This content is from: China

Tax obligations for China’s oil and gas upstream sector

It is absolutely necessary to plan ahead when operating in China’s oil and gas upstream sector, which allows international oil companies (IOCs) to participate in and operate the exploration development and production of petroleum resources in China.

However, such foreign companies must enter into production sharing contracts (PSCs) with the Chinese government or its designated Chinese national oil companies (NOCs) to operate or acquire such PSC interest in China.

State Council Decrees No. 606 and No. 607 generally outline the framework for PSCs for national and international oil companies. There are also a number of tax measures that businesses must comply with in this sector. To help oil companies operating in China to have a full picture of all applicable taxes and levies regarding the upstream of the oil and gas industry, we discuss the key measures below.

Corporate income tax

According to the Corporate Income Tax Law (CIT Law), tax resident enterprises must pay CIT on income derived from source inside and outside China. In addition, non-tax resident enterprises, which have an establishment or a place in China, must pay CIT on income that is derived by an establishment or place in China when the income is sourced from within China. It should be noted that CIT is also payable on income derived from sources outside China, but is connected with establishments or places in China.

Under the CIT Law, taxable income is defined as the amount of gross income in a tax year minus non-taxable income, tax-exempt income, various deductions and allowable losses brought forward from previous years.

All necessary and reasonable expenses incurred in running a business are deductible for tax purposes, except for advertisement and sales promotion expenses, entertainment expenses, union fees, employee welfare costs and employee education expenses, which are subject to specified deduction thresholds. Qualified R&D expenditure may be deducted at 150% of the actual expenses. Charitable donations within 12% of the total annual profit are also deductible. The implementation regulations of the CIT Law define these deductions in detail.

Separately, the circular Caishui [2009] No. 49 was issued specially for oil and gas upstream enterprises in China, including NOCs and IOCs, to provide detailed instructions on tax amortisation of exploration and development expenditures considering the significant difference of this industry compared with other sectors.

For PSC petroleum operations in China, deductions may typically include payments of revenue-based taxes and levies (including the Special Petroleum Levy (SPL) and VAT), petroleum royalties or resource tax, abandonment fees paid to the designated bank account, deductible production and operating expenses, tax amortisation of exploration expenditure and development expenditure, as well as others.

VAT

Although China’s government has been implementing the VAT reform to fully consolidate the business tax into a VAT regime since May 1 2016, sino-foreign joint ventures for the exploitation of crude oil and natural gas (PSC blocks) are still subject to a flat rate of 5% VAT on gross production (excluding the self-used volume in operation) without input VAT credit. The VAT must be paid in kind and the Chinese partners (generally a NOC) has the responsibility of declaring and filing the VAT owed to the competent tax authorities on behalf of the IOC. The circular Guoshuifa [1994] No. 114 provides more details in this regard.

It is worth paying close attention to monitor the forthcoming VAT legislation in China, which may create a significant impact to PSC blocks.

Special petroleum levy

The Circular Guofa [2006] No. 13 was issued by the State Council in 2006 to collect a revenue windfall levy on all oil production companies (both NOC and IOC) that sell the crude oil produced from China. Sometimes SPL is translated into special petroleum tax (SPT), with Circular No. 13 stating it belongs to non-tax income by the central government and it should be collected by the Ministry of Finance (MoF) or local finance bureaus, instead of tax authorities.

To implement Circular No. 13, the MoF issued two circulars Caiqi [2006] No. 72 and Caiqi [2006] No. 183 to outline the detailed procedures. Based on the two circulars, both selling crude oil domestically and exporting crude oil to overseas market are subject to SPL with the threshold price of $40 per barrel calculated on the monthly weighted-average basis in 2006. As the international crude oil price has fluctuated dramatically in recent years, the threshold price was renewed to reflect the trend. Circular Caishui [2014] No. 115 set the revised threshold price for SPL calculation at $65 per barrel.

