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Russia is preparing to transition to a profit-based tax in the oil sector, but while many multinational firms would welcome this, they are concerned about plans in a draft law that would require them to give up existing tax breaks, industry insiders said.
Details of Russia’s pending oil and gas tax overhaul and potential time frame for enactment of the plan remain in question. However, the latest version of the Feb. 18 draft law by the Finance Ministry, seen by Bloomberg BNA, suggests amending parts 1 and 2 of the tax code, and adding a new tax on additional profits from the production of hydrocarbons (NDD) in exchange for gradually removing oil export duty.
The government has been discussing tax reforms in the oil industry for more than two years, but the issue stalled again because of a dispute between the Finance Ministry and the energy lobby over individual tax breaks for oil companies.
The Russian Finance Ministry, which is promoting austerity during the country’s economic downturn, wants to eliminate individual tax breaks and introduce a profit-based tax on the oil sector. The Energy Ministry is suggesting implementing the new tax gradually, without affecting the tax breaks at the first stage.
So far, the two government bodies haven’t been able to agree on the parameters of the new profit-based tax, Alexey Sazanov, tax and customs policy director at the Ministry of Finance, told reporters in Moscow on March 28.
Oil and gas revenues account for more than 40 percent of the Russian budget. And Russia’s oil taxes are among the highest in the world. They mainly consist of a mineral extraction tax (MET) and an oil export duty, in addition to the corporate income tax (20 percent), a value-added tax (18 percent), and tax on subsoil use required from oil companies.
The tax burden on the extractive industry in Russia was 73.6 percent in 2014, the highest of any industry, according to the Finance Ministry. Tax burden on manufacturing was 30.9 percent in 2014 and tax burden on the construction industry was 19.6 percent).
Oil and gas revenues decreased to 38% of the Russian budget in 2016, the lowest number since 2008, due to the decrease in global oil prices.
MET, the most important tax in the oil industry that brought 2.5 trillion rubles ($44 billion) to the Russian budget in 2016, is paid by oil-producing companies regardless of their profitability. It is calculated based on the complicated formula that involves multiplying the base MET rate (in 2016 it was 857 rubles ($15) per ton of oil) by a coefficient that involves the price of Urals oil brand and the U.S. dollar to rubles exchange rate. An average MET rate in 2016 without including tax breaks was 5,000 rubles ($89) per ton of oil, according to Sergey Ezhov, chief economist at Vygon Consulting, a firm that provides consulting services to oil and gas companies.
The export duty on oil is also tied to the Urals brand price: the higher the price, the higher the duty (when the oil price falls below $15 per barrel, the duty is 0 percent).
The Russian state profits most when oil prices are high. At the same time, companies pay more taxes when the oil price is high, and have their taxes decrease as a share of revenue when oil prices fall.
A decrease in global oil prices pushed Russia towards economic recession, which was exacerbated by international sanctions imposed on the country for its actions in Ukraine in 2014.
Looking for ways to bolster the budget, the Finance Ministry suggested introducing NDD, a profit-based tax to be levied on the revenue from oil sale, minus the marginal costs of extraction and transportation. The new tax would be introduced in addition to the currently existing MET, in exchange for gradually removing the oil export duty and eliminating individual tax breaks.
The Feb. 18 version of the draft law by the Finance Ministry suggests that companies switch to the new tax on additional profits from the production of hydrocarbons on a voluntary basis. However, this option would only be available to those that meet certain criteria with regard to the geographical position and depletion of oil fields.
The NDD would extend first and foremost on “green fields” or pilot projects at early stages of development, as well as certain “brown fields” or developed fields that produce up to 15 million tons of oil per year. To switch to the new tax, companies would have to inform local tax authorities within 12 months after the law comes into force. After the transition, companies wouldn’t be permitted to go back to the old system, the draft law stipulates.
The tax would be calculated at a rate of 50 percent of the difference between the estimated revenue from the oil sale minus the cost of extraction and transportation, minus export duty and MET, plus the coefficient of cost adjustment. For brownfields, the limit of deductible costs would be 7,140 rubles ($127) per ton.
Tax benefits for companies that switch to the NDD are still under discussion. As the new tax would extend primarily to green fields, it would, in fact, be an equivalent of tax breaks. The companies that switch to paying the NDD on green fields will be exempt from MET during the first five years of production, and entitled to a reduced MET rate until the eighth year of production.
The new tax could be introduced as early as 2018, while the export duty for oil and oil products could be fully abolished in 2022-2025, Finance Minister Anton Siluanov said at the Russian Business Week in Moscow on March 13. However, the exact plans are unclear as the tax maneuver is still under discussion.
