Factors Influencing the Growth in Tax Revenues from the Oil and Gas Sector in 2001
Janat Berdalina, Managing Partner, KPMG, Kazakhstan
Inna Alkhimova,Tax Consultant, KPMG, Kazakhstan
The importance of the oil and gas sector for Kazakhstan cannot be overemphasized. The oil and gas industry alone accounted for 40% of overall industrial production in 2001, which in turn comprised 26% of Kazakhstan’s gross domestic product. However, there was a considerable decrease of oil and gas production at the end of 2001. In the fourth quarter of 2000 there was a 5.6% decline in the growth rate, as compared with the same period for the prior year, while in the 2nd quarter the drop in growth was 23%. There was also a considerable decline in 2001 of the average oil price, which was 29% lower than in December 2000. Average prices for oil and gas products declined by 23% and 21.9% respectively.1
1. Source: Statistics Agency of Kazakhstan
At the same time the year 2001 witnessed an increase in tax revenues from companies working in the oil and gas industry. We will attempt to analyze the reasons for this phenomenon.
According to data provided by the Ministry of Energy and Mineral Resources on oil and gas companies for the period from 1998 to 2001, sales not only didn’t increase, but actually declined slightly, despite stable growth in oil production. This decline was a result of oil price decreases in the end of 2001.
However, tax revenues from the oil and gas sector almost doubled from US$557 million in 2000 (11.3% of sales) to US$1,033 million in 2001 (21.3% of sales volumes).2
2. Source: Ministry of Energy and Mineral Resources of Kazakhstan
According to data published by the Ministry of State Revenues, which reflect sales and taxes paid for the largest taxpayers in Kazakhstan, the general trend was an increase in the tax burden on the largest oil and gas companies by 5% on average in 2001.
Although we have only limited basic information, it is sufficient to demonstrate general trends, and we will try to understand the possible reasons for such a considerable surge in tax revenues from companies working in the oil and gas sector.
An analysis of data received from the Ministry of Energy and Mineral Resources shows that the increase in tax revenues in 2001 resulted from a considerable increase in tax revenues from corporate income tax (by 250%), royalty (3.8 fold) and, to a lesser degree, from social tax, excess profit tax and vehicle tax. At the same time, we observe a considerable decrease in tax revenues from VAT and property tax.
We make several assumptions to explain these facts. Further, we consider various factors that, in our opinion, may influence the volume of tax revenues.
The royalty rate is established by contract (except for common minerals) as a percentage of the value of extracted hydrocarbons, but no less than 0.5%. The royalty rate on hydrocarbons is set by using a sliding scale depending on the volume of accumulated output, unlike the royalty rate on hard minerals, which is a fixed rate for the whole term of a contract. In addition, royalty rates may vary from one contract to another depending on the commerciality of the contract. Thus, the increase in royalty payments in 2001 may be explained by the fact that many oil enterprises reached a higher level of production, resulting in higher royalty rates.
Corporate Income Tax
Let’s assume that the reason for the increase in tax revenues from corporate income tax could be either an increase in the corporate income tax rate or an expansion of the taxable base as a result of higher revenues or lower deductible expenses or both.
In 2000 and 2001 the tax legislation did not undergo any significant changes in relation to corporate income tax that could explain a 100% increase in tax revenues from corporate income tax.
Furthermore, tax regime stability provided by subsurface use contracts means that a subsurface user is governed by the law valid on the date of conclusion of its contract, which guarantees constant tax rates with respect to most taxes.
However, some contracts provide for progressive corporate income tax rates from, for example, 25% to 35%, depending on taxable income (similar to progressive personal income tax rates). In this case, when a company reaches a certain profitability threshold established by the contract, the effective tax rate increases, and as a result the tax grows disproportionately in relation to the increase in taxable income. However, this fact should result in a smooth increase in corporate income tax revenues, not a 100% increase.
Because the legislative corporate income tax rate did not change, tax rates in subsurface use contracts are stabilized, and income resulting from sales of oil did not increase significantly according to the Ministry of Energy and Mineral Resources, we might assume that there was a decrease in expenses of subsurface users in connection with the decrease in production volumes due to the oil price decrease in 2001. The data from the Ministry of Energy and Mineral Resources indicates that expenses decreased by 2% in 2001. However, this cannot account for a sufficient change in the taxable base to explain a doubling of tax revenues from corporate income tax.
Which deductible expenses might have such an impact on taxable income? These might be direct oil production expenses, overhead expenses, or depreciation and amortization costs. Analyzing the data, we observe that production expenses decreased. Although overhead expenses doubled, they do not constitute significant amounts, so their influence on taxable income is not material. Therefore, we suggest that the main reason for an increase in taxable income in 2001 over the previous year was a decrease in depreciation and amortization charges.
