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Issues of profit taxation of oil companies

Alexandrova Elena Rodionovna, Advisor to the Department for Support of Activities of Advisors to the President of the Russian Federation, Senior Lecturer of the Energy Law Sub-Department of O.E. Kutafi n Moscow State Law University, Candidate of Legal Sciences

In this article the author considers issues of calculation and payment of profit tax by the companies dealing in crude oil and petroleum products, and presents a legal analysis of the applicable law, its trends, and judicial practice.

This article considers challenges of calculation and payment of profit tax by the companies engaged in transactions with crude oil and petroleum products.

Pursuant to Art. 247 of the Tax Code of the Russian Federation[1], profits received by a taxpayer are recognized as an item of corporate profit taxation.

For Russian organizations that do not belong to a consolidated group of taxpayers, profits shall mean earned revenues minus incurred expenses defined pursuant to Section 25 of the Tax Code of the Russian Federation.

For organizations that belong to the consolidated group of taxpayers (hereinafter referred to as the CGT) profits shall mean the CGT members’ aggregate profits accrued to this member and calculated in the prescribed manner.

First of all, let’s examine the issue of tax calculation for the consolidated group of taxpayers. January 1, 2012 saw the entry into force of provisions of the Tax Code of the Russian Federation[2] on the CGT allowing payment of corporate profit tax based on the cumulative financial performance result of a group of organizations.

These provisions are most relevant for the major taxpayers engaged in exploration, production, refining, transportation and sale of crude oil and petroleum products.

Thus, the consolidated group of taxpayers means a voluntary association of taxpayers of corporate profit tax based on an agreement establishing the consolidated group of taxpayers for calculation and payment of corporate profit tax taking into account the said taxpayers’ cumulative financial performance result (Art. 25.1 of the Tax Code of the Russian Federation).

The terms of the CGT establishment, procedure for conclusion of the agreement establishing the CGT, the CGT members’ rights and duties are defined in Section 3.1 of the Tax Code of the Russian Federation.

The agreement establishing the CGT charges a responsible member of the consolidated group of taxpayers with the duties on calculation and payment of profit tax for this group. In terms of legal relations in calculation and payment of the said tax, the responsible CGT member exercises the same rights and has the same duties as taxpayers of corporate profit tax.

Other CGT members discharge their duties of taxpayers of corporate profit tax for the consolidated group of taxpayers to the extent needed for its calculation by the responsible member of this group.

According to the general rule, a tax base for revenues earned by all CGT members (consolidated tax base) shall be determined based on the amount of total revenues and the amount of total expenses of the CGT members accounted for profit taxation. This rule covers the determination of the tax base, to which the tax rate of 20% applies pursuant to cl. 1, Art. 284 of the Tax Code of the Russian Federation. A tax base with any other tax rates shall be independently determined by the CGT members and shall not be considered in calculation of the CGT’s tax.

The consolidated tax base does not include the CGT members’ revenues subject to tax withheld at the source of income[3].

The specifics of the tax base determination for profit tax on revenues received by the CGT members shall be established due to the need to adjust the tax base in the CGT members’ revenues and expense associated with their relations with each other.

Thus, pursuant to sub-cl. 44, cl. 1, Art. 251 of the Tax Code of the Russian Federation the tax base determination does not consider revenues in cash received by the responsible CGT member from other members of this group for profit tax payment (advance payments, penalties, fines) and cash received by a CGT member from the responsible member of this group of taxpayers for specification of tax amounts (advance payments, penalties, fines) subject to payment for this group of taxpayers.

Similarly, the tax base determination does not include expenses in the form of cash given by a CGT member to the responsible member of this group for tax payment (advance payments, penalties, fines) and cash given by the responsible CGT member to a member of this group for specification of amounts (advance payments, penalties, fines) subject to payment for this CGT (sub-cl. 48.14, Art. 270 of the Tax Code of the Russian Federation).

Article 278.1 of the Tax Code of the Russian Federation prevents the CGT members from forming doubtful debt reserves for debts of a member of this group owed to other members of such a group. Besides, members of the consolidated group of taxpayers shall not form warranty repair and service reserves for sales of goods (works) to other member of this group.

