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Taxation in the sphere of oil production: conceptual disputes and specific solutions

Korotkikh Oleg Olegovich, third-year student of O.E. Kutafi n Moscow State Law University

In this article the author considers issues of taxation in the sphere of oil production, studies trends of the applicable law, provisions on tax remissions, special tax regimes, differentiations depending on complexity of deposits.

Production of hydrocarbons as a taxable activity is very specific due to a number of factors, including the world price environment for energy carriers, geological description of a deposit, the level of depletion of deposits, quality of hydrocarbons produced, etc. Even the economic theory classic, David Ricardo, wrote that mines have different quality and equal resources spent on their development lead to different results, while new technologies and new productive mines can be discovered[1]. Meanwhile, the role of oil and gas sector in the Russian economy remains extremely high. The share of oil and gas budget revenues (formed primarily by MET) of the Russian Federation in 2012 made over 50% with the contribution to the country’s GDP of about 1/3 and to export – about 2/3[2]. In 2013 the share of oil and gas revenues dropped just below 50%[3], but is still extremely high. Besides, the oil production experiences objective changes associated with gradual depletion of former deposits and the need to shift to new, more technologically advanced deposits.

On that basis, it may be concluded that, first, legal regulation and management of the oil production taxation is quite complex; second, oil revenues as a source of budgetary receipts play a special part; thirdly, such receipts are volatile, which in view of their significant share in the budget create high budgetary risks; fourthly, it is necessary to comply with the Laffer curve principle and switch to a strategic vision of the problem, which is, on the one hand, attributable to the need to commission new expensive deposits, and, on the other hand, to the need to complete production of hydrocarbons at mature deposits, which are not as profitable as they used to be.

Since January 1, 2002 mineral production is subject to the mineral extraction tax (MET), which at once replaced several taxes: contributions for reproduction of the mineral resources base, excise duty for oil and payments for subsoil management in mineral production[4].

MET can be summarized as follows. Pursuant to Art. 336 of the Tax Code[5], taxable items subject to MET are minerals extracted from subsoil in the territory of the Russian Federation at a subsoil area. Article 337 stipulates that minerals mean products of mining and development contained in mineral raw materials (rock, liquid and any other mix) virtually produced (extracted) from subsoil (waste, losses), the first ones to comply in their quality with the national standard, regional standard or international standard, and if there is no such standards for a certain mineral produced – to the organization’s standard (cl. 1). Raw hydrocarbons are a kind of produced minerals, which include dehydrated, desalted and stabilized oil (cl. 2). According to Art. 338 of the Tax Code, the MET tax base means the cost of produced minerals (cl. 2), while for produced minerals with various tax rates or with a tax rate calculated by reference to a coefficient, the tax base shall be determined for each tax rate (cl. 5). The amount of produced dehydrated, desalted and stabilized oil is determined in net weight units. The net weight means the amount of oil minus separated water, associated petroleum gas and impurities, and minus water, chlorine salts and mechanical impurities suspended in oil and identified by laboratory testing. The amount of produced minerals is determined by a direct (by means of measuring instruments and devices) or, if it is impossible to determine the quantity using the direct method, indirect (estimation based on the data on content of the produced mineral in the mineral raw materials extracted from subsoil (waste, losses)) method (cl. 2).

The procedure for cost estimation of produced minerals in determination of the tax base is of particular interest. Pursuant to Art. 340 of the Tax Code, a cost estimate of produced minerals (cl. 1) is based on the taxpayer’s selling prices for the produced mineral within the relevant tax period (including cost before subsidies – subcl. 1, cl. 1), or, if the taxpayer does not sell the produced mineral (cl. 4), on the estimated cost of produced minerals.

Thus, the cost of a produced mineral unit is estimated based on the proceeds from sales of produced minerals determined on the basis of the selling prices from transfer pricing, with no value added tax (when selling in the territory of the Russian Federation and to the member states of the Commonwealth of Independent States) and excise duty, net of the taxpayer’s delivery expenses depending on delivery terms.

The delivery expenses include expenses for payment of customs duties and foreign-trade transaction fees, expenses for delivery of the produced mineral from the finished product warehouse to the recipient, and expenses for compulsory cargo insurance.

