Excess Profits Tax in the Republic of Kazakhstan: Methods and Problems Arising when Calculating Excess Profits Tax
Anvar Yaushev, Partner, MinTax Consulting Company
Excess Profits Tax (EPT) is a tax levied on additional revenues earned by subsurface users in excess of the rates determined by the tax legislation. EPT as we know it today was first levied in the US on the excess profits of corporations which supplied armaments during World War I. In Kazakhstan, until the adoption of the Tax Code, fixed (rent) payments to the budget were applied for the same purpose. They were payable by large oil, gas and coal mining enterprises whose production was judged by specialists to be highly lucrative in comparison with the production of other minerals.
Until recently not many people were interested in the calculation of EPT, and there were reasons for this. EPT is a comparatively new type of tax. In Kazakhstan it was adopted into law in 1995, when the new Tax Code1 came into force. Until then, provisions relating to EPT were only included in subsurface use contracts.
1 Decree of the President of the Republic of Kazakhstan “On Taxes and Other Mandatory Payments to Revenue” dated April 24, 1995 No. 2235
The reason for introducing EPT in Kazakhstan was that it is impossible to precisely forecast the price and production cost of minerals produced within the framework of subsurface use contracts. Although these factors cannot be known when the contract is signed, they may have a major impact on the balance of the parties’ economic interests, i.e. the distribution of income between the state and the subsurface user.
The balance of economic interests between the parties is determined in the course of a tax expert examination on the basis of technical and economic calculations. In accordance with the tax legislation, the internal rate of return (IRR) may not exceed 20%, and it is regulated by setting the amounts of royalties and bonuses. The IRR can therefore only be approximately estimated, and so EPT serves as insurance for the state in not allowing subsurface users to make vast profits for reasons independent of their activities which are not subject to additional taxes.
On the other hand, EPT can discourage subsurface users from using modern equipment and technology that would enable them to increase production and cut the cost of production.
A particularly topical issue at present is how to determine EPT for companies that operate in Kazakhstan under subsurface use contracts, particularly those relating to raw hydrocarbon production. The sharp increase in world crude oil prices (from US$11 per barrel in December 1998 to US$34 per barrel in 2000), such as has not been seen since the Caribbean crisis, has raised the question of how to avoid paying EPT that was not foreseen in the technical and economic calculations. Of course this sort of price increase is inevitably reflected in the revenues of oil production companies. The author has therefore decided to focus on a review of Kazakhstani tax legislation as it relates to EPT and to describe how this tax is calculated, as well as looking at problems arising from calculation.
As mentioned above, EPT was established in Kazakhstan in 1995 by the Tax Code. However, until 1997 the method of calculating EPT was defined in each individual subsurface use contract. It was not until then that the Procedure for Determining the Internal Rate of Return for the Calculation of Excess Profits Tax was established by Resolution 1330 of the Government of the Republic of Kazakhstan dated 12th September 1997 (hereinafter referred to as Resolution 1330). The detailed method for calculating EPT was approved by Instruction 41 of the Ministry of Finance of the Republic of Kazakhstan On the Taxation of Subsurface Users dated 29th December 1997 (Instruction 41).
In Kazakhstan at present, under clause 102 of the Tax Code, EPT is payable by all subsurface users except those operating under production sharing contracts and contracts on the mining of common minerals and ground water, provided that such contracts do not include the mining of other minerals. EPT is levied on the net income from each separate subsurface use contract for an accounting year in which IRR exceeds 20 %. Clause 5.5 of the Tax Code defines IRR as the rate of return on the investments made. The calculation of IRR is cumulative, starting from the year in which the contract enters into force. For instance, if a contract came into force in 1996 and the accounting year is 2000, IRR is calculated for the period of five years since the first year of validity of the contract.
In accordance with Resolution #1330, IRR is calculated on the basis of annual cash flows adjusted for inflation. The annual cash flow of a subsurface user is defined as the difference between total gross annual income and expenditure incurred within the framework of the individual subsurface use contract for the accounting year. When EPT is calculated, the total annual gross income is determined in accordance with Chapter 3 of the Tax Code, i.e. it is identical to the total annual gross income used for calculating corporate income tax.
The following costs are deemed to be expenditure of the subsurface user under his individual subsurface use contract:
• Capital expenditure – expenses capitalized in accordance with the tax legislation in the course of subsurface use operations and depreciated according to the tax legislation. If contracts are concluded for areas where deposits have been discovered, the value of the fixed assets available on the date of conclusion of the contract is regarded as the first year’s capital expenditure;
• Expenditure that is deductible when calculating corporate income tax, except amounts charged on depreciation of capital costs and remuneration (interest) on borrowing (loans);
• The amount of the subsurface user’s income tax and dividend tax charged for the accounting year, and the amount of EPT charged for the year preceding the accounting year.
