Global Tax Alert | 26 September 2013
Russian Duma passes in third reading draft law on tax and customs regime for offshore hydrocarbon extraction activities
The text of the draft law on the tax and customs regime for offshore hydrocarbon activities was incorporated in a Gazprom-sponsored bill passed in the first reading in December 2012 (which at that time included measures related to gas extraction only). The bill now includes measures relating to both oil and gas extraction. In addition to tax and customs measures the bill includes several amendments to the Continental Shelf Law relevant to offshore hydrocarbon extraction activities.
Many of the concerns related to the May draft were addressed in the revised bill passed in the second reading on 5 July but some significant areas of concern remained.
The State Duma decided to reconsider the draft law a second time in the second reading, and on 11 September the draft law was passed in this second reading and the third reading. The draft law is now under consideration by the Federation Council. The draft passed in the third reading does not differ dramatically from the July draft.
This Alert covers the tax and customs measures proposed in the draft law, highlighting the key changes since the May draft.
Scope of the draft law
The draft law concerns offshore hydrocarbon deposits (OHD) lying wholly within the boundaries of Russia’s territorial waters, its continental shelf and/or the Russian sector of the Caspian Sea. New offshore hydrocarbon deposits (NOHD) are OHD for which the date of commencement of commercial extraction of hydrocarbons falls on or after 1 January 2016. The commencement of commercial extraction at a deposit is deemed to be the date of the State balance sheet of reserves which first shows that the level of depletion of reserves of one or more types of hydrocarbons (except associated gas) extracted has exceeded 1%.
MET on Extraction from NOHD
The proposed tax base for mineral extraction tax (MET) is the value of extracted commercial minerals subject to a calculated minimum.
The value of a unit of natural fuel gas, of dewatered, desalted and stabilized oil, or of gas condensate is to be determined on the basis of the average level of the actual selling prices of those goods for a tax period (a calendar month), but not lower than threshold prices which are to be determined in accordance with a procedure to be established by the Government. Amendments to Article 340.1 provide a separate basis for determining the minimum value of a unit of natural gas.
NOHD are to fall into one of four categories. Special ad valorem MET rates for hydrocarbons will be established for each category to apply for a fixed period with some special rates for natural fuel gas. The categories and MET rates proposed are as follows:
- • Category one: deposits which lie wholly in the Sea of Azov or at least 50% within the Baltic Sea - the MET rate will be 30% for 60 months after production begins, but not later than 31 March 2022.
- • Category two: deposits lying at least 50% within the Black Sea (up to 100m deep), in the Pechora
- or White Seas, in the Russian sector of the Caspian sea, in the southern part of the Sea of Okhotsk (south of 55 degrees north latitude) - the MET rate will be 15% for 84 months after production begins, but not later than 31 March 2032.
- • Category three: deposits lying at least 50% within the deeper waters of the Black Sea, the northern part of the Sea of Okhotsk (at or north of 55 degrees north latitude) or the southern part of the Barents Sea (south of 72 degrees north latitude) - the MET rate will be 10% with respect to hydrocarbons other than natural fuel gas for 120 months after production begins, but not later than 31 March 2037. The MET rate will be 1.3% in case of extraction of natural fuel gas from deposits in this category subject to the same time limits.
- • Category four: deposits lying at least 50% within the Kara Sea, the northern part of the Barents Sea (at or north of 72 degrees north latitude) and the eastern Arctic - the MET rate will be 1% for extracted natural fuel gas, 4.5% for other hydrocarbons extracted by companies which do not have the right to export LNG produced from natural fuel gas extracted at NOHD to world markets, and 5% in other cases. These rates are to apply for 180 months after production begins, but not later than 31 March 2042.
The general MET rules as to the tax base and tax rate will apply after the expiration of the above incentives.
The MET rate for Other OHD
A zero MET rate is envisaged for subsurface sites for which a license was issued before 1 January 2009 and for which the level of depletion at 1 January 2015 is less than or equal to 0.05 until cumulative oil extraction reaches 35 million tonnes. This rate is to apply to subsurface sites which lie to the north of the Arctic Circle wholly or partially within the boundaries of the internal sea waters and the territorial sea and on the Russian continental shelf and provided that the period of development of the reserves of the subsurface site does not exceed seven years or is equal to seven years commencing from 1 January 2015. The extraction limit is expressed in terms of oil only. It may be that the zero rate is not intended to apply to gas.
Under a new subsection 20) to clause 1 of Article 342, a 0% rate will also apply to hydrocarbons (other than those extracted from NOHD) extracted from a hydrocarbon reservoir within a subsurface site which lies wholly within the boundaries of the internal sea waters or the territorial sea, on the Russian continental shelf or in the Russian sector of the Caspian Sea, provided that at least one of the following conditions is met:
- • The level of depletion of reserves of each type of hydrocarbon (excluding associated gas) extracted from the hydrocarbon reservoir in question as at 1 January 2016 is less than 0.1%; or
- • Reserves of hydrocarbons extracted from the hydrocarbon reservoir in question as at 1 January 2016 have not been placed on the State balance sheet of reserves of commercial minerals.
