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 KAZAKHSTAN International Business Magazine №3, 2000
 Production Sharing Agreements: The Legal Aspects
Production Sharing Agreements: The Legal Aspects
Aigoul Kenjebayeva, Partner of the international law firm Salans Hertzfeld & Heilbronn* managing the Almaty office, Ph.D., LLM.
(*Salans Hertzfeld & Heilbronn is an international law firm with offices in Paris, New York, London, Moscow, St. Petersburg, Kiev, Warsaw, Almaty and Baku.)
The purpose of this article is to set out a legal analysis of the Production Sharing Agreement in comparison with the Concession Agreement, as well as to highlight certain other legal problems related to the Production Sharing Agreement, drawing upon the experience of the Republic of Kazakhstan.
Currently, one can point to two main contractual systems in the world for the conduct of petroleum operations by subsoil users: the concession system and the service system.1(1 The proposed classification of subsoil use contracts is based on the author’s research of various contracts currently utilized in different countries, including Kazakhstan.)
Ownership of Mineral Resources. The main difference between the concession and service systems lies in the ownership of mineral resources.
The concession system is used either (i) in cases where mineral resources in place may be privately owned or (ii) in cases where the ownership of mineral resources passes on to the subsoil user at the moment of their lifting to the surface, i.e. at the well head. Because the legislation of the Republic of Kazakhstan does not allow private ownership of the mineral resources in place, the first type of concession agreement is not used in Kazakhstan. Although the legislation of Kazakhstan does not use the term “concession agreement,” agreements representing the second type described above are used in practice and are regulated by the legislation.2 (2 The names of the various types of agreements which appear in this article are used for discussion purposes only. As is well-known, from a legal point of view it is the legal substance of the agreement that is important, not its title.)
Under the service system the host government retains ownership of mineral resources even after they are lifted to the surface. In compensation for its services the subsoil user is accorded the right to receive payment either in kind (a share of production) or in cash (a flat fee or a share of profit). The second type of arrangement, which requires payment in cash, is usually referred to as either a pure service contract or a risk sharing contract, depending on the basis of the payment.3 (3 For more details see Daniel Johnston. Petroleum Fiscal Systems and Production Sharing Contracts (PennWell Publishing Company, Tulsa, Oklahoma, 1994).) The type of service agreement which requires payment in kind is usually referred to as a Production Sharing Agreement. 
Pursuant to a Production Sharing Agreement the subsoil user (the contractor) becomes the owner of certain amount of the mineral resources produced from the named deposit. But there is a significant legal difference between the nature of the mineral resources owned by the concessionaire under a Concession Agreement (“CA”) and the mineral resources owned by the contractor under a Production Sharing Agreement (“PSA”). Under the CA title to production normally passes to the concessionaire at the well head and, subsequently, the concessionaire pays to the state its entitlement in the form of royalties, taxes and similar fees. Under the PSA the state typically owns the mineral resources up to the delivery point and, subsequently, the host government transfers title to a certain quantity of mineral resources to the contractor, as reimbursement of the costs incurred (known broadly in the petroleum sector as “cost oil”), as well as transfer title to the additional share of production as the payment to the contractor for the services (“contractor profit oil”).
A clear understanding of the basics of these two types of contracts is extremely important, since the legal relations between the parties to such agreements depend entirely on the type of agreement used.
Example: An Oil Company acted in Kazakhstan under a License and PSA. However, under the terms of the PSA, for a specified period of time the Company was not entitled to any share of production; it was entitled only to the recovery of its costs. The Republic received crude oil from the Oil Company at the delivery point, sold the delivered crude and, according to the contract, was supposed to reimburse the Oil Company’s costs out of the proceeds of such sales. However, the tax authorities took the position that the transfer of crude oil from the Oil Company to the Republic at the delivery point constituted “realization” within the meaning of the tax law and purported to penalize the Oil Company for its non-payment of income tax at that moment in accordance with the accrual system of accounting. The Oil Company’s argument was that under this type of arrangement the Oil Company never took title to any portion of the crude oil, even at the delivery point. The crude oil always belonged to the Republic, and the Oil Company was simply paid for its services by the Republic on a cost basis. Because there was no clear understanding by the tax authorities at the local level of the nature of the PSA, the dispute lasted for a long time and was resolved to the satisfaction of the Oil Company only at the level of the highest tax authority. 4 (4 For the purposes of this discussion the facts of the case were simplified.)