The doubtful debts reserves (for debts of one member of this group owed to other members of such a group) and warranty repair and service reserves (for amounts of reserves related to goods (works) sold to other members of this group) created earlier shall be restored. The relevant amounts shall be referred to non-operating revenues in the tax period preceding the tax period, in which the taxpayer became a member of the consolidated group of taxpayers.

If the CGT members suffered losses in the tax periods preceding the tax period, in which they joined this group, such losses shall not reduce the consolidated tax base starting from the tax period, in which they joined such a group. Pursuant to provisions of Art. 278.1 and Art. 283 of the Tax Code of the Russian Federation an organization being a member of the consolidated group of taxpayers is entitled to reduce the tax base of the current tax period by the amount of losses at the end of the tax periods, in which it was not a member of the consolidated group of taxpayers, after withdrawal from this group (termination of this group).

Where the relevant articles of Section 25 of the Tax Code of the Russian Federation stipulate standards for expenses approved for taxation purposes (for example, in relation to advertising expenses, hospitality expenses, contributions for establishment of funds for support of scientific, scientific-and-technical and innovative activities, expenses on corporate vehicles maintenance, expenses on compensation of employees’ expenditures on payment of interest under loans (credits) for purchase and (or) construction of housing, etc.), such standards shall be applied by each member of the consolidated group of taxpayers (Art. 278.1 of the Tax Code of the Russian Federation).

Nowadays, there is no developed practice for application of the provisions of the Tax Code of the Russian Federation establishing the procedure for calculation and payment of profit tax by organizations establishing the CGT — tax control activities have only just begun. Meanwhile, the lawmaker set a number of distinctions for these inspections.

Thus, pursuant to Art. 89.1 of the Tax Code of the Russian Federation a field tax inspection of the CGT shall be performed in relation to the CGT’s profit tax both in the territory of the responsible member of this group and in the territories of other members. The term of such an inspection makes two months and may be increased by the number of months equal to the number of the CGT members (except for the responsible member of this group), but no more than a year.

It is important to note that the field tax inspection of the CGT does not preclude independent field tax inspections of members of this group in relation to taxes that are not subject to calculation and payment by the said CGT with results of such inspections being documented separately.

It is also important to address the issues of revenue determination for taxation purposes. Revenues for profit taxation include revenues received from sales of goods (works, services) and exercise of property rights along with non-operating revenues.

On the thirtieth of July 2013 the Presidium of the Supreme Arbitration Court of the Russian Federation examined case No. 3290/134[4] on exclusion from revenues of organizations engaged in main pipeline transportation of oil, gas and their products of subsidy amounts received from the budget of a constituent entity of the Russian Federation for compensation of costs associated with construction, reconstruction and modernization of fixed assets.

According to the results of tax control activities, the tax authority charged additional profit tax and penalties, because according to the inspectorate, subsidies received by the taxpayer shall be recognized as non-operating revenues as donated property pursuant to cl. 8, Art. 250 of the Tax Code of the Russian Federation.

The case examination by the Presidium of the Supreme Arbitration Court of the Russian Federation resulted in the conclusion on invalidity of additional tax charge on the following grounds.

Cl. 2, Art. 251 of the Tax Code of the Russian Federation as in force during the period of inspection stipulated that the tax base determination shall not consider special-purpose receipts (except for special-purpose receipts in the form of excise goods), which include special-purpose receipts from the budget and special-purpose receipts for maintaining non-profit organizations and statutory activities performed by them donated by other organizations and (or) individuals and used by the said recipients for intended purposes. In this regard, taxpayers - recipients of the said special-purpose receipts shall keep separate records of revenues (expenses) received (incurred) as part of special-purpose receipts.

Article 78 of the Budget Code of the Russian Federation[5] stipulates provision of subsidies to legal entities on free-of-charge and non-repayable basis for compensation of expenses or short-received revenues in relation to production (sale) of goods, performance of works and rendering of services.

Based on the Samara region’s legislation, the year 2008 saw the provision of subsidies funded from the with regional budget, in particular, to legal entities - producers of goods, works and services conducting its activities in the territory of the Samara region for compensation of expenses or short-received revenues to the said entities in relation to production of goods, performance of works and rendering of services in the fuel and energy complex.

In 2008, the taxpayer received a subsidy funded from the regional budget as a producer of goods, works and services in oil transportation for compensation of expenses in relation to production (sale) of goods, performance of work and rendering of services in oil transportation for expenses on implementation of activities aimed at facilitation of economic development of the Samara region.

