Production Sharing Agreements
According to the assessments of international experts, production sharing agreements will become one of the major contracts for subsoil use in the oil and gas sector of the CIS in the near future. Taking into account the huge potential and significance of the oil sector for Kazakhstan’s economy, the government and all the concerned parties should focus on a number of economic and legal problems which arise during the implementation of PSA projects. In this respect, Russia’s experience will help in finding an effective solution to the problems and creating more favourable conditions for domestic and foreign investors.
First, there are no disputes in Russia about the necessity for a federal law on PSA1.(1 Federal Law On Production Sharing Agreements dated 11th January 1996.) The law has already been passed, is in force, and is being improved. The list of blocks approved by laws for PSAs is growing. New normative documents regulating relations between the state and investors are being devised. Nevertheless, the law requires a thorough revision and a number of amendments to be made.
Second, Russia’s major interests in such projects lie in the participation of Russian enterprises in contract operations. Russia is striving to develop its own production and create new jobs.
The main distinguishing feature of PSAs in Russia is full compensation by the country for all expenses incurred by a foreign investor for contract operations. The cost of such operations under most agreements on the development of Russian oil fields is around 80 % (although not more than 50% in world practice). Taking into account the specific character of PSAs, when the state is able to increase its share in a contract only after compensating the foreign investor’s expenses (which may take several years), the economic effect ought to be achieved at an early stage using the potential of Russian heavy engineering, metallurgy, and the defence sector. However, the experience gained in PSA preparation and fulfilment shows that Russia has not yet developed an effective mechanism for supporting Russian participants in contract operations. The problem is that the laws of the Russian Federation allow investors to use foreign equipment at the initial stages on condition of compensating the required quota in the future, notwithstanding amendments made to the PSA Law2 which provide for obligatory use of not less than 70% of Russian equipment.( 2 Federal Law On Amendments and Supplements to the Federal Law On PSA dated 10th January 1999.) Since the laws do not establish the exact period allowed for the use of foreign equipment, this causes resentment among Russian producers. The practice of applying relevant amendments shows that some investors have imported foreign equipment through third parties.
According to Russian analysts, this situation with PSAs in Russia is caused by the lack of a single state authority for the co-ordination of the work of Russian participants in contract operations. In their opinion, the prospective state operator of a PSA operation should not be a monopolist. This body will create conditions for a wider and fuller representation of interests from all Russian industries. Its duty will be to ensure a gradual attraction of local enterprises to contract operations under oil projects. Thanks to a state PSA operator, Norway, China and some other countries could obtain large-scale orders for high technology products and equipment, as well as develop new branches of national economies. According to Russian experts, the state’s economic interest should be legally defined in corresponding amendments to the PSA Law.
Another problem faced by Russia is that government authorities of entities of the Russian Federation take part in the PSA preparation and signing. Amendments2 made to the PSA Law vest more powers with such authorities. Today, the executive authorities of a relevant entity of the Russian Federation are competent to sign agreements with investors on small mineral fields (not classified as strategic or those forming gold and foreign currency reserves of a country). The interest of local authorities is quite understandable, since such contracts bring revenues to local budgets. However, the Government of the Russian Federation is still the only competent authority to appoint commissions for negotiating PSAs, even on small fields. Many experts in Russia assume that it would be more expedient to vest this right with a relevant executive authority.
Incidentally, Kazakhstani laws do not establish any procedures for local authorities to participate in the preparation and signing of PSAs. Some of the income from PSAs is transferred to local budgets in accordance with Article 94-1.3 of the Tax Code3, which states that the share is defined in the law of the Republic of Kazakhstan on the national budget for a given year. The share, however, is too small, which is why local akims (mayors) are unhappy with investors’ activities under PSAs.
In future, Kazakhstan plans to develop a number of normative documents which would enable local executive authorities to sign contacts with investors for the use of subsoil resources in small and medium fields. However, such contracts are hardly possible for oil which is classified as a strategic raw material. The best solution to the problem would be a legal regulation of the share of local budgets for each PSA.
Since many aspects of investors’ activities under PSA have not been regulated in laws, the reasonable question of quotas on such agreements arises. Referring to Russia’s experience, it should be noted that the Law has established a 30% quota on PSAs on explored and registered mineral reserves. At present, the fixed oil quota in Russia has been practically fulfilled, which does not suit potential investors. Nevertheless, investors, risking their capital, may obtain new oil reserves to be added to the existing ones in some PSA blocks (poorly explored, but quite prospective) in Russia. This will surpass the 30% quota. Russian specialists believe that the PSA Law should be amended to free from quota restrictions reserves which have been explored and registered after signing a PSA.
A rhetorical question arises – does Kazakhstan need a quota? According to Kazakhstani experts, fixed quotas will lead to inefficient use of reserves in a field in future. This position is based on the probability that investors, after the 30% quota is filled, may leave low profitable reserves, which will require additional investment in further development. Since the first years of a field’s development are characterised by easily extracted oil or ores reserves, the amount of which is reduced with the period of their development, experts assume that a 25-year term is sufficient for the efficient use of minerals in any field (except for huge fields, such as Tengiz and Karachaganak, the development of which takes around 40 years).
Russia has already made a list of blocks which can be developed under production sharing terms. There is no such list approved by the Government in Kazakhstan. The Tax Code only establishes two equal taxation models applied to subsoil contracts in accordance with Article 94-1. The first model provides for the payment of all taxes and other obligatory payments required by law. The second model (PSA) provides for the payment of income tax by legal entities, taking into account income tax withheld at source and net profit income of a permanent legal entity office, VAT, bonuses, royalty, social tax, a fee for the registration of legal entities, licensing fees for certain activities, and other obligatory payments required by the laws of the Republic of Kazakhstan.
The procedures for obtaining the right to the use of subsoil under a PSA in Kazakhstan are only regulated by the general provisions of Article 4-1 of the Law On Subsoil and Its Use4. The right is given based on investment programme tenders. The only condition for signing a PSA in Kazakhstan is that the scope of tax liabilities of a subsoil user should be equal, irrespective of which of the taxation models is applied (refer to Article 94-1.4 of the Tax Code).
It is no secret that the main cause of disputes in Kazakhstan is non-transparency and insufficiency of the legal framework for subsoil use. Any haste in signing a PSA could result in various scandals which, in their turn, may cause sound investment losses for Kazakhstan and a decline in its investment attractiveness for investor.
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Fundamentals of the Legal Regulation of Production Sharing Agreements in the Russian Federation Sergei Gudkov
Production Sharing Agreements: The Legal Aspects Aigoul Kenjebayeva