Oil companies in Russia currently benefit from various tax breaks that depend on many parameters, such as characteristics of the produced fields, the company’s rate of return, etc. In 2016, tax benefits accounted for 16 percent of the planned MET revenues, Vygon Consulting’s Ezhov told Bloomberg BNA by phone on March 23.
Since parameters of the oil reserves are changing in the course of production, oil companies have to constantly confirm their right to tax breaks and apply for new ones to which they are entitled by law. The process is complicated and requires time and resources, and some individual tax benefits are received through lobbying that only big companies can afford. Introducing the NDD would bring Russia’s oil sector taxation system closer to international standards and make the rules more clear and transparent for all companies, Ezhov said.
Economic benefits of transition to the NDD will depend on each company’s existing tax breaks and the parameters of specific oil fields, Galina Naumenko, partner at PwC, said.
“For those who meet the requirements for switching to the profit-based tax, it is recommended to make thorough calculations, because the transition can potentially be profitable for every company that meets the criteria,” Naumenko told Bloomberg BNA by phone on March 23.
Large companies that currently enjoy tax breaks with regard to MET, export duty, and greenfields, must be particularly careful with calculations, because switching to the new tax requires companies to give up existing tax breaks, Naumenko noted.
The current taxation system in the oil industry is “absolutely ineffective” because oil companies pay the same mineral extraction tax while having completely different expenditures, says Gennady Shmal, president of the Union of Oil and Gas Producers of Russia, an industry lobby.
To extract the same amount of oil, companies have to drill a different number of wells, each well costing $2million to $3 million, he said. “[One’s] expenditures are much bigger, but they would still pay the same tax per 1 ton of oil. Companies are working under unequal conditions,” Shmal said in a phone interview with Bloomberg BNA on March 31.
According to Shmal, transition to the profit-based tax would create fairer conditions for oil companies. However, the uncertainty with regard to specific measures makes it complicated to calculate all the potential consequences.
Despite the oil industry discontent, the MET isn’t going away, PwC’s Naumenko said. The mineral extraction tax is an “easily calculated and predictable tax, which forms a significant part of the Russian budget,” so it is unlikely that the Finance Ministry would agree to abolish it any time soon, she said.
Smaller oil companies in Russia welcome the idea of the profit-based taxation, but are concerned about giving up existing tax breaks, a representative of AssoNeft, an association of independent small and medium oil and gas producing organizations of Russia, told Bloomberg BNA in an e-mailed statement on March 31.
“For those of our companies that currently have tax privileges, their cancellation due to the transition to a new taxation model at the specific parameters that are currently being discussed would be a very unfavorable factor,” AssoNeft said in the statement.
Large oil companies were unwilling to comment on the issue.
Russneft, one of Russia’s largest oil companies, confirmed its intent to participate in the NDD project. “[H]owever, the final decision will be made after the completion of a comprehensive analysis of the tax measures proposed by the Ministry of Finance,” the company representative said in an email to Bloomberg BNA on March 30.
The company currently lacks input data to complete the analysis, the representative added. Rosneft, Gazpromneft, LUKoil, and Surgutneftegaz, which participated in the talks with the government regarding the maneuver, did not respond to Bloomberg BNA’s requests for comment on the issue.
Given that foreign companies mostly participate in the Russian oil industry as shareholders in the capital of Russian oil companies, the proposed changes would affect them to the same extent as other market participants, PwC’s Naumenko said. The bill has no restrictions for oil companies with foreign capital, she noted.
“If switching to the profit-based tax at a particular oil field is beneficial for a company with foreign shareholders, they are free to take full advantage of this,” Naumenko said.
Foreign companies that work in Russia on the basis of production sharing agreements (PSAs) will be largely unaffected by the reform, Galina Naumenko said. A PSA is a contract between the foreign investor and the government in which the foreign company gets rights to explore and extract mineral resources.
“PSAs will continue paying taxes as stipulated in their production sharing agreements. There is no special exception in the draft law, and it is unlikely that the new tax regime will impact PSAs as a model of operation in Russia,” the practitioner said.
Foreign companies mostly participate in the Russian oil industry as shareholders in the capital of Russian oil companies. For instance, British multinational oil and gas company BP owns a 19.75 percent stake at Rosneft, Russia’s largest state-owned oil company, in which another 19.5 percent stake is owned jointly by the Swiss oil trading firm Glencore and Qatar Investment Authority. Gazprom, the world’s largest gas producer, also has a small percentage of foreign shareholders.
Russia also has three production sharing agreements in which foreign companies are involved:
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