The courts ruled that the company incurred costs associated with reconstruction and modernization of fixed assets. The said costs entered separately by the company were recognized as expenses by means of depreciation only in accounting records; as for tax accounting, they did not reduce the tax base for profit tax.

Due to the fact that the taxpayer respected the terms for using and accounting special-purpose receipts, the Presidium of the Supreme Arbitration Court of the Russian Federation ruled that the charge of additional tax and penalty was illegal.

Nowadays, there is a new wording of cl. 2, Art. 251 of the Tax Code of the Russian Federation, however, the issue of whether it is necessary to recognize special-purpose receipts gained by the taxpayer as revenues remains relevant in some cases. In particular, there have been cases, when taxpayers - producers of goods (works, services) receive subsidies for compensation of previously incurred costs associated with construction and modernization of fixed assets. The issue of whether to include these amounts in the tax base for profit tax arises, when past expenses reduced taxable profits.

In this regard, it is important to draw attention to the fact that in Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dd. July 30, 2013 No. 3290/13 the court examined the issue of inclusion of recoverable costs in expenses that reduce taxable profits, and specified that previously the taxpayer did not reduce its taxable profits by these expenses, inter alia, in the form of depreciation charges.

In the event that the said expenses are calculated in profit taxation, when the taxpayer gets special-purpose receipts for their refund, these amounts lose the status of the taxpayer’s expenses.

It seems that the position of the Presidium of the Supreme Arbitration Court of the Russian Federation stated in Resolution dd. January 17, 2012 No. 10077/116[6] can be applicable to this situation.

The said resolution examined the situation, when the taxpayer submitted revised tax declarations for land tax, in which the amount of initially calculated land tax was reduced. When the tax authority recognized the fact of land tax overpayment, the company recognized the said amount as non-operating revenues in calculation of an advance profit tax payment for the current period.

However, according to the inspectorate, in the present case the company should have otherwise corrected the amount of its tax duty on profit tax, namely: to submit revised tax declarations for profit tax for those periods, in which expenses were initially calculated as land tax amounts.

The tax authority’s position was based on the rules of Art. 54 of the Tax Code of the Russian Federation: pursuant to cl. 1 of this article, if mistakes (misrepresentations) are found in the tax base calculation that belong to the past tax (reporting) periods, in the current tax (reporting) period the tax base and tax amount shall be recalculated for the period, in which such mistakes (misrepresentations) were made.

The Presidium of the Supreme Arbitration Court of the Russian Federation found that the tax authority’s conclusions were unreasonable and noted that recognition of the initially calculated land tax amount as expenses, which corresponds to provisions of the Tax Code of the Russian Federation, cannot be classified as a mistake. The correction of the tax base on land tax shall be considered as a new circumstance pointing to the need for recognition of the excessively calculated land tax amount in the period of the said correction as non-operating revenues, which list under Art. 250 of the Tax Code of the Russian Federation is not exhaustive[7].

It seems that receipt by the taxpayer of special-purpose receipts to refund past expenses, which reduced taxable profits pursuant to provisions of Section 25 of the Tax Code of the Russian Federation, can also be considered as a new circumstance involving correction of the tax base on profit tax in the manner similar to that examined by the Presidium of the Supreme Arbitration Court of the Russian Federation.

It is also necessary to highlight the problems associated with determination of expenses for taxation purposes. The taxpayer shall reduce earned revenues by the amount of incurred expenses. The expenses mean reasonable and documented expenses (and in the cases stipulated by Art. 265 of the Tax Code of the Russian Federation, losses) made (incurred) by the taxpayer. In this regard, the expenses depending on their nature along with terms and sphere of the taxpayer’s activities are subdivided into expenses associated with production and sales, and non-operating expenses.

The expenses associated with production and sales include, in particular, expenses for development of natural resources[8], which are covered by Art. 261 of the Tax Code of the Russian Federation.

Pursuant to the current wording of cl. 1, Art. 261 of the Tax Code of the Russian Federation, the expenses for development of natural resources mean the taxpayer’s expenses for geological study of subsoil, mineral exploration, preparatory works and sidetracking of producing wells.

The expenses for sidetracking of producing wells were recognized as expenses for mineral exploration by Federal Law dd. July 23, 2013 No. 213-ФЗ[9]. The amendments introduced to Art. 261 of the Tax Code of the Russian Federation by this law entered into force on January 1, 2014.