Our presumption of the considerable influence of depreciation and amortization charges on taxable income is supported by the well-established capital intensity of oil and gas operations. Furthermore, we observe almost a 40% increase in tax revenues from property tax in 2000 as compared with 1999. Then, in 2001 there was a 30% decrease of property tax revenues, which suggests there were 30% more assets purchased or put into operation in 2000 than in 2001.
The data of the Statistics Agency indicate that there was an increased demand for oil during 1999. That served as an impetus for hingher oil production and for creating additional production facilities in 2000. Apparently, this trend did not continue on into 2001.
By tracking Kazakhstan’s tax policy over time and changes in the legislation with respect to depreciation and amortization, from the days when the first contracts were concluded up to the present, we can observe the impact that depreciation and amortization have on corporate income tax.
Before 1995 depreciation charges were made in accordance with the Law on Taxes on Enterprises, Associations and Organizations, signed 14 February 1991, which provided for the possibility of accelerated amortization and depreciation. Amortization and depreciation rates were stipulated by Resolution No.1072 concerning Unified Amortization and Depreciation Rates for the Recovery of Asset Costs, signed 22 October 1990. Usually accelerated amortization and depreciation took the form of doubling of the amortization and depreciation rates provided by the resolution.
In addition, the above-mentioned law on Taxes on Enterprises, Associations and Organizations permitted enterprises to reduce their taxable income by the amount of expenses incurred on capital investments and acquisitions in excess of the sum of depreciation charges for the year plus proceeds from the sale of fixed assets. In other words, a taxpayer could claim additional deductions for the cost of fixed assets acquired in this period if asset costs exceeded the sum of depreciation expense for the period plus the amount realized from sales of fixed assets in this period.
In accordance with tax legislation and the Law on Foreign Investments, signed 7 December 1990, a joint venture with foreign participation was allowed to use the depreciation and amortization rates, including accelerated rates, specified by their charter documents and these rates were sometimes significant.
Law No.2235 concerning Taxes and Other Obligatory Payments to the Budget, signed in 1995, stipulated unified rates and methods for tax amortization and depreciation. Until December 1999, this law contained a special provision on depreciation expenses related to a taxpayer’s own construction for production purposes and technical equipment. In particular, the specified provision allowed taxpayers to deduct the residual value of such assets at any time (at the discretion of the taxpayer), if the equipment was used for not less than three years, (except for a period from June 1995 to December 1996, when the taxpayer was allowed to deduct the residual value of such equipment only after three years of operation).
The maximum depreciation rates for equipment and machinery used for mining and refining hydrocarbons were 15% in 1995-1996 and 25% in 1997-1999.
Starting in 2000 processing equipment became depreciated on the same basis as all other assets. The maximum depreciation rate for equipment and machinery, used in oil extraction decreased to 15%. The only tax preference available to new equipment and machinery was accelerated first-year depreciation rates.
When the new Tax Code entered into force in 2002, the same rule applied. Thus, taxpayers may apply double depreciation rates in the first year of service of newly installed equipment, on the condition that it will be used for not less than 3 years. As a result, depreciation rates have declined from prior years.
Let’s examine the practical application of the tax legislation for different periods of time with respect to depreciation of fixed assets.
For tax depreciation purposes the declining balance method applies, i.e. the depreciation rate is applied to the net book value of each category of fixed assets at the end of the tax period. We don’t consider possible repair or revaluation of fixed assets.
Thus, under depreciation methods specified by tax law up to 2000, depreciation charges in the periods of initial equipment installment could be much higher than depreciation charges under current tax law, and taxable income is higher under current tax law.
Until tax law changed, the depreciation rate for such an important for oil and gas sector group as erections was 7%. Later oil and gas wells and oil and gas storage were separated from the asset group of erections, and their depreciation rates became 29% and 10% respectively.
Thereby, with respect to one group of fixed assets there was an increase in depreciation rates; with respect to another – a gradual cancellation of tax preferences. The aggregate effect from such changes in tax legislation in practice can be determined only for each particular case and subsurface use contract.
Amongst other factors affecting taxable income, we should mention losses carried forward.
A provision in the tax law that allowed taxpayers to carry forward losses for 5 years was introduced in 1995. With changes to the Law on Taxes and Other Obligatory Budgetary Payments, dated December 31, 1996, subsurface users received the right to carry forward their losses for up to 7 years. Since all oil-producing companies in Kazakhstan originally reported losses, the increase in tax revenues from oil companies in 2001 suggests that perhaps oil companies had completely utilized their carried-forward losses and began to report taxable profits. This led to a corresponding increase in tax revenues from corporate income tax.
In conclusion, we would like to emphasize that not all factors that could affect growth of tax revenues from the oil and gas sector were analyzed in this article. When analyzing factors that influence a company’s tax burden, it is necessary to take into account specificity of a company’s business, and, in particular, tax regime established by a subsurface use contract.
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