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Russian oil companies talked about the need to dispense with natural resource extraction tax (NRET), which taxes revenue, in favor of a new system of taxation based on earnings, towards the end of 2008, when the global financial crisis had started to take its toll. The oil companies said they thought the new system ought to apply to all fields. The Energy Ministry promised to think about it.

But in the end, at a meeting in Kirishi in February 2009, the government decided to devise a new system to tax windfall profit applicable to new oil fields.

The tax policy outline that the government approved in May projects that the new windfall tax could be applied to new oil fields from 2011-2012.

Oil companies have formed a working group to sit down with the profile ministries and thrash out an ideal solution.

Differing views

The Finance Ministry and Energy Ministry have differing views on how to prioritize the tax stimulus. The Finance Ministry thinks the windfall earnings tax should only apply to new fields during the initial stage.

Lifting costs seem to be on the rise in the oil industry, which possesses significant investment potential. This is due to the natural impairment of the mineral-resource base, and for this reason the Energy Ministry forecasts oil production will decrease in volume, says a letter, seen by Interfax, from the Finance Ministry to the government.

Production levels could be sustained by stimulating the development of new fields, and by increasing the recovery rate at existing fields. The Energy Ministry believes the focus should be on increasing recoveries at existing fields, as they already have the infrastructure in place and the cost of lifting oil will, consequently, be lower.

The Energy Ministry also believes that if the tax burden is eased only for new fields, then oil companies will sink all their available cash into those new fields, curtailing investment that could bring higher returns in existing fields.

"Due to the need to balance the tax environment for various conditions for producing oil, it would be advisable to switch to taxing windfall earnings generated by oil production. The Finance Ministry believes that this system of taxation should primarily be applicable to new oil fields," the letter says.

Government experts say the new system could be extended to other fields if it can be implemented successfully at new fields.

Not pressing

The Energy Ministry's press office told Interfax that there were in fact no disagreements between ministries. "A working party of Energy Ministry and Finance Ministry representatives has been set up to deliver the Kirishi protocol, and this is working well," the spokesman said.

But a swift decision on the transition to a windfall tax should not be expected. The Finance Ministry does not think this transition should be a top government tax policy priority. It argues that tax and customs decisions adopted last year have eased the fiscal burden on oil extraction and exports by more than 500 billion rubles and are generating high net profit in the oil industry.

The ministry says the earnings-based approach to taxation guarantees a true tax differential, depending on the specific conditions for producing oil. It caters not just for gross income but also for the cost of producing oil at a specific field. The ministry believes that a switch to the windfall tax would be possible after a system of effective tax control has been introduced over transfer pricing for tax purposes and approaches to administering the tax effectively have been devised.

An Energy Ministry source has told Interfax that this ministry also considers it is too early to draft new, additional tax stimuli for the oil industry. He said the measures introduced by the government in 2008 and the growth in oil prices this year had stabilized the Russian oil industry and that daily output was increasing gradually.

Nothing specific

Nikolai Gorelov, spokesman for TNK-BP (RTS: TNBP), told Interfax that the windfall tax was one of the measures that oil companies has proposed for new fields. For this to work, it would be necessary, by the autumn, to devise specific proposals on the introduction of this type of tax, and to draft amendments to existing laws in order to change the way duties and the NRET are levied. A more stable tax system is needed for new fields, one that does not depend as much on global oil price trends and the level of costs.

The spokesman said that in general, oil companies were in favor of changing the way the industry is taxed and introducing the sort of models used in Britain and Norway, where the amount of tax paid depends solely on financial results. "In other words, all the taxes would be bundled into one tax - a tax on income, which is paid when a field has already gone on stream and has started to pay for itself. That system would encourage work at fields with poor accessibility or complex geology. The state would then receive more revenue from the launch of a greater number of fields," he said.

A Rosneft (RTS: ROSN) spokesman told Interfax that the company had always been in favor of improving tax legislation and had always worked with the government in this area. "In today's conditions we consider it vital to ease the tax burden in order to free up funds for additional investment in view of the fact that hardly any easily recoverable reserves are left," he said.

Gazprom Neft's (RTS: SIBN) press office also said the company backed the new tax initiative and was involved in the working group.

A source at Rosneft who had also seen the Finance Ministry's letter told Interfax that this was a "constructive document, but one that does not contain any specific proposals or timeframes." Taxation in the oil industry needs to be changed, "but this will take time, and there are still a lot of questions."

Decision on horizon?

The Russian government will decide how to tax the development of new oil fields by the end of this year, Deputy Finance Minister Sergei Shatalov told a press conference on June 17.

The Finance Ministry is discussing this issue with the Energy Ministry, Natural Resources Ministry, Economic Development Ministry and biggest oil companies, he said.

"We need to redistribute the tax burden in order to minimize tax at the beginning and end of a field's life and collect more during the period when a field is more productive," Shatalov said. "There are several parameters to look at, and we need to decide how those parameters will alter," he said.

Shatalov said he could not say "how this will be done." "It would be good if we can do it by the end of the year," he said.

"We've almost finished analyzing the implications for applying the existing tax system to new fields," Shatalov said, adding that the analysis focused on specific new fields, some of them in East Siberia. "Varying results were obtained, and the problems that the oil companies are encountering are not identical," he said.

If it can be assumed that oil prices will not alter, then the taxes and dues payable by the oil companies (NRET, profit tax and export duty) will be identical both at the initial and final stages. "It would be reasonable to redistribute the tax burden over time," he said.

Shatalov said that the NRET for new fields might be replaced by a windfall tax on earnings. Asked why the new tax might be applicable to new fields only, he said its calculation was based on an estimate of income and costs borne by a company during the life of the deposit. "This information can be collected only for new fields, and then on the condition that legislation on transfer pricing will be in effect," he said.

Shatalov said he was familiar with the Energy Ministry's argument that if the tax burden is eased only for new fields, then oil companies will sink all their available cash into those new fields, curtailing investment that could bring higher returns in existing fields, and that this was "far from indisputable."

In order to start developing new fields, companies will have to "enter regions where hardly any infrastructure exists." "This will have to be built, and it would require huge capital expenditure," he said. "It is not obvious whether (tax relief for new fields) will outweigh the considerably lower capex under the existing tax regime for existing fields," he said.

Shatalov said the Energy Ministry recognized this also, and "we will be discussing this."

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