The Republic of Kazakhstan possesses significant reserves of oil and gas, which means the oil and gas industry holds the leading position in the structure of the national economy. Therefore the tax system in this sector needs to provide stability, transparency and progressivity,, take into account the general global situation and encourage investment.
International practice has shown that the creation of an effective tax system for the natural resources sector is a complicated task. As a rule, it is conceptually different from the tax system in other sectors of the economy, since it incorporates a significant rental income and higher investment risks.
Pursuant to the Law ‘On Subsoil and Subsoil Use’ (‘Subsoil Law’), the concept of ‘oil’ also includes crude oil, gas condensate, natural gas and associated gas, as well as hydrocarbons derived from the treatment of crude oil, natural gas and processing of shale coal or resinous sands.
The State decided in the Tax Code effective from 1 January 2009 to re-distribute the tax burden, increasing it in the mining sector and decreasing it for small and medium business.
The taxation of subsoil users is covered by Section 11 of the Tax Code, under which they pay all taxes and other obligatory payments to the budget established by the Code. In addition, there are special payments (subscription bonus, commercial discovery bonus, reimbursement of historical costs) and taxes (tax on mineral extraction and excess profits tax).
There is a general rule that under the subsoil use contract, tax liabilities are calculated in accordance with tax laws applicable at the time those liabilities arise. In addition, there are specific features with regard to the taxation of income of nonresident subsoil users (Articles 198-200 of the Tax Code).
Stability for tax regimes is reserved for production sharing agreements (contracts) entered into before 1 January 2009, provided that they have been subject to obligatory tax review, as well as subsoil use contracts approved by the President of the Republic of Kazakhstan. However, any tax regime envisaged in such contracts may be changed by mutual agreement of the parties.
The Tax Code requires the subsoil user to conduct separate tax accounting for calculating the tax liability for the activities performed under each subsoil use contract, as well as when developing low-margin, high-viscosity, wet, marginal and exhausted fields, if taxes and other obligatory payments to the budget thereon are calculated in the procedure and at rates different from those specified by the Tax Code.
Tax and Payment of Subsoil User
The subscription bonus and commercial discovery bonus are fixed payments for a subsoil user.
A subscription bonus is a lump sum payment for the acquisition of the right of subsoil use in the contract territory, as well as in the event that contract territory is expanded. The size of the subscription bonus depends on the type of contract and minerals/raw materials. Moreover, the presence or absence of established mineral reserves is also taken into account.
A commercial discovery bonus is a payment under the contract for mineral production and/or combined exploration and production for each commercial discovery of minerals within the contract territory, including discoveries in the course of additional exploration.
It should be noted that certain provisions of the Tax Code are a little unclear in terms of how the ‘object’ of a commercial discovery bonus is defined, which has lead various ambiguous interpretations. Thus, according to a particular contract for combined exploration and production with a stable tax regime entered into in 2004, the obligation of a subsoil user to make this payment only arises in the event that a new field is discovered in the contract territory. Given the fact that a new field was not discovered, therefore, the bonus was not paid. However, in 2005 the competent state authority established that there had been an increase in mineral reserves. Since 2009, a subsoil user calculates its tax liability in accordance with the law applicable at the time. In 2013, as a result of additional exploration of a field, the amount of mineral reserves was increased again. The tax authority considers that pursuant to Article 319.5 of the Tax Code, the commercial discovery bonus should be calculated from the total volume of reserves, because this payment was not made on the previously established volumes.
However, we are of the opinion they should take into account that earlier a subsoil user did not have an obligation to calculate and pay the commercial discovery bonus. Thus, it would be correct to calculate the ‘object’ of taxation based on the positive difference between the volume approved in 2013 and the volume approved in 2009.
In addition, the provisions of the Tax Code in terms of the commercial discovery do not correspond with the concept as defined in the Subsoil Law. Thus, the Tax Code contains the wording “commercial discovery of minerals, including the discovery of minerals in the course of additional field exploration.” While under the Subsoil Law, a commercial discovery is adiscovery made in the course of exploration in the contract territory of one or several commercially valuable fields and confirmed by the state subsoil examination.