Progressive rates and deductions for SPL calculation
Crude oil price ($/barrel)Tax ratesQuick calculation deduction 
($/barrel)
65-70 (inclusive)20%0
70-75 (inclusive)25%0.25
75-80 (inclusive)30%0.75
80-85 (inclusive)  35% 1.5
Above 8540%2.5

According to these circulars, SPL will be calculated on a monthly basis, but settled on quarterly basis, and it can be booked as cost and thus is tax deductible.

Petroleum royalties

The State Administration of Taxation (SAT) issued circular Guoshuifa [1995] No. 202 based on the regulations released by the MoF in 1989 and 1990 on the procedures for collecting and administering petroleum royalties on crude oil and natural gas produced in China. Payments are made in kind with the crude oil and natural gas produced and are based on the volume of annual production after deducting the volume of self-used oil or gas in operation. Same as VAT compliance, the Chinese partners (generally NOCs) have the responsibility to declare and file the royalties to the competent tax authorities for the IOC.

In 2011, the Chinese authority made an effort to transform the fees into taxes and thus consolidate the petroleum royalties into a resource tax. Following the publication of the Resource Tax Regulations in 2011, the onshore and offshore PSCs for oil and gas exploitation concluded before November 1 2011 are still subject to the petroleum royalties regime until the PSC expires. All the PSCs concluded after November 1 2011 are subject to the resource tax.

Resource tax

On September 30 2011, the State Council released Decree No. 605, which stipulates that the companies engaged in the exploitation of natural resources in China are liable to pay resource tax from November 1 2011. A subsequent circular, Caishui [2014] No .73, jointly issued by the MoF and SAT in October 2014, increased the tax rate to 6% based on the sales price with effect from December 1 2014. The circular also removed the previous 1% mineral resources compensation fee. The sales price is determined on the same basis as for VAT purposes, i.e. the total consideration plus any other charges. However, the sales price will not include the output VAT collected.

However, oil and gas used by taxpayers in the operation are not subject to resource tax. Based on the Resource Tax Regulations, tax exemption and reductions are also available in some situations, subject to the approval of the competent tax authorities.

Withholding tax

Non-tax resident enterprises, which have no establishment or place in China ─ or which have an establishment or place in China, but the income derived is not effectively connected with the Chinese entity ─ must pay withholding tax on the income derived from sources inside China. The applicable tax rate is 10% or the rate defined by the tax treaties held between China and its partner countries. Such income generally includes dividends, interest, royalties and rental.

So far, there is no withholding tax on the profit sourced by an IOC through a PSC with a NOC in accordance with circular Shuizonghan [2015] No. 494 issued by the SAT.

Surtaxes

Public Notice [2010] No. 31 published by the SAT requires NOCs and IOCs to pay surtaxes on the 5% VAT payment in kind for their PSC blocks. The surtaxes include urban maintenance and construction tax (UMCT) and an education surcharge (ES) and a local education surcharge (LES). For some locations, flood control engineering and maintenance fees are also imposed. The UMCT for offshore PSC blocks is 1% according to this Notice. The consolidated rate of surtaxes ranges from 6% to 13% depending on the location.

Tax administration of oilfield service providers

The SAT Decree [2009] No. 19 requires the oilfield service provider to register for tax purposes in China if they provide the service within China. Hence, generally the NOC or IOC must request official tax invoices from their vendors to ensure they are tax registered in China after an oilfield service contract is signed.

For those vendors that will not come to China, but provide services from outside China to NOCs or IOCs operating in China, the NOCs and IOCs are responsible for withholding the applicable taxes as service recipients.

Transfer pricing and BEPS implementation 

China implemented transfer pricing rules many years ago and the principals are consistent with most other countries, i.e. requiring related-party transactions to be priced at arm’s length standard.

In recent years, China has actively participated in the OECD BEPS project to reflect its growing economic clout and some forthcoming changes in its domestic policies and regulations on transfer pricing.

