.05 billion pounds) this year alone because of the new legislation, ordered the suspension of all payments, except salaries to public employees, until the country's Supreme Court can rule on the royalty dispute.
While originally aimed at giving non oil-producing states a fair share of Brazil's future oil wealth, the bill cuts the share of royalties received from existing production contracts. That would take existing revenue streams from states and cities bordering maritime fields and redistributes them among all 27 states and 5,560 municipalities.
The veto override was a defeat for President Dilma Rousseff, who had committed herself to limiting the immediate impact of her government's oil industry reform on producing states. She has 48 hours to sign the bill into law.
It was not immediately clear from the Rio de Janeiro order whether the suspension covered debt payments to the federal treasury or just suppliers. Also unclear is whether Governor Sergio Cabral planned to go through with the suspension or was using the order to put pressure on Brasilia.
The Rio governor's office declined to comment when pressed for details on what payments might be suspended.
The suspension order comes as Rio builds roads, stadiums and other infrastructure ahead of the World Cup of soccer next year and the 2016 Olympics. As it is, the state is scrambling to finish its famed Maracanã soccer stadium in time for the Confederations Cup, a World Cup warmup in June.
The order raises myriad legal and fiscal questions for Brazil, a country whose current economic stability in large part is thanks to major reforms that, among other measures, imposed strict debt and budgetary regulations on states, many of whom had a long history of erratic finances.
Most affected are the states of Rio and Espirito Santo, which are responsible for about 80 percent of Brazil's current oil output.
Espirito Santo on Thursday said it will resort to the Supreme Court to challenge the constitutionality of the law. The state estimates it could lose 10 billion Brazilian reais ($5.10 billion) in royalty income between now and 2020.
"The decision by the majority of non-oil producing states undermines the nation's federal balance and the business climate," the state government said. Rio's government had already said it would challenge the law with the Supreme Court, too.
By altering existing oil contracts, the new legislation risks poisoning future debates between Brazilian states over tax reform and mining. It creates new risks for oil companies operating in Brazil and could delay the nation's plans to tap huge subsalt fields and become a major world oil producer.
Delays and cost overruns in new offshore fields and declining production and maintenance in existing older fields have caused Brazil's oil output to fall for 10 consecutive months through January, despite the discovery of giant new reserves south of Rio.
Oil analysts do not expect the royalty dispute to disrupt plans by Brazil to resume oil concession auctions this year. But it has soured relations between Brazil's states and became one of the most divisive issues of Rousseff's 2-year-old presidency.
"The royalty issue has become a zero-sum game, there are clear winners and clear losers and the losers are not happy," João Augusto de Castro Neves, a senior analyst with the Eurasia Group in Washington in an interview.
"The producing states' defeat may contaminate other issues such as Rousseff's push for a new mining code or lead them to block efforts for tax reform," Castro Neves, an economics and energy specialist, said.
Approved by Congress in November, parts of the bill were vetoed by Rousseff under rules that give Brazil's president the right to a line-item veto.
Rio Governor Cabral has said the loss of revenue for his state will undermine plans to host the World Cup games and the Olympics.
Rio and neighbouring Espirito Santo received 86 percent of all oil and gas royalties and windfall profits taxes given directly to states and municipalities in 2012, according to Brazil's oil regulator, the ANP.
Total royalties and windfall profits taxes in 2012 were 31.6 billion reais (10.73 billion pounds) with about half going to the federal government and the rest directly to states and municipalities.
Under the new legislation, producing states' royalties will shrink to 20 percent of the total royalty take by 2019 from 40 percent today. Producing municipalities share will drop to 4 percent in 2019 from 10 percent of the total take today.
Reporting by Jeb Blount and Rodrigo Viga Gaier in Rio de Janeiro; Editing by Alden Bentley