Russian Petroleum Investor
Volume IX, Issue 1
Dr. Irina Paliashvili is president of the Russian - Ukrainian Legal Group, a Washington, D.C.-based law firm, with affiliated offices in Moscow and Kiev, that provides a full range of legal services to international corporate clients. The Russian - Ukrainian Legal Group participated in drafting the production sharing legislation for Ukraine under a technical assistance project sponsored by USAID and the US Department of Energy under the auspices of the US-Ukrainian Binational Commission. To obtain more information about the Russian - Ukrainian Legal Group, please visit its Web Site at www.rulg.com.
Ukraine Enacts Production-Sharing Legislation for Natural Resources
By Dr. Irina Paliashvili
Ukraine recently joined an increasing number of countries that offer a production-sharing regime to investors in the natural resources (most notably oil and gas) sector. On October 12, a new Law on Production Sharing Agreements took effect in Ukraine. The general reaction of the investment community to this development is quite positive. The common opinion is that the adoption of the modern and investor-friendly PSA Law will open channels for major investment in Ukraine’s economy and will expand Ukraine’s own natural resources base.
Although Ukraine’s adoption of the PSA Law on Production-Sharing Agreements on October 12 is a fundamental stage in the establishment of a PSA regime, a few more steps still need to be completed before this regime will be fully effective. The Ukrainian legal system requires that any new law that changes existing legislation be followed by a law introducing such changes and amendments. Since the PSA Law introduces several fundamental changes to existing Ukrainian legislation, most notably in the area of taxation, it must be followed by a Law on the Introduction of Changes and Amendments to the Legislation of Ukraine on the Basis of the ‘Law on Production Sharing Agreements’ (commonly referred to as the enabling law). Such an enabling law was adopted by the Supreme Rada (Ukrainian Parliament) in the first reading in July and is now pending before the Rada Committee on Economic Policy. Adoption of this law is expected by the end of 1999.
In addition, a number of implementation acts based on the PSA Law and the enabling law will have to be adopted, including respective decrees by the Cabinet of Ministers and normative acts by various ministries.
Analysis of Key Features of the PSA Law
The PSA Law is organized into six sections: (I) General Provisions; (II) Conclusion of Production Sharing Agreements; (III) Implementation of Production Sharing Agreements; (IV) Currency Regulation during Implementation of Production Sharing Agreements; (V) Peculiarities of Regulating Labor Relations during Implementation of a Production Sharing Agreement; and (VI) Final Provisions.
The following summarizes the new law’s key features, focusing on typical investor concerns with respect to PSA legislation in general and how the PSA Law deals with these concerns.
Tender Requirement: The PSA Law provides that, as a general rule, PSAs will be granted through tenders organized by a special Inter-Departmental Commission. There are two exceptions to this general requirement:
(a) subsoil users that held a valid license as of July 1, 1999, and have commenced the activities pursuant to such a license, may request conversion of this license into a PSA without a tender (the conversion is not automatic and will require a decision by the Cabinet of Ministers);
(b) if a deposit has low mineral reserves (the threshold will be established by the Cabinet of Ministers), an investor may be granted a PSA without a tender, upon a decision of the Cabinet of Ministers and the respective body of local self-government.
List of Subsoil Areas Eligible for PSAs: One of the advantages that the PSA Law has over its Russian counterpart is that lists of subsoil areas subject to PSAs in Ukraine are approved by the Cabinet of Ministers, rather than the Parliament.
Domestic Supply Requirement: The PSA Law stipulates that, unless otherwise provided for in the PSA itself, the investor may freely dispose of its portion of the project’s output. The investor is not subject to licensing or quotas when exporting, or to similar restrictions on sales in Ukraine. A PSA may require the investor to sell to the state or within Ukraine a portion of its production at world prices (Article 22), but only if such a requirement was set forth in the tender terms and conditions.
Local Content Requirement: The PSA Law, Article 8, provides that the PSA should state the investor’s obligations to grant preference to products, works, and services of Ukrainian origin that meet “international standards” and are competitive in terms of quality and price.
Local Employment and Training: Similarly, Article 8 of the PSA Law envisions that a PSA should set out the investor’s obligation to hire and train Ukrainian nationals, but the precise obligations are left to the parties to negotiate. In addition, Article 35 provides that the investor may hire foreign citizens “within the scope and for the (specialty) positions determined by the PSA without the need for obtaining a work permit.”
Assignment of Rights: Article 26 of the PSA Law allows for the possibility of the investor’s assigning (selling, transferring) its rights and obligations under a PSA to another entity, such as a related company. Relevant licenses and permits to the assignee must be re-issued within 30 days.