On June 29 2016, the SAT finally released the long-expected Public Notice No. 42 to update the transfer pricing documentation requirements under the Circular Guoshuifa [2009] No. 2 issued in 2009.  Public Notice No. 42 has retrospective effective from January 1 2016.

By introducing the key recommendations under Action 13 of the BEPS project relating to country-by-country reporting (CbCR) by multinational enterprises, Public Notice No. 42 will have a significant impact on taxpayers including the companies in the oil and gas upstream sector, which engage in a cross-border, related-party transactions.

According to Public Notice No. 42, the annual reporting forms for related-party transactions will be increased from 9 tables to 22 tables. In addition, the transfer pricing documentation will include the master file, local file and special file if a certain criteria is met by the company. CbCR is also required for some companies that meet the criteria defined by the Notice.

With more transfer pricing documentation being submitted and disclosed to Chinese tax authorities, more and more transfer pricing audits and tax controversies will happen and the tax compliance cost will definitely increase.

Disposal of PSC interest 

The gains from the disposal of PSC interest are taxable in China. The taxable gains are the difference between the disposal proceeds and the remaining balance of the exploration and development expenditure that has yet to be amortised for tax purposes.

For the purchaser, costs incurred for acquiring an interest in a PSC may be allowed to be booked as exploration and development expenditure and thus is eligible for tax amortisation. Although circular Guoshuifa [1991] No. 191 is now void, some tax authorities still refer to this circular to assess the disposal of PSC interest in China.

SAT Public Notice [2016] No. 29 on consolidating business tax to VAT contains a provision that should be highlighted. The provision states that sales of intangible assets is subject to 6% VAT. The intangible assets under this scope includes the usage right of natural resources, including land use, use of maritime space, exploitation rights, and other rights of natural resources. So far, there is no clear assessment on whether the disposal of PSC interest is subject to VAT or not. In practice, there are different opinions and thus taxpayers should be well prepared to defend their own tax position.

In February 2015, the SAT released Public Notice [2015] No. 7 to supersede the tax rules in relation to the offshore indirect equity transfer defined by the circular Guoshuihan [2009] No. 698.

Public Notice No. 7 has fully embodied the Chinese tax authority’s determination to combat tax base erosion through offshore indirect transfers because it introduces a whole new tax regime:

  1. It captures not only the offshore indirect equity transfer transaction addressed under Circular No. 698 but also transactions in transferring immovable property in China and assets held by the establishment or place in China of a foreign company through the offshore transfer of a foreign intermediate holding company;
  2. “The transfer of the equity interest in a foreign intermediate holding company” is defined very widely to cover any changes in the shareholder of that foreign company being transferred in the course of overseas group restructuring; and
  3. The “equity” also is extended to include “other similar rights”.
Actually, according to the Public Notice No. 7, a tax bureau successfully collected tax on a case concluded in 2014 in which one IOC sold the share of its offshore subsidiary, which owned non-operating interest in the Bohai Bay field. Therefore, taxpayers should re-consider whether it is necessary to use an intermediate holding structure for their investment in China, and if so, their reasonable commercial purpose should be documented properly.

Overall, it is never a dull time in the tax world. For taxpayers in the oil and gas upstream sector, it is absolutely necessary to thoroughly understand the implied tax obligations in China when they invest, hold, operate and divest their assets in China to manage their tax exposures and therefore achieve success in China.

By Maggie Zhuang, tax manager at Chevron China Energy Company

Notes: The following documents were used as a reference for this article by the author:

1. The English translation of PRC CIT Law and Implementation Rules by PWC China;
2. “Global Oil and Gas tax guide 2015” by EY
3. “A totally different tax landscape for offshore indirect transfer – wider, clearer & more challenging” by PWC China (February 2015)
4. “China introduces New Transfer Pricing Documentation Rules to Implement BEPS Country-by-Country Reporting” by Baker & McKenzie China (July 2016)
5. “China: An overview of taxation of oil and gas in China” by Andrew Zhu and Amy Lo (July 2012)



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