The expenses for delivery of the produced mineral to the recipient include, in particular, expenses for delivery through main pipelines, by rail, water and any other transport, expenses for loading, unloading, handling and transshipment, for payment of services in seaports and for transport and forwarding. The produced mineral cost is defined as a product of the amount of the produced mineral and the cost of the produced mineral unit determined pursuant to this clause. In this regard, the cost of the produced mineral unit is calculated as a ratio of the proceeds from sales of the produced mineral determined pursuant to this clause and the quantity of the produced mineral sold (cl. 2, 3).

When making the calculation based on the estimated cost of produced minerals, the taxpayer applies the procedure for recognition of income and expenses, which is applied for determination of the tax base for corporate profit tax (cl. 4). Unlike the gas production rate with fixed multipliers (subcl. 10, 11, cl. 2, Art. 342), the oil production rate is calculated by a complex formula with regard to the global price dynamics for the Urals benchmark and other coefficients (subcl. 7, cl. 2, Art. 342).

Replacement of the above tax and its predecessors by an additional income tax (AIT) has been discussed over the years, and currently this issue is still relevant. Thus, the draft of the Energy Strategy up to 2035[6] developed by the Ministry of Energy as part of the state energy policy in the sphere “Tax and Customs-and-Tariff Policy” stipulates the shift from MET to the financial result taxation in the form of additional income tax (AIT) or excess profit tax in production of hydrocarbons. Until recently, similar views were supported by the Ministry of Finance.

Based on Art. 165 of the Budgetary Code[7], the Ministry of Finance develops and submits to the Government of the Russian Federation major trends of budgetary and tax policy. “Major Trends of Tax Policy of the Russian Federation for 2012 and for the Planning Period of 2013 and 2014”[8] indicated the need for continued arrangement of a long-term shift to the mineral production taxation based on the results of the organization’s financial and business activities (additional income tax). The grounds evoked were the experience of developed oil-producing foreign countries, in particular, Norway, Great Britain and the USA, and the fact that this form of rent collection seems to be the most effective in economic terms. It was at that time when the complexity and ambiguity of such a decision were noted, which involved changes of the whole natural resource rent taxation system – from MET and export customs duties to excise duties for petroleum products.

The rental nature is usually ranked as an advantage of AIT over MET, i.e. the concept is to levy taxes upon oil revenues after refund of all expenses for development of the project in order to charge an additional rent for each specific project (licensed area), while the mineral extraction tax in relation to oil production not only fails to charge a part of the natural rent, but also redistributes a part of revenues of the enterprise producing oil in remote regions in favor of producers with favorable locations. The economic rent concept used for oil production means a difference between the cost of products and expenses for their production. In this regard, the expenses include costs of production, geological exploration and development of a deposit, and the so-called industry average return rate[9]. Therefore, extension of the tax system with the tax on additional income from production of hydrocarbons will, first, help to provide economic conditions for re-opening of currently idle, almost depleted wells, and, second, to create a framework for investment in new deposits.

Unfortunately, despite a great number of supporters, AIT has no formalized and published bill, which can be evaluated and discussed. Moreover, in January 2014 representatives of the Ministry of Finance stated that this work had been stopped, while the Ministry of Energy takes no active steps in this regard. Therefore, in order to illustrate the AIT concept, we can mention Bill No. 342373-3 rejected in 2009[10].

According to this Bill, the tax base for each licensed area is determined as the cost of hydrocarbons produced and sold by the taxpayer and (or) transferred by the taxpayer for refining net of any deductible expenses similar to profit tax. The tax rate is determined depending on the price coefficient for the previous tax period, i.e. the ascending scale is applied.

As for foreign countries’ experience, we can identify three models based on a correlation between rental payments, royalty and profit tax. The first model is mostly based on a differentiable royalty and common profit tax. Such states include the USA, Canada, etc. The second model is based on increased rental payments from oil revenues in addition to the common profit tax as, for example, in Norway or Great Britain, where there is no royalty or export duties. Such states co-finance geological exploration by allowing oil companies to deduct expenses from the previous projects’ profits. The third model is based on a low royalty, considerable rental payments from profits and the profit tax. Thus, the oil production tax in China is levied as a rent from profits on the ascending scale upon payment of royalties[11]. It should be noted that there is no panacea in blind acceptance of foreign experience in the oil production taxation. For example, a royalty in America with its “advanced” federalism in taxation was replaced by a rent in Norway, and now both countries enjoy effective oil taxation. Besides, the oil production taxation should be considered as an element of the tax system as a whole, therefore we should bear in mind that the Russian laws have a different approach to oil export duties, when proposing to adopt the Norwegian model of oil production taxation with its rental payments from revenues instead of MET.