Starting from the second year of validity of a subsurface use contract, the subsurface user’s annual cash flow is adjusted according to the inflation index set by the authorized state body (presently the Statistics Agency of the Republic of Kazakhstan). Adjustment for inflation is calculated using the following formula:
CCF (n) = ————————————————,
(1+II1) ? (1+II2) ? . . . (1+II n-1)
CF - subsurface user’s cash flow for
the accounting year;
CCF - cash flow adjusted for inflation;
II - inflation index;
1, 2, ... n - period of time (year).
After cash flow adjustment, IRR is calculated directly. In fact, Instruction #41 gives a very detailed description of IRR calculation using the net given value and discount rate. However, in practice this calculation is complicated and requires specialist knowledge. Also, when the formula given in the Instruction is used, slight errors could be made, depending on how correctly the discount rates used for IRR calculation have been applied (they may be any amount) and how the results have been rounded up or down. The discount rates must be changed until the minimum positive and negative values of the net given value are achieved. Naturally complications with the tax authorities may arise when this method of IRR calculation is used, as they may obtain different results when they calculate IRR.
In order to solve this problem, we recommend that the use of Microsoft Excel be established in law, since it makes it very simple to calculate IRR on the basis of cash flow adjusted for inflation using the IRR function.
In accordance with clause 104 of the Tax Code, taxpayers should calculate EPT depending on the level of IRR using the rates given in table 1 below.
Other EPT rates may have been set for contracts signed before 1st January 1997.
Having determining IRR for the accounting year, the subsurface user must file an EPT declaration to the tax authority where it is registered for tax purposes by 10th April of the year following the accounting year.
If the IRR for the accounting year exceeds 20%, EPT is payable on the subsurface user’s net income for that year at the appropriate rate. EPT is payable in cash by 15th April of the year following the accounting year. Such an example of EPT calculation is given in Table 2.
A question that may arise here is that the calculation shown in the table does not correspond to the sample calculation given in Instruction 41 with respect to determining the net income on which EPT is payable. In accordance with clause 5.47 of the Tax Code, “net income is taxable income minus the income tax charged on such income”. Also, point 10 of the same clause defines dividends as “part of net income” and therefore tax on dividends is part of net income. However, in the example given in Instruction 41 net income is determined after the deduction of dividend tax and excess profits tax, which contradicts the provisions of the Tax Code. Clause 103 of the Tax Code should therefore be amended in order to correctly determine the taxable base for EPT and establish that the taxable base for EPT is net income minus dividend tax and excess profits tax paid in the year preceding the accounting year. We consider that such amendments would be only fair, in order to avoid subsurface users’ net income being taxed twice.
At present quite a number of subsurface users encounter problems in calculating EPT. For example, companies which have made investments by purchasing shares in enterprises where deposits have already been discovered experience difficulties in determining capital expenditure in the first year of validity of the contract. This is because the tax legislation does not regard the cost of purchasing the shares as capital expenditure for the purposes of calculating EPT. And in most cases it is not economically feasible to regard the value of the fixed assets available as of the date of conclusion of the contract as capital expenditure of the first year, since these assets have not been revalued since the Soviet times. The question therefore arises whether it is possible to include the cost of purchasing the shares when calculating the first year’s cash flow. In international practice, any amount of money used in an investment project affects IRR, so it would be logical to reflect the cost of purchasing shares when calculating cash flows.
Let us assume that the subsurface user obtains permission from the authorized body to regard the purchase of shares as capital expenditure of the first year when calculating EPT. However, even then much is unclear. For instance, if a company purchases shares in an enterprise that has several deposits with separate subsurface use contracts, how should the cost of purchasing the shares be distributed between the contracts, given that separate tax accounting is applied for each contract?
Or, if a company purchases only some of the shares in an enterprise while the rest of the shares belong to the state or the enterprise’s employees, what part of the value of the shares would be regarded as capital expenditure of the first year?
It may also happen that cash flow is positive from the first year of validity of the contract, in which case IRR cannot be calculated and all methods of calculating EPT are useless.
Another problem relating to the estimation of cash flow arises in the case of dividend distribution. As a rule, dividends are distributed on the basis of a resolution of the general meeting of shareholders, provided of course that the enterprise is a joint-stock company. And as a rule, the deadline for holding the annual general meeting of shareholders is later than the deadline for filing the EPT declaration. This makes it impossible to correctly determine cash flow for the accounting year. In our view, the best way to solve this problem would be to decrease cash flow for the accounting year by the amount of dividend tax paid in the previous year, i.e. in a similar way to the principle of reducing cash flow by the amount of excess profits tax paid.
In spite of these problems, no amendments relating to EPT are anticipated in the new draft Tax Code. We hope that the state authorities will realize the importance of these problems and will make the necessary adjustments to the tax legislation in the very near future.
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