Unrestricted Carry-Forward of Losses: Although current Ukrainian tax legislation limits the carrying-forward of losses to five years, the PSA Law provides specifically that an investor’s expenses may be attributed to subsequent tax periods for taxation purposes without any limitation (Article 25, Paragraph 3).
Limits on Cost Recovery Production: The amount of cost-recovery production is limited to 70% (Article 19.3).
Control by the State: Article 28 of the PSA Law requires a comprehensive audit by the state of each PSA project every five years. In the case of substantial violations by the investor, the Cabinet of Ministers must terminate the respective PSA through a dispute-resolution forum denoted by the parties in their PSA.
Guarantees against Unfavorable Legislative Change: The PSA Law contains two provisions in this area, both of which have certain limitations. The first provides that Ukrainian legislation in force on the date of conclusion of a PSA shall apply to the rights and duties of the parties, unless otherwise provided for in the PSA, with the exception of changes in legislation in the areas of “defense, national security, ensuring civil order, and the environment.” The second exempts investors from normative and legal acts of executive and local authorities in the event that such acts limit the investor’s rights provided for in the PSA, with the “exception of directives of state control and supervisory bodies issued pursuant to Ukrainian legislation in order to establish conditions for the safe performance of works, protection of subsoil, environment, and people’s health.” While this language is not unusual in PSA legislation throughout the world, such guarantees are often difficult to implement in practice, and there is, of course, the considerable risk that these exceptions will be broadly construed.
Dispute Settlement and Waiver of Sovereign Immunity. The PSA Law allows the parties to determine the method of dispute resolution themselves, thus providing an opportunity for the use of international arbitration. Also of importance, the PSA Law contains an explicit waiver by Ukraine of its sovereign immunity with respect to its obligations under a PSA, including with respect to the preliminary enforcement of a claim or enforcement of a court ruling.
No Need for Local Partners. The PSA Law does not require an investor to take on a local partner. Nonetheless, the Ukrainian government and its local agencies are likely to encourage it.
Obtaining Various Approvals. The PSA Law provides for government guarantees with respect to the granting of various approvals (licenses, permits, etc.) in favor of the investors. Article 4, however, states that these approvals shall be issued in accordance with the requirements set forth in Ukrainian legislation. The enabling law and implementation acts must provide for a streamlined procedure for the investor to obtain such approvals.
Customs Treatment of Goods and Property Imported for the Purposes of Implementing a PSA. The PSA Law does not currently provide for a simplified procedure for the customs clearance of items imported in connection with the implementation of a PSA. In addition, the PSA Law neither provides for an excise tax exemption for property imported into Ukraine, nor does it allow for the temporary import of goods (equipment) for a period longer than one year. It does, however, provide for a value added tax exemption for such imports.
Special Tax Regime
The PSA Law’s tax provisions deserve a detailed examination that space constraints do not allow. Article 25 establishes a special tax regime for the investor. It provides that the investor shall be subject only to the following taxes and mandatory payments throughout the term of the PSA’s validity (up to 50 years):
· value added tax (import of goods and property for the needs of PSAs is exempt from VAT; export of the investor’s production is subject to VAT, but the current rate for exports is zero);
· a tax on the profit of enterprises (which may also be paid in kind), with special rules for the calculation of this tax established in Paragraph 3 of Article 25;
· a fee for geological exploration works performed at the expense of the state budget, as established in an individual PSA;
· payments for the use of subsoil, as established in an individual PSA;
· payroll taxes, such as payment for mandatory social insurance and payment for mandatory state pension insurance for employees (local or foreign) employed in Ukraine;
· excise taxes (including during the import of excisable goods, though this is not stated explicitly in the PSA Law);
· Article 25 also exempts foreign investors from the profit repatriation tax.
One of the major criticisms of Article 25 is that it does not adequately set out what expenses are deductible for profit tax calculations. On the other hand, since the PSA Law is quite flexible on the composition of the costs subject to recovery, investors will have an opportunity to recover some costs that are otherwise not tax-deductible, through the cost-recovery production.
In addition, foreign investors have complained that it does not exempt them from having to make VAT payments on locally purchased goods or on local sales of output (which would be difficult to recover under the current VAT regime).
In general, the PSA Law meets international standards desired by the industry and, in many respects, is much more investor-friendly than the PSA legislation of other CIS countries. Of course, creation of a solid and transparent legal basis for the PSA regime will also depend on the enabling law and implementation acts. In practical terms, however, the success of PSAs in Ukraine will be determined by the willingness of the government to encourage and support investment on the PSA terms. Ultimately, whether or not foreign companies invest in the Ukrainian natural resource sector will depend on their assessment of the potential rewards and the political risks.