This rate will apply for no more than sixty calendar months commencing from the first day of the month following the month in which any type of hydrocarbon from the relevant hydrocarbon reservoir which is subject to tax is first placed on the State balance sheet of commercial minerals and not beyond the end of the tax period in which the process design for the development of the OHD was first approved. Given that approval of this plan is likely to be a prerequisite for commercial extraction the application of this rate is likely to be limited in practice.
The 0% tax rates already established for certain subsurface sites for limited periods by subsections 10, 11, 14 and 15 of Clause 1 of Article 342 will not apply to NOHDs or the OHDs for which the bill establishes reduced MET rates under subsection 20.
Export duty exemptions
There are also significant changes regarding the periods in which the export duty exemptions will apply. The following goods which are exported from Russia and were obtained (manufactured) as a result of the exploitation of an OHD are to be exempt: crude oil (including an oil and gas condensate mixture obtained as a result of factors inherent in the process of the transportation of crude oil and stable gas condensate by pipeline), natural gas condensate, liquefied and gaseous natural gas and natural gas liquids. Article 35 clause 1, subsection 5) concerns NOHDs and subsection 6) other OHD.
The government regulation1 outlining the proposed tax and customs regime specified that the above goods if derived from NOHDs were to be exempt from export customs duty. However, the bill specifies that goods derived from NOHDs falling into categories one and two established for MET purposes are exempt only until 31 March 2032 and those from NOHDs in categories three and four until 31 March 2042. Some proposed projects may not be viable owing to these limits on the exemption.
The exemption from export customs duties for the above goods if derived from other OHD will apply if the deposit has 50% or more of its area in the southern part of the Sea of Okhotsk (south of 55 degrees north latitude) until 1 January 2021, provided that the level of depletion of reserves of each type of hydrocarbon (excluding associated gas) extracted at the deposit in question as at 1 January 2015 is less than 5%.
Rewording of a paragraph to be added to subsection 1 of clause 1 of Article 165 of the Tax Code seems to allow subcontractors as well as contractors to apply the zero rate to goods exported for use in hydrocarbon activities at an OHD. A requirement that the contract provided to support the application of the zero rate be with a taxpayer such as is referred to in clause 1 of Article 275.2 has been deleted.
Work (services) involving the carriage and/or transportation of hydrocarbons from departure points situated on the Russian continental shelf and/or in its exclusive economic zone to a destination point situated outside Russian territory and other territories under Russian jurisdiction will be equated with international carriage and hence be zero-rated. The documentation required to apply this rate will be specified in subsection 3 of clause 3.1 of Article 165.
Transactions between the operator and the license-holder of a NOHD which are concluded by them in the course of carrying out hydrocarbon extraction activities at the NOHD in relation to one and the same deposit are to be exempt from transfer pricing control.
Previously proposed provisions, under which sales of hydrocarbons by a license-holder or operator of an NOHD to a third party could be automatically deemed to be transactions with interdependent parties, and hence subject to control, have been deleted. Such transactions may still be subject to control under existing transfer pricing rules, depending on the parties.
Only one addition to the list of transactions deemed to be controlled remains in the draft. It concerns transactions where one party will take the results into account for profits tax in accordance with the new rules established for operators and license-holders of NOHDs by Article 275.2 of the Tax Code and the other (or another) will not and the amount of such transactions with the counterparty exceeds 60m roubles (approx. US$2m) in a year.
Profits taxation of license-holders
The most significant changes to the profits tax treatment of license-holders since the May draft, concern the treatment of expenses for the development of natural resources. There is now some scope for expenses arising from activity relating to one subsurface site to reduce the tax base arising from NOHDs elsewhere with the same license-holder.
In the event that the right to use subsurface resources at a subsurface site is terminated, the license-holder will have the right to treat the entire amount of expenses incurred for the development of natural resources or any part thereof as expenses for hydrocarbon extraction activities at an NOHD which are carried out at another subsurface site (other subsurface sites). In this respect, the amount of expenses which may be treated as expenses for such activities which are carried out in relation to each deposit at another subsurface site may not exceed one third of the total amount of expenses for the development of natural resources incurred at the subsurface site in relation to which the right to use subsurface resources has been terminated.
