Russian Federation: Analysis 2/96 - Production Sharing Agreements / Oil Ventures / Economic Stabilis

Last Updated: 5 September 1996
In this issue of Analysis we examine the effect of the new law on production sharing agreements on oil ventures, discuss the impact of the present political uncertainty on the economy as a whole, and review the present state of tax reform.

New PSA Law Leaves the Taxation of Oil Ventures Uncertain

Almost all observers of the Russian legislative process were amazed when the Russian parliament passed the long debated "Law on Production Sharing Agreements" (The PSA law) last December 1995 and put it on Boris Yeltsin's desk for signing. Almost on one was amazed, however, when President Yeltsin subsequently sighed the law into effect, as it represents the key to an estimated 60 to 100 billion US dollars which have been earmarked by western petroleum firms to be spent in Russia on major oil and gas projects.

The PSA law is a rather brief document as Russian laws go, but it represents the foundation for foreign investors to negotiate future investments for developing major oil and gas reserves, both onshore and in Russia's territorial waters. The law defines the structure of Production Sharing Agreements (PSAs) and describes how PSAs are negotiated, concluded and implemented. In further describes the special tax and payment regime which will apply to all PSAs that will be operational in Russia, as well as other rights and obligations of the investor, operator and the various governmental entities which are a party to the agreement.

However, the PSA law itself does not represent a complete basis for implementing such an agreement. In order for any PSA to be properly concluded and implemented it is estimated that over 20 other laws will have to be revised or adopted. These laws address a range of issue including all aspects of taxation, licensing of oil and gas ventures, regulation of foreign investments and the process for exportation of mineral resources. At the time of writing this article, very few of these laws had been modified or addressed by the Communist-controlled Duma, as its current focus is clearly on the Presidential elections next June. If a Communist President is elected then the whole concept behind the PSA legislation may be questioned as a relevant vehicle for the new administration to develop its oil and gas resources.

Currently, over forty ventures are licensed in Russia of which about 25 are producing and exporting oil. About two thirds of these ventures are structured as "joint ventures", usually using a Russian company to hold the investments of the Russian and foreign parties involved. The other one third are generally structured as service ventures where the Russian contracting party pays the foreign operator for its services either in each cash from export proceeds, or though a share of the production. None of these ventures would be effected by the new PSA law, and will continue to be taxed like other Russian companies, as by now most tax incentives which were extended to foreign investors have been abolished. There are a handful of PSA agreements which were negotiated and recognised be the Russian government before the PSA law passed, however, and these ventures will not have to comply with the new PSA regime unless they choose to conform their agreements to the new law.

If one considers that optimistically it might take six months to finalise the changes to the laws underlying the PSA agreements; six months after that to effect any tender offerings for the affected oil and gas fields; and another year to negotiate any particular PSA to conform to the new law; it is probable that it will be early 1998 before any material amounts of investment in oil ventures will flow into Russia as a result of the PSA legislation. In the meanwhile, foreign investors will continue to struggle with the oppressive and enigmatic tax laws that conform existing petroleum producing joint ventures and service operators.

At a minimum , any company attempting to invest in a petroleum venture in Russia should understand the impact of the Profits tax, the Property or Assets tax, withholding taxes, the VAT, taxes on turnover, taxes and payments due as a result of payroll, the special taxation of hydrocarbons produced, the Pollution tax, the import and export customs regime, the regulation of the use of foreign currency, as well as several taxes and fees imposed by local jurisdictions. In addition, mot producers of oil and gas will have to pay pipeline transportation fees, and terminating and storage charges to companies that are essentially state-run monopolies. Finally, many foreign companies have found out that the hard way that the interest penalty imposed on non-payment of taxes due is 0,7% per day - or 255% per year! Because of the cumulative effect of these various taxes and payments only those oil operators which keep their operating costs per tonne low, and have good control of the their tax and administrative functions, can expect to realise a profit from Russian operations.

Economic stabilization in political turnoil

Russia is facing a Presidential elections in June. Given the extensive power granted to the President by the Constitution, the outcome will guide the political and economic development Russia until the turn of the century. The opinion polls indicate that President Boris Yeltsin and the communist leader Gennady Zuganov are the two contenders most likely to oppose each other in the second, final round of the elections.

Boris Yeltsin's election platform is anti-Communist and he campaigns as a guarantor of continued economic reforms. The increasingly stable economic situation, with falling inflation and recovering real wages, may help to increase the President's popularity in the few months that are left. However, four years of high inflation and falling standards of living are not easily forgotten by the electorate. A second shadow falling on the president's campaign is the inability to end the conflict in Chechnya. The war has intensified in the last few months, but there are few signs of a quick resolution to the conflict.

The communists party's agenda is unclear, especially when it comes to the economic policy a communist president would pursue. Gennady Zuganov is well known for adaptation his policies to the audience he is facing. Whereas he will ensure a Western audience of the safety of their investment in Russia, the Russian electorate is promised the restoration of state control over manufacturing and a reintroduction of price controls. Even if the communists are not planning a full return to the planned economy, their inexperience and lack of understanding of fundamental economic principles will, no doubt, be very detrimental to the economic situation the economic situation in the event of their victory.

The political turmoil has not prevented the macroeconomic situation from improving. The inflation rate keeps falling, with February rate of 2.8 percent at an all time low. The figures for the first two weeks in March indicate that March inflation will fall even further. The rouble/dollar exchange rate is almost stable, and the rouble corridor will survive until June as planning.

