Difficulties in Applying the Tax Legislation Provisions When Calculating a Commercial Discovery Bonus

Difficulties in Applying the Tax Legislation Provisions When Calculating a Commercial Discovery Bonus

In a society where the ownership of the subsoil belongs to the State, the latter must play at least a dual role. First, the State should act as the owner of resources and aim to maximise the income from the ownership of the subsoil. Secondly, the State must collect taxes on income derived from using the subsoil. The State must therefore simultaneously act as a resource owner and as a tax collector.

For Kazakhstan, which is one of the world's largest producers of mineral resources, the relevant problem is the formation of an efficient tax system that provides  excess profits or resource rent in favour of the State. Taxation of subsoil users should provide significant and stable tax revenues to the National Fund of the Republic of Kazakhstan, on the one hand, and maintain sufficient incentives for investment in this sector of the economy, on the other. In practice in Kazakhstan, the taxation of subsoil users is not sufficiently effective in achieving these objectives.

Of course, generally to date, the legal and regulatory framework governing the use of mineral resources in Kazakhstan has already been established and is functioning reasonably well: the fundamental subsoil laws have been adopted and are applied, and the system of taxation in this area is effectively functioning. It is however still too early to say whether all of the problems in the area of the taxation of subsoil users have been solved.

In this article, I would like to draw your attention to some issues of the tax legislation faced by subsoil users in Kazakhstan, when calculating commercial discovery bonuses.

The transition from the pre-existing system of taxation of subsoil users to the current system was not easy, not devoid of error and doubt, and was full of a considerable number of legislative acts, which are now  only of historical significance.

The basic applicable principles of taxation of subsoil users were originally laid down in the Decree of the President of the Republic of Kazakhstan ‘On Oil Transactions’ No. 1662, dated 18 April 1994, and later in the Tax Law[1].

Under the Tax Law, Special Payments and Taxes Section determined the original list of payments and taxes, including:

1.   Bonuses:

a)  subscription;

b)  commercial discovery;

c)  production.

2.   Royalties;

3.   Excess Profit Tax.

A large number of the subsoil use contracts were concluded on the basis of the above list of special payments and taxes.

Later, the Tax Law for the entire period of its effect was subject to many amendments and additions in respect of all types of taxes, including special taxes and payments of subsoil users.

The most significant innovation for subsoil users was the introduction of the payment for historical costs in August 1997, as well as the exclusion by the Law of the Republic of Kazakhstan No. 255-1, dated 1 July 1998 of production bonus from the bonuses list.

Until 1998, the procedure, size and other terms of payment of the special payments of subsoil users had not been defined by law. At that time, enterprises producing hydrocarbons paid special rental payments in accordance with the agreements concluded with the Government of the Republic of Kazakhstan.

For example, in 1997 based on the Tax Law, Resolution No. 1330[2] and Instruction No. 41[3] were developed, which regulated the calculation and payment of special payments and taxes of subsoil users.

By 1998, the formation of a new system of taxation of subsoil users that met the market conditions had been started. This system included both taxes of general application and special payments of subsoil users, including:

1.   Bonuses:

a)  subscription;

b)  commercial discovery;

c)  production.

2.   Royalties;

3.   Excess Profit Tax;

4.   Share of the Republic of Kazakhstan production sharing;

5.   Other payments for the use of mineral resources, established in accordance with the laws of the Republic of Kazakhstan and the terms of contracts, including reimbursement to the budget of the amounts of the historical costs.

With regards to bonuses, the tax legislation however formally regulated the procedure of these payments. In fact, the size of bonuses was determined by the authorised state agency and established by the contracts for subsoil use.

After the introduction of the Code of the Republic of Kazakhstan ‘On Taxes and Other Obligatory Payments to the Budget’ No. 209-II, 12 June 2001, the amount of the subscription bonus also established by the subsoil use contracts, and the amount of commercial discovery bonus payable to the budget, were estimated by a subsoil user independently and did not require the approval of the contract for subsoil use.

By 2009, the tax legislation of Kazakhstan had undergone some fundamental changes. Within this reform, the Tax Code[4] enshrined the procedure for calculating subscription bonuses for the first time. With regard to the commercial discovery bonus, there were no conceptual changes.

In determining the amount of the commercial discovery bonus, subsoil users are nevertheless experiencing some problems.