“Major Trends of Tax Policy of the Russian Federation for 2013 and for the Planning Period of 2014 and 2015” also included proposals to introduce AIT[12]. However, the next year’s “Major Trends of Tax Policy of the Russian Federation for 2014 and for the Planning Period of 2015 and 2016”[13] approved by the Government of the Russian Federation on May 30, 2013 did not mention AIT, and, instead, stipulated a specific plan of MET reforms representing the current ideology of the Ministry of Finance that was later on implemented in the lawmaker’s policy.

The Ministry of Finance proposed to develop a more flexible system of rates that would make the tax burden adjustable to any changes of the foreign and domestic pricing environment. For the oil sector, these measures include: (i) completed preparation of the new tax regime for production of raw hydrocarbons in development of new sea deposits of raw hydrocarbons located within the internal sea waters, territorial sea, on the continental shelf of the Russian Federation and in the Caspian Sea; (ii) completed development of the special tax regime for oil produced from hard-to-recover reserves, and (iii) possible beginning of gradual decrease of the rate of oil export customs duty with a simultaneous refund of the shortfalls in revenues by raising the oil MET rate as part of implementation of the long-term strategy of tax reform in the oil sector.

It should be noted that MET is initially problem-plagued due to its isolation from complex relations that it regulates, therefore the lawmaker had to “manually” eliminate the shortcomings brought by conceptual imperfection. A primary example is numerous additions to cl. 1, Art. 342, which establish a zero rate for MET (tax holiday).

Federal Law dd. July 27, 2006 No. 151-ФЗ “On Amending Section 26, Part Two of the Tax Code of the Russian Federation and Invalidation of Certain Provisions of Legislative Acts of the Russian Federation”[14] updated cl. 1, Art. 342 with subcl. 9 – superviscous oil extracted from subsoil areas containing oil with a viscosity value over 200 MPa*s (in reservoir conditions) with application of a direct method of oil production amount control at specific subsoil areas.

Federal Law dd. July 22, 2008 No. 158-ФЗ “On Amending Sections 21, 23, 24, 25 and 26, Part Two of the Tax Code of the Russian Federation and Some Other Legislative Acts of the Russian Federation on Taxes and Levies”[15] updated cl. 1, Art. 342 with a number of sub-clauses stipulating the zero rate terms in the Azov and Caspian Seas, at subsoil areas situated to the north of the Arctic Circle fully or partially within the internal sea waters and territorial sea, on the continental shelf of the Russian Federation.

Federal Law dd. July 21, 2011 No. 258-ФЗ “On Amending Art. 342, Part Two of the Tax Code of the Russian Federation”[16] also updated cl. 1, Art. 342 with a number of sub-clauses, including oil production at subsoil areas fully or partially situated to the north of the 65th degree of North latitude fully or partially within the Yamal-Nenets Autonomous District, under the terms specified in the clause.

Federal Law dd. November 28, 2011 No. 338-ФЗ “On Amending Part Two of the Tax Code of the Russian Federation and Certain Legislative Acts of the Russian Federation” stipulated a MET remission for two separate regions. Pursuant to this Law, the Code was updated with Art. 343.2 specifying the procedure for reduction of the tax amount calculated for production of dehydrated, desalted and stabilized oil by the tax deduction related to oil production at the subsoil areas fully or partially situated within the Republic of Tatarstan (Tatarstan) or within the Republic of Bashkortostan.

Decree of the Government of the Russian Federation dd. May 3, 2012 No. 700-р “On Stimulation of Development of Oil Fields Defined by Complex Conditions of Production and Properties of Oil”[17] triggered the improvement of MET by means of its differentiation with a systematic approach. A reform was implemented based on this Decree, which was formalized by Federal Law dd. July 23, 2013 No. 213-ФЗ “On Amending Sections 25 and 26, Part Two of the Tax Code of the Russian Federation and Art. 3.1 of the Law of the Russian Federation “On Customs Tariff”[18] and by Federal Law dd. September 30, 2013 No. 263-ФЗ “On Amending Section 26, Part Two of the Tax Code of the Russian Federation and Art. 3.1 of the Law of the Russian Federation “On Customs Tariff”[19].

