Several pieces of legislation have been adopted recently that will help form a special tax regime for projects operating under production sharing agreements.

The draft law "On Direct Production Sharing" is awaiting the president's signature. It was adopted by the Federation Council and establishes a simplified procedure for production sharing between the government and investors.

It is well known that the law "On Production Sharing Agreements" (PSA) basically substitutes some taxes and duties for production sharing. In other words, an investor running a PSA project is exempt from taxes and duties, except royalties, profit tax, universal social tax and duties on the use of land and natural resources.

A special taxation system for PSA needs to meet the following two basic requirements. It must fit in with the principles established in the law "On Production Sharing Agreements" and be compatible with the Russian Tax Code and other legal and executive acts concerning taxation.

The State Duma Committee on Budget and Taxes, together with representatives of the fiscal structures, drafted a relevant document that was submitted to the Duma on January 23, 2001. But on April 26 the Finance Ministry refused to cooperate and put forward its own draft. Finally, it was decided that the latter document should be finalized and submitted to the government by June 20, 2001.

The Finance Ministry's draft provides for a dramatic increase in the number of taxes (from four to 22) and, what is worse, establishes that investors' expenses cannot be reimbursed in excess of the limits set by the agreement. This means that it will not be long before such "limits" appear in every PSA. And the larger the number of taxes the less production is left to be shared between the parties of a PSA. This is a step back toward the existing taxation system that we have been trying to put straight for six years.

On April 13, 2001, the Consultative Council on Foreign Investments in Russia, the European Business Club, the American Chamber of Commerce's Russian branch, the German Economic Union and the Oil Consultative Forum, who represent the interests of foreign investors in Russia, sent a letter to Economic Development Minister German Gref where they clearly stated that the Finance Ministry's draft law was not in line with the law "On Production Sharing Agreements." They said it "will not help create any adequate conditions for investments," that it "undermines the foundations of the production sharing principles and ideas," and "leaves no opportunity for any long-term economic assessments."

The letter, which definitely deserved serious attention, was shown little respect by the government. As if deriding it, the government meeting that convened shortly after it was received resolved "to uphold the main principles of the Finance Ministry's draft."

Without waiting for the deadline of June 20, the Finance Ministry finalized the draft and submitted it to the government on May 11. Compared with the initial draft, the final version showed some improvements as well as some changes for the worse. For example, a number of purely conventional payments, such as "compensation to the state for exploratory and prospecting work," were classified as taxes.

In their letter, the investors gave a highly positive appraisal of the draft law prepared by the State Duma Committee on Budget and Taxes. The letter said that the adoption of this draft "with some amendments and appendices would be a major step forward and … would signal the improvement of Russia's investment climate in the oil and gas industry."

The investors' opinion was ignored, and the Duma's Committee's proposals were rejected right away.

Another dangerous provision in the government's draft substitutes "royalties" for "extraction tax." As things stand, the "royalty" rate varies between 6 percent and 16 percent and is specified in a PSA license, while the government's draft calls for setting the "extraction tax" at 16.5 percent. Obviously, this may push some of the PSA projects out of business.

According to estimates made by the head of the YUKOS oil company, Mikhail Khodorkovsky, the substitution of "royalties" for "extraction tax" will nearly double the tax burden.

The cost of oil production and operational efficiency of an oil company strongly depend on the deposit's location, depth of the oil layer, deposit's capacity, and so on. The proposed "extraction tax" does not take these differences into account.

So, the "extraction tax," if introduced, will cause numerous problems and require existing licenses to be revised. What is worse, the tax will destroy the present rational use of natural resources and provoke social and political destabilization in a number of regions. For many oil provinces, especially the old ones located in Tatarstan and Bashkortostan, the tax may well turn out to be too much.

In other words, the government's draft law will stimulate operations at the richest oilfields and will force companies to abandon deposits as soon as oil production costs increase, leaving the problems to future generations.

Meanwhile, the adoption of the draft law "On Direct Production Sharing" has made both the Duma and Finance Ministry drafts obsolete. This gives all interested parties – the State Duma and the government – one more chance to draft a sensible version of the Tax Code's article "On Production Sharing" to make it possible for Russia to take part in serious talks with potential investors.

(The author is a member of the Expert Council, part of a State Duma commission in charge of Production Sharing Agreements)