Taxation of operators
The criteria for becoming and remaining an operator of an NOHD have been replaced. An operator of an NOHD must simultaneously satisfy the following conditions:
- • A direct or indirect interest in it is held by an organization which possesses a license to use the subsurface site within whose boundaries the prospecting for and appraisal of and/or the exploration and/or exploitation of an NOHD are intended to be carried out or by an affiliate recognized as interdependent for tax purposes;
- • It carries out at least one of the types of hydrocarbon extraction activities specified in the draft, independently and/or through the use of contractors;
- • It carries out these activities on the basis of an (operator) agreement concluded with the license-holder and that agreement provides for the payment to the operator of a fee in an amount which depends, inter alia, on the volume of hydrocarbons extracted at the relevant OHD and/or receipts from sales of those hydrocarbons.
There can be only one operator in relation to an NOHD at a time. A taxpayer is to be recognized as an operator for tax purposes from the date of conclusion of the operating agreement subject to the tax authorities being notified within 10 days. The number of grounds for a taxpayer to cease to be recognized as an operator has been reduced. Notably, failure to comply with Article 275.2 no longer entails ceasing to qualify for tax benefits under the proposals.
The bill does not include any special provisions concerning the tax treatment of a taxpayer which has ceased to be an operator or concerning the treatment of income and expenditure incurred in relation to a new shelf project prior to the entry into force of the law.
The proposed tax relief for an operator’s cost of reimbursing historic costs of a license-holder has been moved from Article 261 Expenses for the Development of Natural Resources to Article 264 Miscellaneous Expenses Associated with Production and Sales. The bill no longer envisages any expenses of the operator being deductible under Article 261.
The tax base for each NOHD must be calculated separately. The bill does not address how any losses carried forward by an operator from periods prior to any NOHDs being designated within a subsurface site are to be taken into account in calculating the tax base for each NOHD.
Profits taxation and contractors
The draft envisages that contractors are subject to profits under the general tax regime. However, income and expenses associated with hydrocarbon activities at an NOHD are included in the tax base subject to the standard rate of profits tax. As Russian companies are taxable on worldwide income this represents a change for foreign contractors only. The bill does not specify how such income and expenses are to be included in the tax base of a foreign organization. Special rules proposed for foreign operators will not apply. It is unclear whether it will be necessary to recognize a separate permanent establishment for each place of offshore activity or possible to consolidate the results of activities at multiple locations for tax purposes.
Transport tax and assets tax exemptions
In addition to the taxes dealt with in the May draft, the bill proposes amendments to introduce assets tax and transport tax exemptions. The transport tax exemption proposed is for offshore fixed and floating platforms, offshore mobile drilling rigs and drilling vessels. The exemption is not limited to assets used at an NOHD.
The assets tax exemption has been rewritten rather than using the wording previously used in the Gazprom-sponsored bill. Again, exemption does not depend on the asset being used in the exploration or development of a “new” OHD. The exemption is for:
- • Assets which are situated on the Russian continental shelf, in Russia’s internal sea waters and territorial sea and/or in the Russian sector of the Caspian Sea; and
- • Are used in activities associated with the development of OHDs, including geological study, exploration and the performance of preparatory work; and
- • They are used such activities in such areas for not less than 90 calendar days in the course of one calendar year if the assets in question are also used beyond the boundaries of those areas during a tax period.
Causes for concern
The bill is intended to enter into force on 1 January 2014. While much work has been done, there are obvious gaps in the tax regime and given the extent of the changes it is certain that further omissions, unintended consequences and other causes for concern will be identified. Key areas of concern include the following.
- • Can the exemption of transactions between a license-holder and an operator apply to transactions prior to the discovery of any NOHDs within a subsurface site? Must operating agreements envisage separate transactions and consideration in relation to each NOHD which will be discovered within a subsurface site to ensure that transfer pricing control will not apply?
- • Much is unclear about how the provisions seeking to ring-fence the results of NOHDs for tax purposes will function. How, for example, are losses of an operator or license-holder from activities related to a subsurface site carried forward from periods prior to any deposit being discovered within it to be taken into account?
- • How the tax base arising from shelf activities of foreign contractors is to be calculated is not addressed in current law or the draft.
- • There are no provisions dealing with income and expenditure prior to 1 January 2014 in relation to NOHDs. License-holders and proposed operators are already engaged in activities related to a number of subsurface sites which will fall within the scope of the proposed regime.
- • Will the necessary customs procedures be introduced in time to allow exemptions to apply as intended?
Meanwhile, tenders are already taking place related to activities planned for the 2014 drilling season. This means commercial decisions are being made on the work to be done and the terms on which contractors will be engaged before the applicable tax and customs regimes have been finalized.
1. Government Regulation No.443-r of 12 April 2012.
For additional information with respect to this Alert, please contact the following:
Ernst & Young (CIS) B.V., Moscow
- • Victor Borodin
+7 495 755 9760
- • Richard Lewis
+7 495 705 9704
- • Maureen O’Donoghue
+7 495 228 3670
Ernst & Young LLP, Russian Tax Desk, New York
- • Julia Samoletova
+1 212 773 8088
EYG no. CM3828