Of course, the Tax Code is a higher level of legal act than the Subsoil Law. However, this Law is a special legal act regulating relations in the area of subsoil use. Therefore, it is reasonable to use special terms with regard to tax legislation in the way they are understood and interpreted in their own sector of legislation.
The payment for reimbursement of historical costs is a fixed payment for a subsoil user to reimburse the state’s costs incurred for geological exploration of the contract territory and exploration of fields before the subsoil use contract is signed. A part of historical costs calculated by the competent state authority shall be paid in accordance with the subsoil laws as a payment for the acquisition of geological information which is in the public domain. The remaining part is payable to the budget in the form of a payment for reimbursement of historical costs.
Pursuant to the earlier Tax Code, the obligation to make this payment arose from the date of a confidentiality agreement was signed between a subsoil user and the competent state authority for the study and use of subsoil. Due to the disputes between the tax authorities and subsoil users over the meaning of the concept of “confidentiality agreement”, the Law No. 152-V, dated 5 December 2013, ‘On the Introduction of Amendments to Some Legislative Acts of the Republic of Kazakhstan on Taxation Issues’ defined the said term as any agreement between a subsoil user and the competent state authority, under which geological information is provided for use. A contract (agreement) for acquisition of information also qualifies as a confidentiality agreement.
This provision was effective from 1 January 2009. This raises a question regarding penalties for subsoil users which failed to reimburse historical costs in accordance with the procedure and within the timeframe established by the Tax Code, because they signed agreements for the acquisition of information rather than confidentiality agreements. Obviously it would be better to introduce this innovation since 1 January 2014.
Mineral extraction tax (hereinafter – ‘MET’) is paid separately for each type of mineral, including oil types such as crude oil, gas condensate and natural gas. This tax replaced the royalty, which was established by the Tax Code, and was effective until 1 January 2009. The object of MET, like that of the royalty, is the volume of extracted minerals. However, unlike the royalty, the procedure for determining the value of this volume depends on the purpose of the crude oil, gas condensate and natural gas use. Thus, the volume of natural gas is divided into natural gas sold at the domestic market and/or used for a company’s own production needs, and associated gas used for the production of liquefied petroleum gas sold at the domestic gas market. Amounts thereof are deducted from the total amount of extracted minerals.
The MET rate for exported natural gas is 10%. In respect of the gas sold at the domestic market, the rate of 0.5-1.5% applies depending on the annual extraction volume. In calculating MET, the costs of a subsoil user are not taken into account.
Excess profits tax (‘EPT’) is a tax on that part of the net profit, which is recognised as excess profits because it significantly exceeds the income for the preceding period. This tax is intended to limit the profitability of excess-returns productions. The object of taxation is the part of the net income exceeding 25% of the deductions of a subsoil user. Net income is defined as the difference between the total annual income, deductions, corporate income tax (‘CIT’), as well as a tax on the net income of a permanent establishment (for non-residents performing subsoil use operations through a permanent establishment). For the purposes of calculating EPT, deductions are defined as the sum of costs deductible for CIT purposes and additional costs, such as the costs for acquiring (creating) fixed assets. The tax is calculated by applying the rates to the taxable part of income. Each part of the taxable income is determined by applying a percentage to the deductions and by excluding from this previous taxable parts of income until the entire taxable income is apportioned.
Recent amendments to the legislation on taxation of subsoil users had a greater effect on the oil industry than the gas sector. In this regard, there are outstanding tax related problems in the gas industry. The tax burden level is not differentiated depending on the terms and conditions for hydrocarbons production from various fields that differ in the amount of reserves and the degree of deposit depletion. As a result, subsoil users are not interested in investing in further exploration in order to increase the mineral reserves and in using new production technologies. Therefore, further improvement of the tax system, which would create conditions and incentives to increase production and gas field development, including small and medium ones, is required.
