CHINA'S TAX SYSTEM RELATIVELY BENIGN, BUT PROBLEMS REMAIN

Nov. 28, 1994
Michael Cannon Price Waterhouse L.L.P. Hong Kong Recent developments in China's oil market have reignited the the interest of multinational oil and gas companies in China. New onshore and offshore blocks are being granted, and the Tarim basin has been opened to foreign participation for the first time. Foreign participation is also being sought in refining and other downstream areas.
Michael Cannon
Price Waterhouse L.L.P.
Hong Kong

Recent developments in China's oil market have reignited the the interest of multinational oil and gas companies in China. New onshore and offshore blocks are being granted, and the Tarim basin has been opened to foreign participation for the first time. Foreign participation is also being sought in refining and other downstream areas.

Though Chinese officials have long been viewed as difficult negotiators, the tax provisions applicable to oil and gas exploration and production in China are some of the more generous in the area. This article describes some of the relevant features of the system and some of the problem areas.

PRODUCTION SHAPING CONTRACTS

China adopted the production sharing contract (PSC) with some unique features.

A royalty is payable to the state. The Chinese national oil companies, China National Offshore Oil Corp. (Cnooc) and China National Petroleum Corp. (CNPC), respectively offshore and onshore companies, have the right to participate in any commercial discovery up to 51% and will bear their proportionate share of development and production costs.

Oil and gas exploration and production is taxed according to the three phases contained in the production sharing contract: exploration, development, and production. Special treatment is accorded costs incurred before a contract is signed and costs associated with an abandoned contract area.

A PSC is not a Chinese legal or taxable entity. The parties to a PSC, the Cnooc or CNPC affiliate on the Chinese side and the foreign contractors on the other, pay their own tax. Each contractor's PS(f interest, except in certain circumstances, is a separate taxpayer.

In China the PSC is used to calculate the gross income and its allocation among the various parties only. Tax deductions are provided under the tax lability rather than the PSC. Treatment of items for cost recovery purposes is not generally relevant for tax purposes.

APPLICABLE TAXES

Oil and gas operations are potentially subject to income tax, value added tax (VAT), stamp tax, and customs duties.

Income tax is levied at 33%. There is no tax on remittance of profits overseas. None of the generally available tax exemptions or holidays are applicable to oil and gas production.

VAT was recently introduced, replacing the Consolidated Industrial and Commercial Tax (CICT), which was a type of sales tax. The rate remains 5%. VAT is only due on the production of oil or gas. VAT is not levied on imported equipment but is payable on in-country purchases.

VAT on oil and gas production is not offsettable against VAT on purchases. VAT on capitalized purchases, e.g. asset purchases, is not offsettable either.

With the opening of the Tarim basin, the issue of VAT will be more important as much more equipment will be bought in China. One of the areas where multinationals are likely to push for concessions is in the area of VAT on in-country purchases.

Imports of equipment related to exploration, development, and production are exempt from duty. Crude oil exported is also exempt from duty.

Stamp duties at various rates are due on contracts executed. In the petroleum industry the rate is generally .05%. It is levied on the value of contracts and capital contributions. In the oil and gas context, problems arise with "evergreen" contracts which have no stated value and/or may never be used. They are more in the nature of approved vendors' lists. Other problems arise when funds are contributed by the overseas headquarters to the PSC and then spenter, worse, used to pay an evergreen contract. Stamp duty is due at each level, although it is being levied on the same funds each time.

GROSS INCOME DETERMINATION

Gross income is allocated among the state, national oil company, and foreign contractor under terms of the PSC. VAT at 5% comes off the top. Production is then allocated to state royalty, cost recovery oil, and remainder or profit oil.

The royalty is levied on a scale that increases with production. The rate varies from 4% to 12.5%.

Cost recovery oil is the sum of production expense plus exploration expense plus amortization of development expense. The maximum cost recovery production is negotiated as part of the PSC. It is usually between 50% and 60%.

Remainder oil is then allocated first to the Chinese side for its X factor - a type of special allocation that is negotiated in the PSC - and then between the foreign contractor and the Chinese side based on their interests in the field.

Both VAT and the royalty are payable in kind. Development expense is amortized over no fewer than 6 years. Unrecovered development expense is increased by "deemed interest" each year it remains unrecovered. To the extent cost-recoverable expenses exceed cost recovery oil the expenses are carried forward indefinitely.

TAXABLE INCOME

Once gross income is determined and allocated, tax-deductible expenses must be calculated.

Costs incurred during the exploration phase, be they capital or expense, intangible or tangible, are capitalized during that phase. The costs are amortizable over a period of 1 year or more from the month following the first production. Costs incurred during the development phase and capital costs incurred during the production phase are depreciated straight-line over 6 years or more on the composite method. Thus separate identifiable assets are not maintained, but instead a single mass asset account is used.

Depreciation begins the month following the month the assets are placed in service. An option is given to extend the amortization/depreciation period since the loss carry-forward period is only 5 years.

The life chosen for the amortization of exploration costs applies to all PSCs held by a foreign contractor. Thus the amortization life chosen on the first PSC affects all subsequently acquired PSCS. There are provisions for changing the amortization/depreciation period with the permission of tax authorities.

Costs incurred before the signing of a PSC and the signature bonus itself are treated as exploration costs, as are costs associated with an abandoned contract area. If a contractor abandons a contract area, unamortized costs may be offset against income from another contract area acquired within 10 years of the abandonment.

Exploration costs are amortizable against the income of any producing contract area. If a contractor has two contract areas, one in the exploration phase, the other in the production phase, exploration costs incurred on both contract areas are amortizable against income from the producing area.

TAX CONSOLIDATION

A form of tax consolidation is allowed.

The word "combination" is used because combination of businesses owned by a single company is allowed, not consolidation of multiple corporations.

Two contract areas held by the same legal entity may combine results of operations if they are both in the operating phase.

Combination of upstream and downstream operation is also allowed. The table explains the combination opportunities.

OVERSEAS CHARGES

Interest expense on the minimum work commitment is not deductible. Other interest, so long as it is not paid on capital, is deductible.

Charges from overseas affiliates representing actual costs incurred for the PSC are deductible with certification by an overseas CPA.

Royalties to the head office and management fees are not deductible.

SUBCONTRACTORS AND EMPLOYEES

Payments to subcontractors are subject to 12% withholding on the gross payment. This is in the nature of an advance payment rather than a final tax. Payments to affiliates for overseas costs are also subject to this withholding tax.

Other significant costs include the taxation of the contractor's employees. The top individual rate is 35%, but that rate applies at a relatively low level.

China applies the infinite gross-up system, which produces effective tax rates approaching 75% if the employer pays the employee's taxes.

Housing reimbursements are not taxable, but social security contributions are not tax deductible by the employer.

China is competing in the international arena for capital. Indonesia, Malaysia, Russia, and many other countries are jockeying, for scarce capital.

Although China has a relatively benign income tax regime for oil and gas, its other taxes, combined with its relatively low prospectivity and poor infrastructure, may give the edge to other potential producers.

China has shown that it will modify its terms to remain in the game. With falling domestic production and increasing domestic growth, term modification may again be on the horizon.

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