Russia's new PSA law offers some benefits vs. JV appoach

March 6, 2000
Turning around Russia's oil industry poses challenges as huge as that nation's alluring potential must seem to the foreign majors that would pursue investment there.

There are two main vehicles of investment opportunity that are usually considered by foreign investors-joint ventures (JVs) and production-sharing agreements (PSAs).

JVs are formed between Russian companies and foreign partners, which then apply together for a license to develop an oil field. A legal framework called the general subsoil regime regulates operations within these JVs, unless the JV has established a PSA with the government.

Under the general subsoil regime, the licenseholder receives from the Russian state the right to use the subsoil on terms and conditions set up by the license. Therefore, all obligations and rights of the JV license holder are determined, controlled, and enforced by the state.

Unfortunately, the license can also be revoked or transferred to another entity by the state. Thus, the nature of the relationship between the JV and the state within the general subsoil regime is not contractual but administrative.

Over the past 8 years, a complicated, expensive, and opaque tax system, which centers on a plethora of federal value-added (VAT), profit, and export taxes, has led to a halt in JV activity. This problem is further compounded by a long list of regional and local taxes that vary from oblast to okrug and city to city.

Thus, of these JVs, very few oil ventures have recouped their original capital investment. To make matters worse, laws regarding the conversion of foreign currency and an inefficient banking system have made it extremely difficult for companies to repatriate their profits.

A new possibility

The PSA, on the other hand, provides an alternative to the taxation and license system found in Russia, adding the stability of a contract and the replacement of taxes with production-sharing.

In this case, the state offers resources, while the investor offers the money to invest in such things as development of an oil field and the creation of industrial infrastructure. The state's interests may be held by the Ministry of Fuel and Energy, the Natural Resources Ministry, or other agencies authorized by these two ministries.

Reserves extracted during the project are divided in accordance with PSA conditions previously agreed among participating parties, and these conditions remain unchanged for the whole period of the contract that the investor signs with the state.

Under a PSA, a Russian company that already holds a license to develop an oil field and its foreign partner(s) create an entity or an association of legal parties. This entity or association then enters into agreement with the state, becoming parties to a commercial contract.

The nature of this relationship is contractual, and the terms of the contract determine the rights and obligations of the parties. The PSA signed between parties determines the scheme of production-sharing between them.

The partners are obliged to give to the state either a share of produced oil determined by the PSA or its monetary equivalent. This payment to the state is exempt from VAT and the normally levied subsoil exploitation fee.

The procedure established for production-sharing includes the following steps:

  • Assess total volume of oil to be produced.
  • Determine the portion of oil produced that will be given to the partners as compensation for costs incurred in conducting works and services under the PSA.
  • Share between the partners and the state the profitable oil or the oil that remains once the partners have recovered costs.
  • Transfer to the state its share of oil produced or its monetary equivalent.

At this end of this cycle, the partners can then retain their share of produced oil.

Pluses

There are certain benefits to the new PSA. First, the PSA model should allow investors greater predictability as they seek to develop a model for their operations in Russia. Second, because taxes and payments are determined and fixed by the PSA, the investor has a clear understanding of what tax payments it must make over the contractual period.

For example, the investor is exempt from standard corporate taxes, duties, excise tax, and other obligatory payments as these are replaced by the sharing of production with the state.

The only taxes applicable to PSA investors are profit taxes and royalty payments, payable at fixed rates for the duration of a project. The investor is also exempt from customs duties and customs VAT.

This provides a substantial advantage that is particularly important for investors when they import equipment that is required for work under the PSA. Contractors engaged in conducting work under the PSA can enjoy this same benefit.

The new PSA also provides great stability to an investor, compared with the general subsoil regime, as changes can be introduced to the PSA only upon mutual agreement of the parties. Partners own the whole volume of produced oil, and such production can be exported from the territory of the Russian federation on terms and conditions determined by the PSA.

In addition, partners and subcontractors that are engaged in works and services under the PSA are not obliged to place part of their hard-currency revenues on the hard-currency market of the Russian federation.

Guarantees

In contrast to JVs, the state also guarantees that the investor will maintain all proprietary and other rights acquired and used under the PSA.

The state cannot terminate the PSA unilaterally; it can be terminated only under the regulations applicable to commercial contracts.

The rights acquired by partners in accordance with the PSA cannot be revoked by normative acts by federal executive bodies or subjects of the Russian Federation.

In addition, according to the PSA law, investors can claim compensation for losses if the state does not fulfill or improperly fulfills its obligations.

Minuses

According to Ivan Trifonov, a lawyer with Macleod Dixon, Moscow, new investors cannot immediately consider the PSA a viable option for their investment.

First, the PSA cannot be applied if the PSA-involved deposits exceed 30% of the Russian Federation's resource base (reserves categories A+B+C1+C2). As soon as this 30% threshold is exhausted, any increase in the quota will require new changes in the federal PSA law (Article 2, Clause 3).

Second, the PSA cannot be applied unless the deposit is included in the list of deposits approved by the federal law for PSA purposes (the List Laws) or by the Resolution of the Government and the Decision of the Body of State Administration for each particular region (Article 2, Clause 5).

"Both procedures are extremely time-consuming, and only five federal List Laws have been passed since 1995," Trifonov told OGJ. Currently, PSAs can be applied in 19 areas (see table on p. 28)

Third, new investors do not immediately become "the investors" to whom the provisions of the PSA law apply.

The general rule is that the PSA is signed with the winner of a competitive bid carried out in accordance with Russian law.

Article 6, Clause 2 sets up an exception for those companies that held mineral licenses for deposits on the date the PSA law was passed. In this case, no competitive bid is required. In other words, for those companies that are "grandfathered in," the general subsoil regime can be converted into the PSA.

However, the List Law rule is still applied when new investors join the PSA at the corporate level rather than at the stage when terms and conditions are negotiated with the government.

Finally, the importance of the PSA in its current form will be significantly decreased once Russian lawmakers improve the general subsoil regime-for example, when issues related to a number of taxes applied are addressed.

Nevertheless, "There is no doubt that the PSA has advantages which do not exist under the general subsoil regime," Trifonov said.

"The value of such advantages, however, is not high, if the advantages can only be used by a very limited number of companies."