The need to introduce the said amendments results from a large number of tax disputes on classification of these expenses and their recognition in profit taxation. The key point of these disputes was that, according to the tax authorities, any works associated with sidetracking of wells represent reconstruction of fixed assets (wells), and the expenses shall be recognized as an increase in the wells’ initial cost based on Art. 257 of the Tax Code of the Russian Federation with the subsequent write-off by means of depreciation charges and inclusion of the increased initial cost of each facility of fixed assets in the tax base on corporate property tax based on Art. 374 of the Tax Code of the Russian Federation. The tax authorities proved their conclusions by the fact that the completion of a new wellbore and the discontinuation of an old wellbore part represent a change of the well structure, and an increase of daily oil extraction (the well’s oil flow) represent the well’s technical-and-economic performance improvement.

In the company’s view, the works on sidetracking of wells represent the works on repair of wells; expenses for these works shall be recognized as expenses reducing taxable profits at any one time.

The case on additional charge of profit tax associated with classification of works on sidetracking of wells was examined by the Presidium of the Supreme Arbitration Court of the Russian Federation; the examination resulted in Resolution dd. February 1, 2011 No. 11495/10[10]. According to the Presidium, the increase in daily oil extraction, as such, is insufficient and non-decisive for classification of the said works as a general overhaul or reconstruction.

The judicial act contains the following conclusions. The well’s oil flow in operation of a field is a dynamic indicator, its growth or reduction is directly related to the impact on a productive layer to maintain pressure exerted at the field (including water injection), types and mode of pumping equipment operation, mode of operation of this well and other wells (for example, injection wells) are related to the intensity of oil withdrawal, and not just to characteristics of the well as an item of fixed assets or to changes of its design. In this regard, classification of works demands a cause-and-effect relation established between the change of the well’s design, its performance specifications and oil extraction improvement.

New (side) wellbores are drilled in the event of elimination of major accidents emerging during operation of wells or during repairs; discovery of additional productive capabilities of low production wells’ wellbore; reopening of wells, including suspended or earlier abandoned wells for technical or any other reasons, to open areas with unextracted hydrocarbon reserves by means of a new wellbore. The said works are performed as a general overhaul, if it is technically impossible to apply methods of squeeze cementing (shutoff of watered layers or their certain intervals, removal of cement sheath leakage, build-up of a cement sheath behind a casing string)[11].

To classify the works performed, one should know the circumstances that indicated the need for drilling operations. Sidetrack drilling in inactive wells shall be referred to reconstruction. Reconstruction also includes drilling operations associated with natural depletion of oil reserves in the field resulted, in particular, from rated water injection to certain layers and wells according to the field development program (management plan). Any works preformed in malfunctioning wells or associated with extreme watering of layers resulted from inrush of produced water shall be referred to a general overhaul.

Thus, based on the position of the Presidium of the Supreme Arbitration Court of the Russian Federation, the courts in resolving disputes should have found out the circumstances of the relevant works in each well.

Amending Art. 261 of the Tax Code of the Russian Federation with regard to recognition of expenses for sidetracking of producing wells as expenses for development of natural resources is aimed at reduction of the number of tax disputes and the unified application of this rule.

The procedure for recognition of expenses for development of natural resources is stipulated by cl. 2, Art. 261 of the Tax Code of the Russian Federation. In this regard, expenses for development of natural resources shall be recognized for taxation purposes from the 1st day of the month following the month, in which these works (work stages) were completed, and shall be included into other expenses in the following manner:

with even inclusion within 12 months of expenses for exploration and appraisal of mineral deposits (including audit of reserves), including expenses associated with construction (drilling) and (or) abandonment (suspension) of wells (except for those recognized as depreciable assets), mineral prospecting and (or) hydrogeological surveys, along with expenses for acquisition of necessary geological and other information from any third parties, including public authorities, and expenses for sidetracking of producing wells;

with even inclusion within two years, but in any case no longer than the useful life, of expenses for preparation of the territory for mining, construction and other operations in line with the established requirements to safety, protection of lands, subsoil and other natural resources and the environment; expenses for compensation of complex damages to natural resources related to taxpayers’ activities in construction and operation of facilities, for resettlement and payment of housing demolition compensations during development of fields.

