Kazakhstan Chamber of Commerce in the USA

KazCham


Tax and investment priorities

Posted on March 15, 2010 by KazCham

THE LATEST BI-ANNUAL session of the high-level Foreign Investors’ Council in the northern farming centre of Kostanai in June was called ostensibly to focus on the investment potential of the agriculture sector. But how Kazakhstan will continue to attract foreign investment generally in the context of the new tax structure introduced at the start of the year was at the forefront of the minds of many senior executives and government officials who took part.

The global economic outlook and the government’s current focus  on ‘shovel-ready’, local content agricultural and infrastructure  programmers is light-years away from the world of 24-hour a day  whirling tower cranes and sky-high commodity prices, which  provided the optimistic background to earlier drafts  of the new 2009 tax code that came into effect at the  start of the new year.

Drafters took their cue from President Nazarbayev’s annual address of February 2008 when he called for a new tax code that “must be aligned with the objectives of the new phase in Kazakhstan’s development, a code designed to promote modernization and diversification of the economy”.  In setting out the basic principles of the new code, the president added that the most important element h was to be “a reduction of the total tax burden on non-commodity sectors of the economy, particularly small and medium-sized businesses.” To underline this, he added: “The expected shortfall in government h revenue should be offset by greater economic returns from the extractive sector.”

A year later, in his address to the nation in March 2009, at a time when the authorities were grappling with the banking crisis and re-adjusting to the global collapse in prices of the country’s commodity exports, President Nazarbayev re-affirmed h the strategic direction “charted in the National Development Strategy until 2030” which is “economic growth based on the developed market economy with a high level of foreign investment”.

With the onset of spring came the first tentative signs of recovery from the depths of the crisis that followed the collapse of Lehman Brothers in September 2008. Oil and other commodity prices  started to rise, mainly on Chinese buying, and the  shares of Kazakhstan’s internationally-traded mining  and resource stocks recovered much of their previous – losses on the London and Kazakh stock exchanges.  Kazakhstan, the first country to be hit by the US sub-prime mortgage crisis in August 2007, suddenly started to look like one of the best placed to get back to sustained growth.

Shaken, but not stirred, the economy’s survival is partly the prize for years of careful state budgeting.  This allowed the accumulation of more than $40 billion of reserves in the National Bank of Kazakhstan and the Oil Fund while oil prices were high and reduced the need for public borrowing when market conditions suddenly turned hostile. Running down the previously acquired surplus allowed fiscal expansion and a $21 billion bank and enterprise rescue package to be financed domestically in large part, although a $10 billion oil-asset for-finance deal with China in April certainly helped to steady nerves.

The weak point in the economy was that the public-sector surplus was more than offset by heavy foreign borrowing by the private sector, which issued substantial foreign equity and accumulated debt before the markets turned sour. So while Kazakhstan’s trade has remained in surplus, the current account turned sharply negative as banks and corporate borrowers confronted unexpectedly large foreign debt obligations, which have either had to be refinanced at substantially higher rates or partly rescheduled.

Even with the deployment of accumulated oil revenues, an external funding gap of more than 11 per cent of GDP still needs to be covered by foreign direct investment (FDI) in 2009, despite the fact that the slowdown in economic growth will cut the import bill. The big question is, will that investment come under the new tax regime?

A new tax system

The new tax code came into force at the start of January 2009. It was prepared in near-record time during 2008 and some haste can be perceived in its content. As the global economy continued to deteriorate in early 2009, the Kazakh leadership called for a ‘moratorium’ on further tax code changes until after 1 July. This showed understanding that tax h policy adjustments alone would not provide a ‘quick fix’, however critical tax policy remained for meeting longer term macro-economic challenges.

In keeping with the generally-progressive policy that Kazakhstan has sustained in tax policy reform, the new code represents some, albeit incomplete, forward thinking. It incorporates provisions to help improve clarity and certainty in the tax system as to the rights and obligations of taxpayers and of the state’s fiscal and other relevant agencies.

Among its key policy objectives are reduction of the tax burden on the non-extractive sectors and individuals; and a substantial increase in that of subsurface users and large taxpayers, more generally.  This approach seeks, in a supposedly ‘revenue- neutral’ way, to hasten the diversification of the economy into non-extractive sectors.

Concurrently entering into force is an amended transfer pricing law, which continues negatively to exert control over specified business transactions, whether between related or unrelated parties. In prospect during 2009 are related laws to control money-laundering and fiscal fraud, as well as an amended law on sub-surface use. New outline administrative arrangements orders and procedures are being promulgated to guide the operations of the fiscal agencies.

These new and revised instruments were essentially conceived in economic times more robust than when their entry into force took place. The government may well have acted presciently with tax cuts for the non-extractive sectors which could provide a stimulus h to business activity during the economic crisis. That remains to be seen. But what is already clear is that the new fiscal regime for the oil and minerals sectors provides no incentive to the foreign investment considered essential for achieving the 2030 strategy.  Moreover, a continuing, unfortunate aspect of the tax system for all taxpayers is the ‘gap’ between tax policy and the tax laws and their administration, which some investors believe had begun to show almost ‘Bolivars’ tendencies.