The introduction of a differentiated MET rate may be considered the main priority for reforming the tax system for the gas industry. Differentiation of the rate depending on the conditions of gas production involves a careful analysis of the economic conditions of the industry in order to determine the prime cost of gas produced under different conditions, and the profitability of selling it. In this case, a prerequisite is to minimise problems with the administration of this tax.
There is an opinion that the MET rate shall be calculated by applying at least four reduction factors, which should take into account the distance of fields from the customer, degree of gas reserve depletion in the specific subsoil phase, production depth, as well as the presence of associated components in the produced gas.
A differentiated approach would allow the state to withhold the differential rent to companies operating in the best fields according to the natural characteristics, to encourage the full extraction of oil from the “old” deposits with difficult reserves, to engage new promising fields for development, as well as to create equal competitive conditions for all subsoil users.
In addition, there are questions regarding how to determine income from the sale of gas at the domestic market for the purposes of separate accounting for subsoil use contracts. Under the current Tax Code, such income is based on the selling price of gas produced, but is not lower than the gas prime cost. However, in practice, the prime cost of gas production is often much higher than wholesale prices at the domestic market, the limit for which is set by the Government. In this respect, subsoil users propose to delete from the Tax Code the provision that the income on natural gas and associated gas shall not be lower than the prime cost thereof.
Transfer pricing issues are relevant for both the state and taxpayers. The dependence of the basic tax payments in the mining sector on the product price encourages producers to understate the sale price in order to minimise their tax liabilities. To solve this problem, in 1999 the Law ‘On Taxes and Other Obligatory Payments to the Budget’, dated 24 April 1995, was amended to include the provisions on state control over transfer pricing. Further, in 2001, a separate law ‘On State Control over Transfer Pricing’ was enacted. On 1 January 2009, they adopted the Law ‘On Transfer Pricing’, (the ‘Transfer Pricing Law’) which has been amended several times.
However, even the latest version of the Law has been criticised by taxpayers who believe it is not consistent with international practice. Even the meaning of ‘transfer price’ is different.
In the Guidance to Transfer Pricing for Multinational Enterprises and Tax Services of the Organisation for Economic Cooperation and Development (‘OECD’) transfer prices are defined as the prices, at which a company sells tangible goods and intangible property or provides services to associated enterprises.
Pursuant to Article 2 of the Transfer Pricing Law, a transfer price is the price, which is formed between the related partieswhich differs from the fairly formed market price, taking into account the range of prices in transactions between independent parties.
In international practice, control over transfer pricing is performed when parties are related and the transaction price differs from the objective market price. Under Kazakh law, each of these conditions is an independent basis for state control. In addition, independent parties may be recognised as related parties, if they applied a transaction price that differs from the market price. While according to international practice, the transaction price between independent companies is determined by market factors and, therefore, is always a market price, which means it is exempt from control.
The OECD guidelines prohibit tax authorities from using secret information or information not available to taxpayers to determine transfer prices. Thus, the tax authorities cannot use information that constitutes a tax secret, as well as other information, to which taxpayers have limited access. Kazakhstani legislation does not contain provisions that entitle the tax authorities to use information inaccessible to taxpayers for determining transfer prices.
According to international practice, a change of a transfer price in one country implies a corresponding change thereof in the other country. As a result, it allows a company to avoid double taxation for international transactions. Price adjustment in Kazakhstan does not imply price adjustments in the country of residence of the other party to an international transaction, which has a negative impact on the country’s investment climate.
The most relevant issues for exporters in the oil-and-gas industry are those relating to the refund of excess value added tax (‘VAT’), taken as on offset over the accrued tax. To confirm the amount of excess VAT which qualifies for refund, the tax authorities apply the risk management system (Articles 625, 626 of the Tax Code).
Please note that before the Rules for Applying the Risk Management System for the Purpose of Confirming Excess VAT for Refund No. 279, dated 14 April 2013 and approved by the Government of Kazakhstan on 27 March 2013 (the ‘RMS Rules’) entered into legal force, there was no statutory legal act, which determined the method for applying the risk management system.