For instance, in accordance with the provisions of the Tax Code, a commercial discovery bonus is paid for each commercial discovery in the contract area, including a discovery in the course of further exploration, which leads to an increase in the originally established recoverable reserves.

The following question therefore arises: what is a commercial discovery?

As defined by the Subsoil Law[5], a commercial discovery is a discovery in the contract territory of one or more fields that are economically suitable for production. For tax purposes however, the legislation does not specify what economically suitable reserves are.

In accordance with the Instruction for the Classification of Reserves[6], the category of oil, gas, and condensate reserves and associated components, according to the degree of certainty, is divided into proven and inferred (undiscovered) reserves.

Thereat, the proven reserves include the category of developed reserves (categories A and B) and discovered reserves (category C1). The undiscovered reserves are reserves of category C2.

According to the Instruction for the Classification of Reserves in the fields put into development, there should be a consecutive conversion of reserves from the C2 category into the C1 category, and then into categories B and A, subject to the drilling data and wells information.

Pursuant to the above, the reserves of categories A, B and C1 are proven reserves, and therefore, they are economically suitable for production.

The reserves of the C2 category are undiscovered, i.e. they require further exploration. Accordingly, only after further exploration, is it possible to establish whether they are suitable for economic production or not.

The commercial discovery bonus is paid for the actual (physical) volume of the recoverable reserves, which is approved by an authorised body. The authorised body approves the volume of reserves based on the degree of certainty, including the reserves of categories А, В, С1 and С2. 

Meanwhile, the next questions are: what categories of reserves will be subject to a commercial discovery bonus? Are only the proven reserves of categories A, B and C1 subject to this bonus, or can undiscovered reserves be subject to a commercial discovery bonus as well?

As practice shows, when calculating a commercial discovery bonus, the target object includes, inter alia, the undiscovered reserves of the C2 category.

Is this correct? In the course of further exploration, the inferred reserves of the C2 category are consecutively converted into the reserves of the C1 category, and then into categories B and A. The volume of the inferred reserves of the C2 category, subject to further exploration, may be not confirmed.

There are cases when the commercial discovery bonus is paid for the volume of proven reserves, including the reserves of the C2 category. In the course of further exploration, it was then revealed that the inferred volume of the recoverable reserves was not confirmed, and, accordingly, was reduced.

It is thus not possible to determine the degree of economical suitability of the preliminarily estimated volume of the reserves of the C2 category for production.

In this regard, it would be reasonable to pay the commercial discovery bonus for the proven reserves of categories A, B and C1 because, after further exploration, the volume of the proven reserves of the C2 category will be converted into the C1 category. Accordingly, the increased volume of the proven reserves will be paid the commercial discovery bonus.

This issue has nevertheless not been resolved by the Tax Code, nor has the procedure for calculating the commercial discovery bonus in the case of additional volumes of the recoverable reserves.

Let us suppose that in the course of further exploration, the originally established reserves, which have already been subject to the commercial discovery bonus, have increased. Accordingly, the commercial discovery bonus needs to be paid for this additional (increased) amount of reserves.

The issue is how to determine the amount of the bonus for this additional discovered volume of reserves.

It is logical that with an increase in the previously proven reserves, the commercial discovery bonus should be calculated only for the further discovered amount of the recoverable reserves.

According to the Tax Code however, the object of the commercial discovery bonus is the volume of the recoverable reserves, which was approved by an authorised body.

In this case, the authorised body does not approve the further discovered amount of the recoverable reserves, but the entire specified amount of the recoverable reserves.

According to the direct interpretation of the rules of the Tax Code, with an increase in the originally established reserves, the taxation object will represent not the difference between the originally approved reserves and those further approved, but the entire amount of the recoverable mineral reserves, which was approved by the authorised body. This is unjust and contrary to the principles of taxation.  

Meanwhile, as practice shows, in case the additional volume of recoverable reserves is detected, the tax authority calculates the commercial discovery bonus for the additional volume of discovered reserves. This still does not exclude the risk of unfair additional tax charges, since the rules of the legislation are not clear.

In order to avoid unfair charges in relation to commercial discovery bonuses, there is a need to introduce amendments to the Tax Code, so as to establish a separate procedure for determining the object of taxation in cases where the originally established recoverable reserves increase.