Both the concession and service systems, as described above, are used in Kazakhstan. Although there is no special law pertaining to each of these systems, and although the term “concession” has been excluded from Kazakhstan legislation, both systems remain regulated to a certain extent by the law. 
From the time of its independence in 1991 Kazakhstan operated for a period of more than three years under a system in which subsoil use rights were granted on a contractual basis where almost all of the main terms were negotiable.5 (5 See, Code, "On Subsoil Resources and the Processing of Mineral Resources," approved by the Supreme Soviet of the Republic of Kazakhstan on 30 May 1992; Edict No. 1662 of the President of the Republic of Kazakhstan, "On Petroleum Operations", 18 April 1994.) The subsequently-enacted Edicts of the President of the Republic of Kazakhstan, having the force of law, “On Taxes and Other Obligatory Payments to the Budget”, dated 24 April 1995 (generally known as the “Tax Code”), “On Petroleum” dated 28 June, 1995, and “On Subsoil and Subsoil Use Rights” dated 27 January, 1996, significantly limited the discretion of the Government of Kazakhstan and the contracting oil companies in setting the fiscal terms of their agreements. 
The Tax Code contains a special Chapter VI dealing with taxation of subsoil users. Article 94-1 sets forth two models of taxation of subsoil users: (i) the first model requires payment by subsoil users of all types of taxes and other obligatory payments envisaged by the legislation; and (ii) the second model requires “payment (transfer) by subsoil users of the share of the Republic of Kazakhstan by sharing of the production, as well as the payment of the following types of taxes and other obligatory payments: the income tax on legal entities, value added tax, bonuses, royalties, fees for the state registration of legal entities, fees for engaging in certain types of activities and other obligatory payments provided by the legislation of the Republic of Kazakhstan and not listed in Articles 3 and 4” of the Tax Code. The first model corresponds more to the concession system and the second model - to one of the forms of the service system, namely, the production sharing system.
However, as it follows from the above cited definition of the agreement which corresponds to the second model (PSA), the legislature is wrong in providing that the share of production is paid by the contractor to the Republic, in fact legally everything is vice versa – the Republic pays its share to the contractor.
Royalties. From a legal point of view a royalty is the payment by the new owner of mineral resources upon their extraction to the surface to the original owner of such mineral resources when they were in place, i.e., the payment of royalties requires ownership of the mineral resources by the subsoil user. This is possible only under the concession system. Therefore, in most countries royalties are not used in conjunction with a PSA. However, as follows from the description of the second model in Article 94-1 of the Tax Code, in Kazakhstan PSAs actually do provide for the payment of royalties.
The legal and economic nature of royalties is such that they constitute a payment which comes right off the top of gross revenues. In Kazakhstan royalties are calculated as gross revenue less transportation costs to the point of sale (Article 100-2 of the Tax Code). Such scheme is used regardless of the model of contract utilized.
Some people in Kazakhstan think that the inclusion of royalties in a PSA is just a method of calculation for the economics of the project and that the contradiction between the legal nature of this type of payment and the legal nature of the PSA is not important. We cannot agree with this point of view. Under the PSA arrangement a royalty is effectively the payment by the Republic to itself, because it is paid at the stage when the Oil Company has not yet received its share, and when all production still belongs to the Republic. Therefore, the payment of a royalty under a PSA cannot rightly be viewed as a subject to be regulated by the Tax Code. Such payment is just a contractual obligation of the Oil Company. Consequently, non-compliance with the obligation to make royalty payments under the PSA should be penalized in accordance with the Civil Code (damages) rather than with the Tax Code (fines and tax penalties).
Because of the lack of a clear understanding of the legal nature of PSAs the Tax Code contains certain provisions which are quite confusing and which can create serious disputes between the Republic of Kazakhstan and its subsoil users. One such example is the inclusion of royalties in the PSA model.