The business tax regime

One of the key elements in the new code is a reduction in the corporate income tax (CIT) rate from 30 per cent to 20 per cent, dropping further to 17.5 per cent in 2010 and 15 per cent in 2011. Deductible expenses are correlated with the activities connected with earning income and the loss carry forward period is extended from three years, or seven years for -subsurface users, to ten years. For small and medium- sized enterprises (SMEs) the obligation to calculate and pay CIT advance payments has been repealed.

CIT investment preferences are not available, however, to organizations operating in free economic zones or producing and/or selling excisable goods, or producers of agricultural products and village consumer’s co-operatives

The tax treatment of derivatives depends upon whether the instrument is a normal ‘derivative’ financial instrument, qualifies for hedging accounting, or involves delivery of a hedged item.  Hedging income or loss shall be tax accounted in accordance with the rules determined for the underlying hedged item. In other cases, income is taxable on its own and can be utilised only against income from other derivatives, subject to the ten-year -carry-forward period.

Another eye-catching element in the new code  is a reduction in VAT from 13 to 12 per cent, but  VAT now also applies to goods/services in special  economic zones, previously zero-rated, and to  geological exploration, also previously exempt. The reporting period is now quarterly and a simplified procedure of VAT refund for large ‘good faith’  taxpayers is introduced.

The property tax on immovable property assets rises to 1.5 per cent and investment preferences (including land tax preferences) have been repealed,  while the social tax continues its transition from the h existing regressive scale of 13 per cent to 5 per cent,  to a flat rate of 11 per cent.

Overview of the subsurface users’ fiscal regime

The abolition of CIT preferences is not applicable to assets used for activities within a subsurface use contract (effective from 1 January 2012). The government can permit a subsurface user to apply preferences under the subsurface use contracts  concluded between 1 January 2009 and 1 January  2012, if the extraction of minerals happened within  this period of time. Subsurface users applying investment preferences are not allowed to apply  double depreciation rates on fixed assets exploited in -Kazakhstan for the first time.

The stability of tax regimes remains valid only for production-sharing agreements signed prior to  1 January 2009, which underwent obligatory tax  ‘expertise’, and subsurface use contracts approved  by the president. For all other contracts, the current tax legislation applies. As to the signature bonus, the minimum starting bonus for exploration contracts  is $27,000; for production contracts, $29,000; for  mineral exploration contracts, $2,700; and for  mineral production contracts, $4,800.  The commercial discovery bonus tax base, at a rate  of 0.1 per cent, is determined by prices on the London Metal Exchange (LME), or as published in Piatt’s Crude Oil Marketwire. If minerals are not listed on the LME,  the base is determined by the planned production  costs indicated in the feasibility study.

A new, complex minerals production tax (MPT)  replaces Royalty, and under the new regime,  transportation costs are not deductible. MPT rates for  crude oil and gas condensate rise from five to 18 per  cent in 2009, to six to 19 per cent in 2010 and seven  to 20 per cent in 2011. For domestic sales, crude oil  and gas condensate tax rates drop by 50 per cent. The  MPT rate for exported natural gas is 10 per cent, but  for domestic sale, rates range from 0.5 per cent to 1.5  per cent. The rate for minerals that undergo initial  processing and for coal range from 0-22 per cent in  2009, rising to a maximum of 23 per cent in 2010 and  24 per cent in 2011. For coal itself, the rate is zero.

For crude oil and gas condensate, the MPT base  value is determined upon sale to a refinery within  Kazakhstan, at the actual selling price or upon  transfer for reprocessing/use for own needs, at the  production cost, determined under IFRS, increased by h 20 per cent. Export values are calculated on the basis  of average world prices, particularly for Urals Med &  Brent Dtd, published in Platts’ Crude Oil Marketwire.

For natural gas, the MPT base is the value of  extracted natural gas, determined upon domestic sale at the weighted average selling price and if used for  own needs at the production cost, determined under  IFRS, increased by 20 per cent.

Gas exports are valued at the average world price,  published in Crude Oil Marketwire.

For minerals (except common minerals) and  coal, the MPT base is the value of depleted mineral  resources and coal determined for minerals listed on  the LME, at average exchange prices and for minerals  not listed on the LME, at the weighted average  exchange prices at the time of sale or own-use.

A renovated excess profits tax (EPT) is charged on  the same sliding progressive scale from 0 per cent to  60 per cent, but the thresholds are changed.

The rent tax on oil exports applies to exported  crude oil, gas condensate and coal with rates for  exported crude and gas condensate up to 32 per  cent, linked to world market prices. The top bracket  is $200 per barrel and price thresholds are changed.  The tax base is determined as the exported volume  multiplied by the world price without deduction  of transportation expenditures. The tax rate for  exported coal is 2.1 per cent, with the tax base  determined as the exported volume multiplied  by the selling price – again without deduction of  transportation expenditures.