The reform was as follows. First, Art. 338 was updated with the provision on granting tax holidays for a number of sea hydrocarbon deposits; second, Art. 340.1 was added to the Code, which specifies cost determination for raw hydrocarbons produced at a new sea deposit of raw hydrocarbons; third, the application of zero rate to raw hydrocarbons produced from a deposit of raw hydrocarbons at a subsoil area fully situated within the internal sea waters, territorial sea, on the continental shelf of the Russian Federation or in the Russian part (Russian sector) of the Caspian Sea bottom, subject to the terms specified in subcl. 20, cl. 1, Art. 342; fourth, the oil rate calculation formula was changed, to which we should pay a special attention.

Pursuant to subcl. 9, cl. 2, Art. 342, taxes are levied at the tax rate of RUB 493 (for the period January 1 through December 31, 2014), RUB 530 (for the period January 1 through December 31, 2015), RUB 559 (for the period from January 1, 2016) per 1 ton of desalted, dehydrated and stabilized oil. In this regard, the said tax rate is multiplied by the coefficient that describes the dynamics of the world prices for oil (Кц), by the coefficient that describes the degree of depletion of the specific subsoil area (Кв), by the coefficient that describes the amount of reserves of the specific subsoil area (Кз), and by two new coefficients: by the coefficient that describes the degree of complexity of oil production (Кд), and by the coefficient that describes the degree of depletion of the specific deposit of raw hydrocarbons (Кдв) that are also calculated pursuant to new Art. 342.2.

Along with remissions for deposits explicitly indicated in Art. 342.2 that have 0 Кд coefficient, differentiated tax remissions are also applied to impermeable deposits and deposits depending on their degree of depletion.

Besides, a plan was drawn to reduce oil export duties, while increasing MET. The first step was taken through same Federal Law dd. September 30, 2013 No. 263-ФЗ in the form of the so-called 60-66-90 system. As a follow-up for this policy, there are plans to make a “tax maneuver”, i.e. to sharply lower oil export duties with a simultaneous sharp increase of MET. Both the differentiation of markets for oil companies and the WTO’s requirements are the prerequisites for such changes.

This reform complies with the provisions of Major Trends of Tax Policy for 2014 approved by the Government a few months prior to the adoption of the laws stated above, and can mark the renunciation by the Ministry of Finance of its pioneering role in introducing AIT in favor of MET improvement. S. Shatov, Deputy Minister of Finance, said in his interview to Vedomosti newspaper: “Previously, we were AIT ideologists in the Government, but we failed to introduce it, because there were no effective tax control instruments. During the time spent on amending the Tax Code in transfer pricing, the life has made great strides in a different direction. Numerous tax preferences and even, basically, special tax regimes have sprung up that consider the geographical location, degree of depletion of deposits, oil viscosity, quality characteristics of reservoirs and other factors that influence the economics of specific projects. If fact, in manual mode we were close to achieve the goal, which is supposed to be ensured by the universal AIT regime”[20].

To sum it all up, we should mention a positive trend in improving the tax laws through introduction of systematic differentiation instruments for complex deposits and introduction of 0 rates for the most relevant new deposits. Meanwhile, it should be noted that there is a persistent problem inherent in the very nature of MET, namely, the impossibility for the holder of an oil production license to make a comprehensive estimation of income and expenses; instead we chose an improved, yes, but still “manual” method of regulation. The idea of pilot projects with the application of AIT for certain new deposits seems to be quite reasonable. It is worth recalling that the oil production taxation in Norway and Great Britain, which are nowadays the favorite focus for tax reformers, has also come a long way, including the coexistence of different legal tax regimes in oil production depending on the time of deposit commissioning.



[1] Ricardo, D. The Works. V. 1. The Principles of Political Economy and Taxation / Reissued under the editorship of M.N. Smit. Moscow, 1955, pp. 78-79 (in Russian).

[2] The report of A.V. Novak, Minister of Energy of the Russian Federation, at the National Oil and Gas Forum of 2013 [Electronic resource] URL: http://minenergo .gov.ru/press/doklady/14507.html (in Russian).

[3] The opening speech of D.A. Medvedev on implementation of the Energy Strategy of Russia for the Period up to 2030 [Electronic resource] URL: http://government.ru/news/7876 (in Russian).

[4] Federal Law dd. August 8, 2001 No. 126-ФЗ “On Amending and Enhancing Part Two of the Tax Code of the Russian Federation and Some Other Legislative Acts of the Russian Federation, and on Invalidation of Certain Legislative Acts of the Russian Federation” // Collection of the Legislative Acts of the Russian Federation, 2001, No. 33, Art. 3429 (in Russian).

