Taxation of the Oil Sector: An Analysis of Budget and National Fund Dependence on Oil and on Tengizchevroil

Taxation of the Oil Sector.

Part 1: Analysis of Tax Revenues from the Oil Sector

Taxes paid by Kazakhstan's oil sector are the key source of revenue for the National Fund of the Republic of Kazakhstan and for the state budget. The current system of oil sector taxation should therefore be a priority of the state's tax policy.

In taxing the oil sector, the tax burden should serve several functions:

• To capture the excess profit from oil operations, since they make use of the subsoil resources owned by the state of Kazakhstan.

• To encourage further processing of raw materials in order to diversify the economy.

• To encourage the development of the industry at different stages of its life cycle (from exploration to decommissioning of fields).

Tax policy exists to serve these purposes, and Kazakhstan is no exception.

Before the Tax Code was adopted, each subsoil user in Kazakhstan had its own tax regime. When subsoil use contracts were signed, users were guaranteed tax stability, and tax rates were therefore fixed. When the Tax Code unified the system, almost all subsoil users signed up to the new tax regime and in effect gave up their tax stability.

Today only a few companies have a stable tax regime, among them Tengizchevroil LLP and Karachaganak Petroleum Operating.

This is undoubtedly a serious drawback, because it is hard for oil producers to plan their operations. For example, when the Government on its own initiative introduced an export customs duty on oil, thereby further increasing the tax burden on the oil sector, the decision was unpredictable for investors. It may have been justified, but it has a strong effect on the country's investment climate. A stable tax system is one of the foundations of a healthy investment climate.

All tax revenues from the oil sector go to the National Fund of the Republic of Kazakhstan. The National Fund then makes transfers to the state budget to cover the budget deficit. The idea, de facto, was to give the Government an incentive to work on broadening the tax base and finding alternative sources of financing for the budget deficit. In practice, once guaranteed transfers from the National Fund began, that incentive disappeared entirely, because the transfers covered almost the whole budget deficit. The separation between the National Fund and the budget can therefore be called nominal.

To understand how important the oil sector is to the country, we need to look at how far our revenues depend on oil revenues.

Figure 1

Share of taxes and levies from the oil sector in total tax revenues

As Figure 1 shows, from 2011 to 2014 the oil sector accounted for about 50% of all tax revenues. In 2015 we saw a significant decline in tax revenues from the oil sector, which immediately affected total revenues and the budget deficit (Figure 2).

Moreover, the revenue structure for the oil sector includes only direct taxes: CIT, MET, the export customs duty (ECD), bonuses, the rent tax on exports, and the excess profit tax. But there are also social tax and personal income tax payments, property taxes, transport taxes and other minor payments. In addition, one must calculate how much is spent on local contractors and producers, who also pay taxes. A thorough calculation, taking indirect effects into account, puts the share of the oil sector at up to 60 percent.

In 2010, under the existing tax system, revenues from the oil sector were no longer sufficient to finance the budget and other government expenditures. That is why an export customs duty on oil was introduced in 2010.

In 2013 tax revenues exceeded government expenditures by 19%, but by 2015 the budget deficit, even with all oil taxes counted, stood at 21 percent. The deficit could have been even larger had it not been for the significant depreciation of the tenge.

Figure 2

Ratio of tax revenues to state budget expenditures

If we compare the oil sector revenues in Table 1 for 2015, we see that the budget deficit arose entirely because of the fall in oil sector revenues.

Figure 3

Dynamics of oil sector revenues in US dollars and tenge

Looking at the dynamics of oil sector tax revenues from 2010 to 2015, we see that the increase in 2011 was driven by the introduction of the ECD, while the fall in revenues in 2015, from USD 23 billion to USD 10 billion, was caused primarily by the drop in oil prices. The oil sector tax structure does include taxes that did not depend on oil prices. The first of these is the export customs duty. In 2016 it was linked to the oil price, and in effect it began to duplicate the rent tax on exports.

Looking at the structure of tax revenues from the oil sector, corporate income tax has been the main source over the six years. Next come the mineral extraction tax and then the rent tax on exports. Because the export customs duty did not depend on oil prices, in 2015 it provided the largest share of oil sector revenues.

An analysis of the dynamics of the Republic's share under production sharing also shows that these revenues are growing, owing to the change in the terms of production sharing with Tengizchevroil.

Overall, two major producing companies account for about fifty percent of all oil production in Kazakhstan: Tengizchevroil LLP and Karachaganak Petroleum Operating.

Figure 3

Structure of oil sector revenues by year, KZT billion

An analysis of the financial statements of Tengizchevroil LLP for 2011 to 2014 shows that the company accounts for 35 to 40 percent of all tax revenues from the oil sector (Table 1). In other words, about 20 percent of all the country's tax revenues come from a single organization, Tengizchevroil LLP. This does not include the dividends paid annually to KazMunayGas (about USD 1 billion in 2014), nor income and other taxes, nor the taxes paid by TCO's suppliers and contractors. When a country depends for 20 percent or more of its revenues on one company, this is a fairly high risk, and such a company carries considerable political weight.

Table 1

Tax liabilities of Tengizchevroil LLP, USD thousand

The company's audit report shows that the basic royalty is 25% of revenues net of transportation and marketing costs and of operating costs not related to wells.

Tengizchevroil LLP has a stable tax regime. Since 2009 it has paid an additional royalty of 5%, which rises to 15% from the fourth quarter of 2014. TCO also withholds from the royalty the amount of VAT that the state owes it in respect of accumulated VAT. The CIT rate for Tengizchevroil LLP is 30%.

In July 2010 the state decided to levy the export customs duty on Tengizchevroil LLP, but under the agreement between TCO and the Government the company offsets it against royalty payments. In effect, the state was unable to increase the tax burden on TCO. The same applies to environmental fines for gas flaring and sulfur storage.

Kazakhstan is thus highly dependent on the oil sector and extremely sensitive to the oil price. Table 1 shows that, excluding revenues from TCO, revenues from the oil sector are falling, owing not only to lower prices but also to the decline in oil production in Kazakhstan.

Besides depending on the oil sector, Kazakhstan also depends on a single company, TCO, for its tax revenues. This means significant risks for the state. To end the dependence on oil prices, the economy must be diversified and other industries developed.

The next part of the article will describe the principles behind each tax in the oil sector and will construct an illustrative chart of tax revenues as a function of oil prices under the existing tax system.

Recommendations for optimizing the oil sector tax system will be given separately for each tax.

Tengizchevroil	2011	2012	2013	2014
Basic royalty	4,935,409	4,441,626	5,011,403	4,620,985
Additional royalty	889,748	728,127	725,748	603,624
Income tax	3,926,875	3,756,897	4,066,823	4,201,030
Total	9,752,032	8,926,650	9,803,974	9,425,639
Total revenues from the oil sector	25,992,572	25,450,704	25,797,243	23,360,038
Share, %	38%	35%	38%	40%