The Russian Government and the Central Bank have adopted a far reaching set of economic policy measures to be implemented in 1996 and beyond. This far reaching economic programme has paved the way for a 10 billion dollar loan to Russia from the International Monetary Fund, the Extended Funding Facility, which will be disbursed over three years. In addition to a far reaching macroeconomic programme there is a structural element, dealing with issues such as the regulation of natural monopolies and land reform. A formal approval by theIMF is expected in mid-April. If the Russian Government and the Central Bank adheres to the economic programme, inflation for 1996 should be around 25 percent, growth expected at 2-6 percent for 1996 and around 6 percent annually until the turn of the century.

Present State of tax reform

Taxes play an omnipresent role in the economic and political scene of today's Russia. Revenues from taxes are the main source of income for the state budget, as the state-run economy has become practically non-existent. Despite the general commitment of executive bodies to the development of a free market economy, there is a tendency to maintain or gain state control over certain branches of the economy. Motives for this are partly strategic, partly budget driven.

Given the lack of resources for enforcing compliance with tax and other legislation, the authorities tend to make the more visible parties in an economic transaction liable for paying taxes. Commercial banks are increasingly obliged to serve as controlling bodies for compliance with tax, currency and customs legislation. Provisions to shift the Russian tax obligation of foreign legal entities to their Russian counterparts have been recently put into force for Value Added Tax and have been further elaborated for profits and income tax. This means that foreign companies receiving payments from Russia more often face withholding taxes and burdensome procedures to obtain exemption or recovery.

When granting the 7.2 billion dollar loan to Russia in spring 1995 , the IMF highlighted the Russian tax system as the main indicator of the government's commitments to economic reform. The Russian tax system had become a major instrument for granting political favours to certain categories of taxpayers, certain regions and even to specific companies. The IMF argued that these privileges actually prevented significant revenues from being collected. The Russian government responded so well to this request that many incentives to foreign investors were repealed as well.

A point of permanent dispute is the relationship between the federal government and the regions. A taxpayer in principle deals with three different budgetary authorities to which he pays taxes. Although the taxes are all collected by the State Tax Service, liability to one budget cannot be offset against overpaid taxes from another budget. Region autonomy is one of the fundamentals of the present state structure of the Russian Federation, and most regions attach great value to the right to generate their own revenues by levying taxes, especially if precious natural resources are located in their territory. Both the most important taxes, VAT and profit tax, are partly paid to the federal budget and partly to the regional budget. Rules to attribute income to a regional branch of a legal entity are just starting to be developed, so many regions have taken the opportunity of creating additional taxes. At the moment , there are over 200 different regional taxes in force in the Russian Federation. The draft Tax Code intends to bring this number down to about 30.

Probably one of the most burdensome features of the present Russian tax system is the penalty system. Once a tax is unpaid, whether on purpose or by mere oversight, the taxpayer risks concealment penalties of 100% of the disclosed amount plus late payment penalties that accrue with great speed: 0.5% to 1% per day. This means that a small bookkeeping mistake can result in a substantial tax liability. To overcome such debts without putting an enterprise out of business, tax amnesty regulations have been issued with some regularity, but the terms of these are usually not very generous.

Another reason why the vigorous penalty system continues to exist is because it gives tax officials considerable discretionary power. For example, a percentage of penalties collected goes into a social fund for employees of the Tax Service and the tax police. In addition to this there is an increased tendency to enforce payment of taxes by special means. The tax police have been given additional powers and legislation has been put in place recently to seize not only the bank accounts, but also the property, of taxpayers.

Finally, enterprises do not only have to deal with the tax authorities, but also with 4 different non-budgetary social funds, which levy an aggregate of 40.5% of the payroll expenses. Each fund has its own enforcement agents. the definition of payroll expenses as the basis for contribution payments used to be the same for all funds, but has started to diverge. There are plans, however, to replace the different social contributions with one collective tax.

The new Tax Code intends to remove the sharp edges from the present system and to establish a transparent set of rules with which every taxpayer should be reasonably able to comply. With the presidential elections only a few months away, it is clear whether any part of the Tax Code can be passed in the time available. A lack of technical knowledge on the part of the authorities, combined with the powerful position that the present system gives them, makes present efforts to reform the tax system advance very slow.

Good news in an election year?!

Personal income tax rates have been raised. For 1995 the top rate was 30% on taxable income exceeding Rbl 50 million. For 1996 this has been increased to 35% on taxable income exceeding Rbl 48 million. However, if one assumes that this is levied on an expatriate earning US$60,000 per annum, paid in dollars, and that the tax is paid in the usual three instalments in May, August and November with the balance payable falling due in the following April, the increase is not so significant:

Total amount payable in respect of

1995 . . . . . . . . . . . . . . US$16,300

1996 . . . . . . . . . . . . . . US$18,700

These calculated amounts assumed a rouble continuing devaluation against the dollar and the result shows an increase of 14.7% in the amount of tax payable on taxable income. Such figures are of course as good as the estimated figures used in preparing them. However were we to be dealing with fixed rates, (assuming for example that Rbl 5,000 -$1,00), the tax increase would have been 17%, all of which proves only one thing. When computing tax calculations in respect of Russian, you must always factor in the exchange differential.

For further information contact Bauke van der Meer on tel: +7 503 232 5511 fax: +7 503 232 5522 or e-mail directly: Click Contact Link or enter a text search 'Coopers & Lybrand' and 'Business Monitor'

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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