No. 2, 2010
TAX RULES OF THE OIL GAME
Interview with Viktor Borodin, Tax Partner of Ernst and Young CIS
The oil and gas industry continues to play a key role in the national economy of Russia. Tax payments of oil companies are a significant source of revenue generation. However, working conditions in the energy market are constantly changing. Increased influence of regulatory bodies, geopolitical factors and price fluctuations - all these are inevitable challenges for the industry. The Russian tax legal and regulatory framework is also changing, adapting to new rules of the game.
Q: What key changes in the tax legislation with respect to the oil and gas industry took place in 2008 and 2009?
A: In 2008 a new law regarding foreign investments was introduced. The law restricts investments of foreigners in Russian companies developing strategic fields.
Most changes took place in 2009 and were mainly aimed at reducing of tax burden in the view of decrease in oil prices and stimulation of development of new fields located at the adverse terrains.
The formula determining mineral extraction tax (MET) rate has been amended. The cut-off price (non-taxable oil price) was increased from $9 up to $15, which slightly decreased total MET burden. New list of oil fields enjoying MET holidays was introduced.
The Government set a zero export duty rates for oil produced at 13 oil fields situated in East Siberia for such oil fields as Vankorskoye, Yurubcheno-Tokhomskoye, Talakanskoye and others. In 2010 the list was extended by nine oil fields. These were the first steps of the Government aimed at stimulation of oil production in East Siberia.
The procedure for establishing of export duty for oil has been changed. The period for which the duty rates are established has been changed from two months to one. The new procedures are more flexible in terms of considering changes of the macro economical factors, including world oil prices.
It becomes possible, at taxpayer's choice, to deduct the expenses which composed the cost of an obtained license within two years or include them to the cost of intangible assets. Previously it was the only choice to capitalize such costs.
The quantity of the dewatered, desalted and stabilized oil for the MET purposes has changed to be determined in the weight units of net (netto) instead of gross (brutto). This finally stopped the disputes with the tax authorities, which has been challenging the application of weight units of net for years.
Q: Which types of fields is the zero percent mineral extraction tax rate being currently applied for?
A: The current tax legislation makes possible to use the zero percent tax rate (so called "tax holidays") by the companies engaged in the development of fields situated merely in far away distance regions and by those which incur additional costs while producing the oil thereof.
The list of oil fields in which the produced oil is taxed at zero percent MET rate has been broadened in 2009 by fields situated to the north of the Arctic Circle within the boundaries of the internal sea waters and the territorial sea and on the continental shelf, in the Sea of Azov and the Caspian Sea, in the territory of the Nenets Autonomous Area and on the Yamal peninsular in the Yamal-Nenets Autonomous Area.
Q: What are the fundamental distinctions in taxation of domestic and international oil and gas companies working in Russia?
A: Nowadays oil- and gas-producing companies carry out activities in Russia on the basis of the law Concerning Subsurface Resources (1992), the law Concerning Production Sharing Agreements (1995) and other normative acts governing relations associated with the use and protection of land, waters and the environment that arise in the course of the use of subsurface resources.
These acts prohibit foreign companies to acquire a license for the development of fields. Therefore under the general rule the foreign legal entities cannot be directly engaged in oil production activity and consequently are not subject to MET.
It is necessary to note that if a foreign oil and gas company carries out any other entrepreneurial activity on a regular basis it will therefore be regarded as carrying activity through a "permanent establishment" in Russia and be subject to whole taxation in Russia.
However it is worthy to mention that the law Concerning Production Sharing Agreements provides for particular tax regime for foreign investors and establishes that production of mineral resources and other related activities are to be regulated by a special individual agreement to be concluded between a company (investor) and the state.
That agreement is essentially a contract between the state and an investor and is designed to regulate their mutual relations in the areas of tax, currency and customs legislation, and to ensure stability in those relations. A production sharing agreement (PSA) is an agreement in accordance with which the state grants an investor, on a repayable basis and for a specified period of time, exclusive rights to exploration, prospecting and production of mineral raw materials on a specified site of subsurface resources.
The investor, for its part, undertakes to carry out the work within the agreed timeframe, at its own expense and at its own risk. The state is represented in a PSA by the Russian Government and the executive body of the constituent entity of Russia in whose territory the subsurface site that is granted for use is situated. In accordance with current Russian legislation, investors may be legal entities or associations of legal entities which are established on the basis of a joint activity agreement and do not have the status of a legal entity.
Specific aspects of work performance are those that in order to support the interests of Russian companies, which act as suppliers of goods, work and services for the purposes of PSAs, there are a number of legislative requirements applicable to investors with regard to the engagement of Russian legal entities for the performance of PSAs. In particular, an agreement must include the following provisions, i.e. the preferential right of Russian legal entities to participate in work under the agreement as contractors, suppliers or carriers, citizens of the Russian Federation must account for no less than 80% of all employees, except in the initial phases of work or in the event that there are no workers or specialists available who are Russian citizens, etc.
Q: Nowadays Russia limits access for foreign investors to development of so-called strategic oil and gas fields. How, in your opinion, does this impact on the investment attractiveness of the Russian oil industry?
A: There is nothing unusual in striving of Russia for bringing strategic resources under control of the state. Such process is a common practice in the most of developed and emerging countries. Considering growing importance of energy recourses in today's world, this approach of the Russian Government seems to be absolutely logical.
I don't think that foreign investors really suffer from steps taken by the Russian Government. Widely known RF Law №57-FZ, regulating the process of investment in strategic industries, does not restrict foreign investments in fact, but just helps the Government to control this important area. Foreign companies which intend to invest in, say, Russian oil and gas industry are always actively welcomed. This thought was stressed by Russian officials not once.
Moreover, RF Law №57-FZ becomes a tool of tax control. Under this law foreign companies willing to invest in strategic industries are obliged to disclose their corporate structure. This allows Russian authorities to understand how the companies apportion their tax base between Russia and other jurisdictions, which often represent so-called "offshores" with very low tax burden. Considering that countries all over the world pay more and more attention to tax control and anti-avoidance measures, actions undertaken by Russia are actual and fully in-line with international trends.
Q: In your opinion, what amendments to the current tax legislation of Russia would be most topical for the Russian fuel and energy complex in the foreseeable future?
A: Fundamental principles of the existing tax system of Russia's oil sector were founded in the course of high prices for oil and low demand in additional investments because of the oil sector benefited from the Soviet legacy in terms of exploration and from relatively good accessibility. Fiscal policy was mainly based on withholding of portion of oil companies' revenue, while the calculation of such a withholding was based on low level of necessary investments, future production and investment will come at higher costs relative to the past.
Need in increase of investments in exploration of new oil fields requires reforming the existing system of oil sector taxation. One of the disadvantages of the existing taxation system that prevents the increase of investments is its greater reliance on revenue-based - as opposed to profit-based - taxation. For the purposes of new oil fields we assume that the replacement of the existing revenue based MET by a new profits based "Excess profits tax" will increase investment in exploration of new oil fields.
Other measure that may be taken for the purposes of developing of old and small oil fields is the stimulation of geological and engineering operations by deduction of corresponded costs from MET base.