All the major oil companies active in Russia will see their operations radically altered if a bill introducing "direct sharing" agreements passes in the Federation Council, upper house, and is signed into law.

The draft law introduces a simplified alternative to the current PSA law, which governs how oil production is shared between the state and the private sector.

However the new proposed regime may create an obstacle to foreign investors, exposing them to the threat of double taxation – taxation in Russia and at home – while Russian investors may significantly lose out if there is a slight slump in world oil prices.

Apparently, the newly proposed regime is exclusively beneficial to the state.

Industry Overview

The oil industry is the backbone of the Russian economy and one of the main sources of export revenue. The industry saw a significant decrease in production from 1991—1993. But since 1997, the Russian Federation has been steadily producing almost 300 million metric tons (MT) of crude per annum.

According to the estimates of the Russian Energy Ministry (MinEn), by 2020 oil production will increase to 350 million MT per year. In 2000 alone, the volume of production increased by 18 million MT on the previous year.

As of January 2001, there were over 180 oil-producing companies in Russia, including 13 vertically integrated giants and consortia.

Foreign oil companies hold stakes of different sizes in around 43 Russian oil producers. However, very few oil producers develop their oilfields on a production-sharing basis.

There are three so-called "early" Production Sharing Agreements (PSAs), concluded prior to the adoption of the PSA Law in 1995: Sakhalin I, Sakhalin II and Khariyaga. Twenty-one further oilfields representing 27 percent of all explored oil reserves in Russia are planned for development on a production-sharing basis.

The Basics: What is a PSA?

A PSA is an agreement the state makes with an investor. That agreement grants exclusive rights for exploration, development and production of mineral resources on the subsoil area defined in the PSA over a certain period of time. In return, the investor performs the operations for his own gain and at his own risk.

Under a conventional PSA, an investor pays duties on its oil production in three stages: 1) a royalty payment to the state on the oil-production output; 2) a share of the profit oil, and 3) profit tax.

The original 1995 PSA Law appeared to offer many of the provisions that would be expected of any PSA regime in the world; in particular, guarantees from the state that PSAs would effectively be treated as civil law contracts operating under a self-contained PSA Law regime with a specific tax regime guaranteeing long-term fiscal stability.

However, several existing laws (including the Subsoil Law and some tax and customs legislation) clashed with the newly established PSA law, and cast doubts on the benefits provided to investors under the PSA law.

Recent Developments

In the last two years, the legal framework for PSAs has been altered radically. At the beginning of 1999, the Russian parliament introduced wide-ranging amendments to the PSA Law, which were set to harmonize the legislation with the 1995 PSA law.

The PSA law states that not more than 30 percent of Russia's recoverable petroleum reserves may be developed under PSAs and estimates indicate that signed PSAs now account for 23 percent of Russia's oil reserves.

This limitation will definitely cause problems in the short term. The State Duma lower house of parliament's committee on energy, transport and communications has suggested that this limit be increased from 30 percent to 40 percent.

This amendment was considered by the Duma in the first reading during the autumn of last year. Another solution under discussion could be to exclude oilfields that have already been developed under a PSA regime from the 30 percent quota.

The most recent development, which could shortly be signed into law, sees an alternative to the production-sharing regime under PSAs.

On May 23, the Duma approved, on its third reading, a draft law introducing a direct-sharing model. It will be considered by the Federation Council later in June and, if approved, will be sent to the president to be signed into law.

This recently approved and fundamentally new scheme of production sharing, if accepted into law, would be applied in parallel with the existing method.

According to this direct-sharing scheme, an investor is exempt from all taxes and payments, including profit taxes and royalty payments, and instead hands the state a share of produced minerals defined by the terms of the agreement. In doing this, the investor covers his costs from the output left over after sharing.

Negative impact

The negative impact of the direct-sharing scheme on the terms of taxation for foreign oil companies in their home countries may become an obstacle to implementing the direct-sharing method, and a disincentive for foreign investors.

Under the direct sharing scheme, foreign investors may face the threat of double taxation. This threat arises from the possibility of "home" countries not recognizing, for double tax-treaty purposes, any payment made under a regime that offers a "choice" – in other words, if a choice is offered, the payment could be considered "voluntary" (i.e. by commercial agreement) and would therefore not qualify as a "tax" and thus not qualify for relief under a double tax treaty.

The draft law is also controversial from the standpoint of Russian oil companies. According to representatives of Russian oil companies, the proposed model will only be convenient if world oil prices are very high, and the cost of oil production in Russia is low. Otherwise this model will be beneficial exclusively for the state.

(The author is a Partner of International Law firm Lovells, Moscow.)