Outlines of the Presentation of Dr. Irina Paliashvili,

the President of the Russian-Ukrainian Legal Group,

at the Seminar on the Legislation

on Production Sharing Agreements,

September 14,1998

THE CONCEPT OF PRODUCTION SHARING

I. Introduction: Historical Background

II. The Production Sharing Agreement (“PSA”) Concept

A. General Principles of PSAs

B. Basic Distinguishing Characteristics of PSAs

1. The Subject of a PSA

2. The State as a Party to a PSA.

3. The Activity of an Investor at its Own Expense and Risk

4. Ownership of Product Produced Under a PSA and the Contractor Nature of an Investor Under a PSA

5. The Sharing of Product: Substance and Procedure

6. PSA and Taxation

III. Characteristics Distinguishing a PSA from Other Forms of Subsoil Use

IV. Conclusion: Significance of the PSA for the National Economy and the

Protection of the Interests of Investors

I. Introduction: Historical Background

The first concept for the production sharing was used in Bolivia in the beginning of the ‘50s. But agreements on production sharing, in their current form are instruments of legal regulation of relations between a state and an investor in the sphere of the extraction of useful minerals (in particular oil) were successfully applied in Indonesia in the 1960s and gradually recognized by leading international oil & gas companies.

Since those times, PSAs have received wide applications in countries with economies in transition. PSAs as a form of cooperation between an investor and a state in the process of the use of the subsoil now actively is used in more than 40 countries, including Angola, Vietnam, Libya, Egypt, Malaysia, Peru, Syria, the Philippines, Equatorial Guinea and others. In recent years, PSAs have begin to be used in the CIS: e.g. Russia, Azerbaijan and Kazakhstan. In 1995, the Russian State Duma adopted the Federal Law “On Agreements about Production Sharing”, and at the present time several investors already are conducting their activity in Russia under PSAs, although this law is not yet being widely applied because of the lack of subsequent legislation.

II. The Production Sharing Agreement (“PSA”) Concept

A. General Principles of PSAs

PSA – this is a special form of subsoil use relations based on civil-legal contractual principles for relations between a state and an investor with respect to prospecting, exploration and extraction of mineral resources.

PSA – a contract pursuant to which the state (owner of the subsoil) entrusts the investor to conduct prospecting, exploration and extraction of mineral resources within the confines of a defined subsoil area on a compensated basis and for an established time period during which the investor is obligated to conduct the indicated work at its own expense and own risk.

B. Basic Distinguishing Characteristics of PSAs

The principal distinguishing characteristics of a PSA from other types of a civil legal agreement are set forth below.

1. The Subject of a PSA

The subject of the given contract is the agreed program of the parties for the extraction of mineral resources which must be fulfilled by the investor in favor of the state. Such program includes the type, costs and period of performance. In other words, the state has hired the investor as a contractor to perform the work envisioned by the program.

As a result, contractual relations arise between two legally equal parties, each having rights and obligations, the violation of which shall entail their legal liability.

The State hires the investor as a contractor for the conduct of work connected with the extraction of useful minerals. At the same time, it takes onto itself the obligation to transfer to the investor for use the subsoil area specified in the agreement. In the majority of countries in the world (including Ukraine), the subsoil belongs to the state. The state has a monopoly over the use of the subsoil and the removal from it of natural resources. The granting to an investor of exclusive rights denotes that the state during the period of PSA’s validity, is obligated to abstain on the given subsoil area from activity included in the volume of the transferred rights and not permit such activity on the part of third persons. Only the investor may conduct activity envisioned by the agreement. But this does not mean that the investor shall obtain unlimited rights. The exclusive rights being transferred to the investor are limited by: (i) the types of activity envisioned by the agreement, (ii) the types of minerals indicated in the agreement, and (iii) the terms indicated in the agreement.

2. The State as a Party to a PSA

A PSA as a civil-law agreement is concluded between legally equal parties: the state and an investor. All conditions for use of the subsoil and the performance of work is established by the parties by mutual agreement.

Nonetheless, one has to take into account that the state participating in the agreement preserves its state prerogatives. Therefore in relations for subsoil use arising on the basis of a PSA, the state acts in two roles: on the one hand it fulfills its obligations under the agreement, and on the other hand it preserves its state public-legal functions. These roles may converge or come into conflict with each other. In their delineation, one should be guided by the following principle: within the scope of conditions provided by the agreement, the state and the investor are equal partners, outside such scope - the state makes decisions related to subsoil use on an authoritative, administrative-law basis.

3. The Activity of an Investor at its Own Expense and Risk

The investor carries out the activities envisioned in the agreement (prospecting, search, exploration, extraction and other works) at its own expense and risk. The state, as the other party to the agreement does not bear any expenses or risks. If the investor invests funds in the prospecting and exploration but did not discover any minerals, or discovered that their extraction would be economically unprofitable, the expended funds shall not be refunded to the investor. This is a basic principle of a PSA. The parties, however, may agree otherwise.

4. Ownership of Product Produced under a PSA and the Contractor Nature of an Investor under a PSA

Under a PSA, the state transfers to the investor only exclusive rights to conduct activity involving a subsoil area, but does not transfer rights to such subsoil area into either ownership or lease. Therefore, all extracted minerals or extracted and processed minerals (i.e., the produced product) are the property of the state. The state hires the investor as a contractor to perform work for it, but at the expense and risk of the investor. The work is carried out on a compensated basis, with the state paying the investor not in money, but with a portion of the produced product. This is the so-called production sharing, i.e., the sharing of the results of the work carried out by the investor.