To complete the examination of the above profit taxation challenges, let’s focus on the judicial act passed in relation to a dispute on the period, within which the taxpayer is entitled to reduce taxable profits by expenses associated with development of natural resources. I am referring to Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dd. November 22, 2011 No. 7669/11[12], which is especially related to a dispute on classification of incurred costs as expenses for development of natural resources or as expenses for scientific researches and (or) experimental developments.

Pursuant to the case materials, research organizations as per the taxpayer’s (customer’s) orders performed works on specification of field development projects, such as development of permanent geological-and-technological models for oil extraction forecasting, modelling of geological-and-technical activities for improvement of oil recovery and operating efficiency.

The tax authority charged additional profit tax, because it recognized the costs of these works as expenses for scientific researches and (or) experimental developments, which were subject to even inclusion by the taxpayer into other expenses within three years from the 1st day of the month following the month, in which the relevant researches were completed, pursuant to cl. 2, Art. 262 of the Tax Code of the Russian Federation (as in force during the disputable period).

According to the taxpayer, these expenses shall be referred to expenses for development of natural resources.

In the resolution under consideration, the Presidium of the Supreme Arbitration Court of the Russian Federation specified that expenses for exploration of fields, specification of development projects, development of design specifications and estimates, and preparation of geological models may be classified not only as expenses for scientific researches and (or) experimental developments as prescribed by Art. 262 of the Tax Code of the Russian Federation, but also as expenses for development of natural resources based on Art. 261 of the Tax Code of the Russian Federation. Pursuant to cl. 4, Art. 252 of the Tax Code of the Russian Federation, if any expenses may be equally referred to several groups of expenses at any one time, the taxpayer may define on its own, to which group such expenses will be referred.

In the present case, the company recognized the disputable expenses as expenses for development of natural resources. Since the works were performed in commissioned and developed fields, the company rightfully referred them in full to expenses of the reporting (tax) period, in which they were incurred, based on paragraph 5, cl. 3, Art. 325 of the Tax Code of the Russian Federation.

The foregoing leads to the conclusion that the issues under consideration are quite topical and worth deep legal analysis and further researches.



[1] Tax Code of the Russian Federation. Part II // Collection of the Legislative Acts of the Russian Federation, 2000, No. 32, Art. 3340 (in Russian).

[2] Federal Law dd. November 16, 2011 No. 321-ФЗ “On Amending Part I and II of the Tax Code of the Russian Federation in Relation to Establishing a Consolidated Group of Taxpayers” // Collection of the Legislative Acts of the Russian Federation, No. 47, Art. 6611 (in Russian).

[3] Art. 278.1 of the Tax Code of the Russian Federation.                                                          

[4] Bulletin of the Supreme Arbitration Court of the Russian Federation, 2014, No. 1.

[5] Collection of the Legislative Acts of the Russian Federation, 1998, No. 31, Art. 3823.

[6] Bulletin of the Supreme Arbitration Court of the Russian Federation, 2012, No. 5.

[7] Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dd. January 17, 2012 No. 10077/11 // Bulletin of the Supreme Arbitration Court of the Russian Federation, 2012, No. 5.

[8] See Art. 253 of the Tax Code of the Russian Federation.

[9] Federal Law dd. July 23, 2013 No. 213-ФЗ “On Amending Sections 25 and 26, Part II of the Tax Code of the Russian Federation and Art. 3.1 of Law of the Russian Federation “On the Customs Tariff” // Rossiyskaya Gazeta, 2013, No. 163 (in Russian).

[10] Bulletin of the Supreme Arbitration Court of the Russian Federation, 2011, No. 5.

[11] Safety Regulations in the Oil and Gas Industry ПБ 08-624-03 approved by resolution of the Federal Mining and Industrial Inspectorate of Russia dd. June 5, 2003 No. 56. (It should be noted that nowadays these Regulations are not applicable due to adoption of Order of the Federal Environmental, Industrial and Nuclear Supervision Service dd. March 12, 2013 No. 101 “On Approval of Federal Standards and Rules of Industrial Safety “Safety Regulations in the Oil and Gas Industry” // Bulletin of Normative Acts of Federal Executive Bodies, 2013, No. 24, June 17, 2013.)

[12] Bulletin of the Supreme Arbitration Court of the Russian Federation, 2012, No. 3.