Outside the scope of the new tax code is an export  duty, which can be applied by government decree on  crude oil, bitumen and distillates with progressive  rates referenced to quarterly average world prices.  The rate in early May 2009 on crude oil was $139 per  tonne, with a reduced rate of $121.32 per tonne for  rent tax payers.

International taxation

The new code’s withholding tax (WHT) is levied  at 15 per cent on dividends and interest, with a  capital gains royalty of 16 per cent and a 20 per  cent charge on any income of an entity registered  in a tax haven. Insurance premiums under risk  insurance agreements are taxed at 10 per cent, while  income from international transportation services  and insurance premiums under risk reinsurance  agreements is charged at 5 per cent, and other  income at 20 per cent.

Further, the controlled foreign company rules now  apply to individuals and companies tax-resident in  Kazakhstan and in respect of tax havens where the  critical tax rate is 10 per cent or less.

The new tax code also prescribes exemption of  dividends from WHT for outbound dividends if a non- resident owns shares/participation interest for more  than three years, and if more than 50 per cent of the  value of shares/participation interest derives from  non-subsurface user’s property. It also exempts capital gains from WHT when received by a nonresident  from selling shares/participation interest, except for  shares in Kazakhstan residents holding subsurface  use rights and in foreign or Kazakhstan entities, if  more than 50 per cent of the shares’ value is derived  from subsurface user’s property. An extraordinary  collection mechanism is established for capital gains  of subsurface users

Tax administration

The new tax code introduces a tax accounting policy  requirement upon taxpayers, prescribes separate tax  accounting rules, provides for submission of a single  CIT return by a subsurface user operating under  ring-fenced contracts and stipulates submission of  financial statements under IFRS, along with a CIT  return. Administrative responsibility lies with  the taxpayers

The new tax code

While imposing tax is a sovereign right of states,  attracting FDI is a ‘bilateral’ issue determined by  a range of parameters, including tax. We believe  that in respect of the key extractive industries  sector, Kazakhstan’s new tax code largely ignores  internationally-proven criteria for attracting  investment. These include incentives to encourage  full and efficient exploitation of hydrocarbons  that are economic before tax, an equitable balance  between government and contractor interests,  and the stability needed to support long-term  investment. Attracting FDI is also helped by clarifying administration and simplifying compliance together  with a focus on profit rather than production as the  tax object.

In the new tax code the maximum rate of mineral  production tax (MPT) is 20 per cent, compared to  6 per cent for the replaced royalty at the equivalent  production level, while the maximum rate of  export rent tax is 32 per cent, still based on world  prices, although temporarily adjusted to 0 per  cent by government decree. Both of these taxes are  contingent upon the current average prices for the  fiscal period prevalent at the International (London)  Stock Exchange, but without provision for deduction  of transportation costs.

This means, therefore, that the marginal tax rate  on the upper tier of production is effectively much  higher than the simple addition of 32 per cent plus  20 per cent equals 52 per cent, since transportation  costs are one of the most significant costs of oil field  development in Kazakhstan. Thus, if it costs, for  example, $10-$20 a barrel to move oil from a Kazakh  oil field to Europe, the market value of oil produced  at that field in Kazakhstan is Brent minus $10-$20.

With the addition of transport charges, oil  companies now bear the tax on revenues they never  received, but earned instead by other entities,  including Kazakh state-owned companies. The result  is that internal rates of return (IRRs) – even at oil  prices as high as $65/barrel – fail to meet the oil  companies’ investment hurdles.

ITIC believes that other positive changes to encourage responsible and complete exploitation of subsurface territories would include reinstating  the VAT exemption on the transfer of subsurface  licenses and or rights and the elimination of  ring-fencing. Most importantly, the code should include transportation and other ‘netback’ costs in computation of both the MPT and excess profits tax.

Further tax reform needed to sustain competitiveness and help meet President Nazarbeyev’s goal of joining the “world’s 50 most competitive nations” should commend itself to the Astana  authorities and legislators as they address the issue  after 1 July. Reform of the subsurface users’ tax  regime, in particular, is needed to attract further,  mutually-equitable investment into the extractive  sectors. The current new code, drawn up during record high commodity prices with the explicit intent of  increasing the government’s take, makes the economic attractiveness of new investments questionable. *

This is an edited version of a more detailed analysis by Daniel Witt, president of the International  Tax and Investment Center in Washington, and  Douglas Townsend, senior adviser to ITIC and former Australian ambassador to Kazakhstan. ITIC has been  working on tax and investment reforms in the former Soviet republics since 1993. A more detailed version is available on www.iticnet.org under ‘publications’.

Invest in Kazakhstan An official publication of the Government of the Republic of Kazakhstan, 2009. Page: 92-95.

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