5. The Sharing of Product: Substance and Procedure

Production sharing is the central part and the main distinguishing characteristic of a PSA. This principle actually gave the agreement its name.

In order to determine the volume of the extracted raw materials and to carry out production sharing, the concept of the “point of measurement” is used - an arbitrary point related to the movement of extracted raw materials specified by the parties in the agreement (the mouth of the shaft, the delivery point, etc.). At the point of measurement all the raw materials being extracted is the property of the state. The production sharing is also carried out at the same point and usually follows the following procedure:

n from the product produced by the investor is separated that part that goes toward the compensation of the investor’s expenditures (cost-recovery product);

n that part of the produced product that remains (profit product) is divided between the investor and the state in a proportion provided in the PSA.

From the time of production sharing at the measurement point the investor has the right of ownership to the cost-recovery product and its part of the profit production.

The conditions for production sharing between the state and the investor are determined in each specific agreement.

As a result of the production sharing, the state, without investing its own funds into the prospecting, exploration and extraction of mineral resources and without bearing any commercial risks, receives a substantial part of the product produced by the investor. Instead of the product, the investor may transfer to the state its value.

6. PSA and Taxation

During activities on the basis of a PSA, a special tax regime is used for the investor. Within the time period of validity of the PSA, the existing state taxes and other mandatory payments are replaced by a part of the profit product. They are taken into consideration while drafting an agreement to determine the part of the product produced by the investor which remains in the ownership of the state. Apparently, no tax privileges are granted to investors. The existing tax system is simply replaced by production sharing in the case of the use of a PSA.

Production sharing between the state and the investor is carried out on the basis of principles determined in each specific agreement.

There are two known systems for replacement of taxation by production sharing:

n complete replacement of taxes by a part of profit product (for example, in Libya, the state divided the produced products between itself and the investor in the proportion 81:19 without levying any taxes or fees);

n partial replacement, when simultaneously with production sharing is envisioned the levying of certain taxes (for example, in Russia profit tax and fees for subsoil use are levied, and in Indonesia - income tax and a divident tax are imposed).

Therefore, the PSA concept, on the one hand, protects the interests of the state, and on the other - makes the investor immune from the changing tax policy of the state. Production sharing creates a new procedure for subsoil use, as an alternative to the conventional tax system, in accordance with which individual characteristics of subsoil use are taken into account on a contractual basis in each PSA.

III. Characteristics Distinguishing a PSA from Other Forms of Subsoil Use

In the world practice, the concession and licensing forms of subsoil use are widely used.

A concession is a civil agreement under which the state provides on a compensated basis and the investor purchases the exclusive right to the use of a subsoil area for agreed-upon purposes, in particular, for prospecting, exploration and extraction of useful minerals, bears all expenses and risks, as well as makes payments to the state for the use of the subsoil and for all other taxes and mandatory payments envisioned by law. A concession by its legal nature is a type of a lease agreement.

The licensing system of subsoil use is by its nature administrative-authoritative. Under the licensing system, the investor also purchases from the state the exclusive right to use a subsoil area for the extraction of useful minerals. The investor is also the owner of the extracted raw materials, bears all expenses and risks, makes payments to the state for the use of the subsoil and all other taxes and fees envisioned by law, but the state structures its relations with the investor on an authoritative, administrative- managerial basis. By granting a license, the state by its authoritative act permits the investor to use the subsoil on conditions established by the state unilaterally. In the same manner, the state may withdraw its decisions, limit the rights of the investor or completely withdraw the investor’s rights and revoke the license.

Under a PSA the relations between the state and the investor are contractual, that is formally equal. In the agreement itself, the parties define conditions governing the transfer of subsoil for use. The produced product is the property of the state, and after production sharing at the measurement point, a certain part of it is transferred to the ownership of the investor. A PSA is a type of contract where the right of ownership belongs to the customer [i.e. the state], and the contractor receives compensation for the performed work.

In this case the tax system envisioned by law is replaced by a special new system of settlements between the parties - production sharing.

When subsoil is used under a PSA, a license issued by the relevant body of the state is also needed. But its role is different. The rights and responsibilities of the parties are determined in the agreement itself, while the license only exists for purposes of formalizing and registration when a right to use the subsoil arises.

IV. Conclusions

It follows that in the environment of a transitional economy and changing legislation, subsoil use under PSAs is desirable both for the state and the investor. It is desirable for the state because:

n attracting substantial volumes of investment, including foreign, to the exploration and extraction of useful minerals is important not only for the stable functioning of the economy but also for ensuring the national security of the country by means of reducing dependency on energy imports;

n exploration and extraction of useful minerals demands less material-financial resources which the state does not have. The necessary resources are contributed by the investor;

n the state has the opportunity to conclude long-term agreements with investors on the basis of which it can calculate future growth in the extraction of oil, gas and other useful minerals, as well as budget income;

n instead of tax payments, which as practice shows are often difficult to collect, the state receives a certain fixed part of the extracted product.

It is also desirable for the investor to invest under a PSA, because it gives such investor a greater degree of independence from the constantly changing tax system. The relations of the investor with the state under a PSA are in large part structured on a civil-legal basis. Of particular importance to the investor is the stability of legal relations between the state and itself in the time-period of validity of the agreement.