A foreign investor may acquire rights over land and natural
resources in Azerbaijan (though a foreign physical person may not
own land). Petroleum existing in its natural state in underground
or sub-surface strata in Azerbaijan, including that portion of the
Caspian Sea within its jurisdiction, is vested in the Azerbaijan
Republic.
The granting of rights to foreign investors to explore and
develop natural resources appears to be regarded by the authorities
as a form of international agreement and, therefore, authorized by
presidential decree and approved by parliament.
Until the creation of the Ministry for Fuel & Energy by
presidential decree in April 2001, the State Oil Company of the
Azerbaijan Republic (SOCAR) carried out both the functions of a
national oil company and the body responsible for negotiating
exploration licences. However, particularly since the promulgation
of the statute of the Ministry of Fuel & Energy on September 6
2001, the task of negotiating and overseeing the implementation of
production sharing agreements (PSAs) now appears to have been
vested in that ministry. However, it appears that SOCAR still
retains many of the contractual obligations of the exploration,
development and PSAs already signed, although the new ministry is
given a supervisory authority over the PSAs.
Although a draft oil and gas law has been prepared, there is no
indication of its early enactment. The law on subsoil has been in
force for some time but, as almost all PSAs have themselves been
enacted into law, PSAs do not have to comply with this law.
Overview of the oil and gas regime
Azerbaijan has one of the most favourable regimes in the region
for producers, especially from the viewpoint of taxation. Each PSA
embodies its own provisions regarding exploration, production,
development, environmental protection, employment and taxation, and
there are significant differences in important areas (eg the
profits tax rate). In addition, at least from a tax viewpoint, the
later PSAs are less attractive than the earlier ones and all apply
a mixture of special tax regulations and ordinary domestic
rules.
The governmental organs in Azerbaijan have largely applied the
provisions of the PSAs despite determined opposition from some
quarters.
Common features of PSAs
PSAs largely follow a common pattern, at least in terms of
general content:
- bonus payments and acreage fees - normally, payments
include an initial bonus, a fee when the first exploration well
is spudded, a royalty based on the amount of commercially
recoverable oil discovered, a lump sum upon attaining sustained
commercial production, and annual acreage fees;
- exploration periods - usually three years, with a
requirement that at least two exploration wells be
drilled;
- development and production periods - generally 25 years,
with the possibility of a five-year extension;
- operating company - may be incorporated inside or outside
Azerbaijan but must be registered to do business in Azerbaijan
at the Ministry of Justice;
- personnel - general freedom to employ such personnel as the
consortium members, in their opinion, require, but the
operating company must give preference to Azerbaijan citizens
and must meet certain target levels of Azerbaijan
professional/non-professional employees;
- reports and records - among those required: geological and
geophysical data, well completion reports, daily reports on
drilling operations (weekly reports on field geophysical
surveys), and a quarterly progress report;
- cost recovery - recovery of petroleum costs as follows –
all operating costs (recovered from total production); and all
capital costs (from total production) up to a maximum of 50% of
crude oil and non-associated natural gas remaining after
recovery of operating costs. Costs are recovered through the
delivery of crude oil and non-associated natural gas;
- ownership and use of assets - title to fixed and moveable
assets, the cost of which has been claimed as a petroleum cost,
are to be transferred to SOCAR once costs have been recovered
(or upon earlier termination of the PSA);
- abandonment - an abandonment fund of up to 10% of all
capital costs is to be created and payments are to commence
once 70% of petroleum reserves have been recovered;
- foreign exchange - right to open, maintain and operate
foreign exchange bank accounts, to convert local currency, to
pay expatriate salaries overseas, and to receive and hold
overseas payments for the export of their share of petroleum,
exemption from mandatory foreign exchange conversion
requirements;
- import and export - generally, imports/exports are free of
duties or VAT (subject to a customs service/documentation fee),
in respect of all equipment necessary for the proper conduct of
petroleum operations. However, any item purchased for petroleum
operations the costs of which have been included in the
petroleum operations account may not be exported. Petroleum may
be exported free of taxes;
- government guarantee - required; and
- applicable law and arbitration - generally: principles of
law common to the law of Azerbaijan and English law and, to the
extent no common principles exist, the common law of Alberta,
Canada. Disputes are subject to arbitration under the rules of
the UN Commission on International Trade Law (UNCITRAL).
Taxation
The PSAs set out the method of calculating profits tax for the
various field participants. The methods of calculation are based on
standard western tax computation methodologies. Each participant is
permitted to keep books in dollars and to calculate taxable
profits/losses in dollars. Tax losses may be carried forward
indefinitely. The rate of profits tax is normally fixed in the PSA
and subsequent legislation is not permitted to apply.
The profits tax rate has, for the most part, been fixed at 32%,
although the standard rate for companies operating outside the oil
and gas sector is 27%. The tax is generally paid by SOCAR on behalf
of the oil companies out of its share of profit petroleum.
The PSAs also provide for complete exemption from import duties
and the full zero-rating of all supplies of goods and services for
value added tax (VAT) purposes.
The special advantage of the tax regimes in Azerbaijan is that
they extend beyond the field participants, to subcontractors and
foreign sub-contractors (FSCs) with respect to certain taxes.
Foreign sub-contractors: profits tax
Profits tax for FSCs is calculated on a deemed profits basis and
collected through a withholding mechanism.
There are four withholding tax rates in operation which are
applicable to FSCs. The rates are set by assuming a deemed profit,
usually 25%, and applying a fixed rate of corporate profits tax (in
the main, 32%).
The Tax Code 2000 (which came into force on January 1 2001)
states that, in the event of conflict, the provisions, whether or
not adopted prior to the entry into force of the code, of PSAs or
of agreements relating to main export pipeline routes, take
precedence over the code and normative legal acts passed pursuant
to it.
Leaving aside the legality or effectiveness of attempting to
bind the legislature in this way, through the artifice of treating
PSAs as international agreements, it might be expected that with
such a sweeping statement persons operating under the umbrella of
PSAs could remain blissfully unaware of the contents of the code.
This will not always be the case, in particular where a taxpayer
has a mixture of both PSA and non-PSA income. And, indeed, in
respect of employees who are Azerbaijan nationals, domestic tax
legislation has always applied even to those working within the
framework of a PSA.
Each of the PSAs has its own reporting regime. In principle,
these are very similar but there are differences in detail: the
formats for tax returns, slightly different reporting dates etc.
The tax protocols made under some PSAs permit a multi-PSA FSC to
elect under which PSA it will make all its returns. This, however,
is relatively rare. Indeed, under some PSAs, the normal Azerbaijani
reporting requirements apply, so some unlucky FSC taxpayers will
find themselves reporting as if they were not operating under a PSA
as well as under one or more PSAs.
Conclusion
The eventual adoption of the long-awaited law on oil and gas
appears uncertain, and PSAs, both existing and those to be
negotiated with the Ministry of Fuel & Energy and passed into
law, are likely to continue to govern the method by which oil and
gas operations are conducted. This has the advantage that oil and
gas operations are relatively insulated from changes in the law but
gives rise, at times, to mind-boggling complexity.
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