The Instructions to RMS for the purpose of refunding excess VAT, approved by the Order of the Minister of Finance No. 385, dated 29 July 2010 (the ‘Instructions’), cannot be considered tax law because they do not meet the requirements of the Tax Code. In this respect, we believe that the decision of the tax authorities not to confirm the refund of VAT excess with the reference to these Instructions, is unlawful.
Article 626 of the Tax Code states that the actions of the tax authorities regarding risk assessment and management include analysing the documents and information on the activities of a taxpayer (tax agent). The taxpayer’s (tax agent’s) activities include its interaction with direct suppliers and customers. Documents and information concerning the subsequent consumers and suppliers are not related to the activities of the taxpayer (tax agent).
For taxpayers referred to risk category, the RMS Rules stipulate drafting an analytical report, a ‘Suppliers Pyramid’ for the suppliers of goods, works and services. Thus, in accordance with Article 635.8 of the Tax Code, in making a decision on the appointment of a mandatory counter audit of a supplier, they shall take into account the discrepancies found by the direct suppliers of the audited taxpayer on the basis of the results of an analysis of the Pyramid analytical report. The said report is defined as the results of monitoring performed by tax authorities on the basis of examination and analysis of the tax reports on VAT submitted by the taxpayer (tax agent).
Pursuant to Article 4.3 of the Law ‘On Regulatory Legal Acts’, the RMS Rules shall not be contrary to the Tax Code, which is a higher regulatory legal act. According to Article 6.1 of the said Law, when there are inconsistencies between regulatory legal acts of different levels, higher acts shall prevail.
The procedure for a specialised tax audit based on the taxpayer’s claim for the refund of excess VAT is established by Article 635 of the Tax Code. An analysis of this provision also shows that the grounds for the refusal to refund VAT relate to direct suppliers of the audited taxpayer.
Another unclear issue is the issue regarding the refund of excess VAT on turnovers taxable at zero rate accumulated during the exploration period.
Thus, in one particular case the courts supported the position of the tax authorities, which refused to refund excess VAT to a subsoil user due to the fact that the 5-year limitation period for tax periods had expired and during the next periods the company did not export crude oil. The company, however, became entitled to the refund of excess VAT only in the tax period, when it started exporting oil.
Accordingly, the limitation period begins to run after the end of this period. The courts also noted that excess VAT on turnovers taxable at zero rate for a given tax period may only be refunded, if the taxpayer in this tax period met the conditions specified in Article 272.3 of the Tax Code. In particular, the taxpayer was engaged in the permanent sales of goods, works and services taxed at zero rate, and such sales turnover was at least 70 percent of the total taxable turnover. Meanwhile, this provision of the Tax Code envisages the refund of excess amounts accumulated under the declaration on an accrual basis at the end of the tax period. In this respect, the company believes that this requirement shall take place in the tax period, for which the declaration was submitted with an indication of the VAT refund claim. Thus, it has the right to the refund of excess VAT accumulated prior to the export of oil, because it is associated with the turnover taxable at zero rate.
The Taxation Council of the Government of the Republic of Kazakhstan pointed out that the refund of excess VAT formed in connection with the development of a field before the export of goods (before zero turnovers) is not settled by laws (protocol No. 10, dated 17 October 2013). It is expected that the Ministry of Finance of the Republic of Kazakhstan proposes to exempt exploration works from VAT subject to a list of such works to be determined by the relevant ministries. In addition, they are discussing the possibility of taking any accumulated excess VAT as an offset on account of future payments of other taxes.
These proposals, however, are under consideration now, so the question arises – what should the subsoil users do today when they spent considerable amounts paying VAT in connection with the acquisition of goods, works and services for the said works during exploration before export? How valid is the refusal of the tax authorities to refund VAT refund when it is recognised that there are some gaps in the legislation?
The flexibility of taxation must be a priority for the development of the oil and gas industry. Thus, let us hope that improvements in the taxation system will continue and a compromise will be found which is acceptable both in terms of budget and in terms of conservation and the realisation of development potential for companies in this industry.