Economics of the project. Article 94-1 of the Tax Code provides that “the level of tax obligations of the subsoil user must be the same regardless of the application of one of the two models of the tax regime.” This provision is in need of serious re-drafting. As it is clear from the description of the two models in Article 94-1 tax burden under the two models is quite different. The PSA requires less by way of tax payments but more in the form of contractual payments. Even if we disregard royalties (since they are included in the Tax Code and, therefore, constitute an “obligatory payment” within the meaning of the Tax Code) the transfer of the Republic’s share of production to the Republic and the retention of the oil company’s share of production are contractual obligations of the oil company and, clearly, are outside of the tax regime of the project. Therefore, the better approach would be not to equalize the tax regimes of the two models but, rather, to equalize the economic regimes.
Cost recovery vs. deductions. The usual practice in the world is to allow cost recovery under both the CA and the PSA systems. Under the CA system everything left after the payment of royalties and cost recovery (and, possibly, certain bonuses) is the basis for taxation. However, Article 94-1 of the Tax Code does not say a word about the possibility of cost recovery. Under the strict wording of that provision on the first model subsoil users must pay all taxes envisaged by the legislation. Presumably, the calculation of the tax basis is subject to general provisions of the Tax Code. Technically, this means that subsoil users in all subsoil use contracts except PSAs are not entitled to cost recovery, they are entitled only to tax deductions, which are clearly not the same.
Article 30-6 of the Edict of the President of the Republic of Kazakhstan, having the force of law, “On Petroleum” dated 28 June, 1995, as amended (“Law on Petroleum”) allows cost recovery only in cases envisaged by the contract. Since Article 94-1 of the Tax Code does not provide for a possibility of cost recovery, it can be argued that any CA concluded on the basis of the first model technically could not envisage cost recovery, i.e. Article 30-6 would not be applicable.
In practice, we do not think that any oil company would agree to conduct petroleum operations without a cost recovery mechanism. However, the ambiguities in the drafting of Article 94-1 could prevent oil companies from using anything other than a PSA, since Article 94-1.2 provides that the first model must be used in all cases other than where the second model (PSA) is used.
Negotiable economic element of the contract. It is quite clear from the description of the two models for subsoil use contracts in Kazakhstan that the first model does not leave any room for negotiations except with respect to excess profit tax. For this reason the first model is quite unattractive for investors. In contrast to the CA system, the PSA system is quite flexible and allows more opportunities to adjust the economics of the contract to various specific conditions, taking into consideration the commerciality of the deposit, work commitments, domestic obligations, and the like.
The PSA as a subsoil use contract vs. the service agreement as a general civil law contract. At the beginning of this article we stated that the service system for subsoil use contracts includes the PSA, the pure service contract and the risk sharing contract. All of these forms can be classified as subsoil use contracts, and they must be differentiated from civil law service agreements. In our practice there was one case where a foreign oil company entered into an agreement with a state-owned oil company for the rehabilitation of wells on one deposit. The remuneration was agreed to be a payment in kind as a percentage of total production. The foreign oil company subsequently decided to assign its rights under the agreement, and the potential buyer wanted to ensure that, in fact, it was going to acquire subsoil use rights. 
An analysis of the situation showed that this agreement was not a subsoil use contract; it was simply a civil law contract for services. This conclusion was based on the fact that the production license for the field belonged to the state - owned oil company, which was the party to the contract with the Competent Body. The foreign oil company was merely a subcontractor to the state - owned oil company, even though their contract was entitled “Production Sharing Contract”.
The importance of such differentiation between the two types of service contracts is obvious. Many important benefits are not available to the parties in civil law service contracts. For example, civil law service contracts do not benefit from stabilization provisions under the Foreign Investment Law, Tax Code, Law on Petroleum and Law on Subsoil and Subsoil Use. At the same time, many obligations of subsoil users are also not applicable to the parties of the civil law service contracts.
CONCLUSION. The above brief discussion brings us to the following conclusions:
• Chapter VI of the Tax Code needs serious re-drafting to reflect the fundamental legal differences between the CA and the PSA systems for subsoil use contracts;
• The PSA, as the most attractive type of subsoil use contract under the laws of Kazakhstan, should be better and more clearly regulated in order to avoid possible disputes between the Republic of Kazakhstan and investors.

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