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

[6] The draft of the Energy Strategy for the Period up to 2035. URL: http://minenergo.gov.ru/documents/razrabotka/17481.html (in Russian).

[7] The Budgetary Code of the Russian Federation dd. July 31, 1998, No. 145-ФЗ (in Russian).

[8] Major Trends of Tax Policy of the Russian Federation for 2012 and for the Planning Period of 2013 and 2014. URL: http://www1.minfin.ru/common/gen_html/index.php? id=13307&fld=HTML_MAIN (in Russian).

[9] Vygon, G.V. Challenges of Oil Rent Assessment and Taxation of Oil Production. [Electronic resource] URL: http://www .lawtek.ru/analytics/53 (in Russian).

[10] Bill No. 342373-3. On Enhancing Section 25.1 of the Tax Code with the Tax on Additional Income from Production of Hydrocarbons. [Electronic resource] URL: http://asozd2.duma.gov.ru/arhiv/a_dz_5.nsf/ByID/75FAF77FB18866C8432571BB005AC8A4?OpenDocument (in Russian).

[11] Kondrashov, A. The Country Needs Effective Taxes. [Electronic resource] URL: http://www.ey.com/Publication/vwLUAssets/Kondrashov-Article-February-2012/$FILE/Kondrashov-Article-February-2012.pdf (in Russian).

[12] Major Trends of Tax Policy of the Russian Federation for 2013 and for the Planning Period of 2014 and 2015 [Electronic resource] of URL: http://www.consultant.ru/document/cons_doc_LAW_129118 (in Russian).

[13] Major Trends of Tax Policy of the Russian Federation for 2014 and for the Planning Period of 2015 and 2016 [Electronic resource] of URL: http://www.minf in.ru/common/img/uploaded/l ibrary/2013/06/ONNP_2013-06-05.pdf (in Russian).

[14] Federal Law dd. July 27, 2006 No. 151-ФЗ “On Amending Section 26, Part Two of the Tax Code of the Russian Federation and Invalidation of Certain Provisions of Legislative Acts of the Russian Federation” // Collection of the Legislative Acts of the Russian Federation, 2014, No. 23, Art. 2936 (in Russian).

[15] Federal Law dd. July 22, 2008 No. 158-ФЗ “On Amending Sections 21, 23, 24, 25 and 26, Part Two of the Tax Code of the Russian Federation and Some Other Legislative Acts of the Russian Federation on Taxes and Levies” // Collection of the Legislative Acts of the Russian Federation, 2008, No. 30 (Part I), Art. 3614 (in Russian).

[16] Federal Law dd. July 21, 2011 No. 258-ФЗ “On Amending Art. 342, Part Two of the Tax Code of the Russian Federation” // Collection of the Legislative Acts of the Russian Federation, 2011, No. 30 (Part I), Art. 4606 (in Russian).

[17] Decree of the Government of the Russian Federation dd. May 3, 2012 No. 700-р “On Stimulation of Development of Oil Fields Defined by Complex Conditions of Production and Properties of Oil” // Collection of the Legislative Acts of the Russian Federation, 2012, No. 19, Art. 2510 (in Russian).

[18] Federal Law dd. July 23, 2013 No. 213-ФЗ “On Amending Sections 25 and 26, Part Two of the Tax Code of the Russian Federation and Art. 3.1 of the Law of the Russian Federation “On Customs Tariff” // Collection of the Legislative Acts of the Russian Federation, 2013, No. 30 (Part I), Art. 4046 (in Russian).

[19] Federal Law dd. September 30, 2013 No. 263-ФЗ “On Amending Section 26, Part Two of the Tax Code of the Russian Federation and Art. 3.1 of the Law of the Russian Federation “On Customs Tariff” // Collection of the Legislative Acts of the Russian Federation, 2013, No. 40 (Part III), Art. 5033 (in Russian).

[20] The interview with Sergey Shatalov, Deputy Minister of Finance. URL: http://www.vedomosti.ru/library/library-persons/news/22065781/my-ischerpali-rezerv-povysheniyanalogov#ixzz31GHgXxkb (in Russian).

Bibliography:

  1. Ricardo, D. The Works. V. 1. The Principles of Political Economy and Taxation / D. Ricardo; reissued under the editorship of M.N. Smit. Moscow, 1955. pp. 78-79 (in Russian).