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INTERNATIONAL PETROLEUM TAX CONFERENCE 5 - 6 November 1998

THE OIL TAX REGIME OF AZERBAIJAN

Gerard Anderson Senior International Tax Advicor Statoil (UK)Limited DISCLAIMER

Portions of this document may be illegible in electronic image products. Images are produced from the best available original document. PLEASE NOTE SLIDES 1 TO 6,

10 AND 11 ARE NOT INCLUDED SLIDE 1

THE OIL TAX REGIME OF AZERBAIJAN

For over five years I have been travelling regularly to Azerbaijan. It is by turns a fascinating, frustrating, charming place, with a long history in the oil business and the chance of a spectacular future. In order to understand why the oil tax regime evolved into its present form and how it is likely to develop, it is necessary to know something of the country’s history and the commercial environment, and so I will focus on these initially. I will then go on to outline the Production Sharing Agreement (“PSA”) regime in Azerbaijan, and talk briefly about the Kazakh and Georgian Tax Codes, as these are likely to be the basis of a new general tax law in Azerbaijan from next year.

For practical purposes, the oil tax regime of Azerbaijan is contained in the tax articles of the thirteen PSAs that are in force there and these are confidential documents. This does create some difficulty for giving a public presentation, nonetheless a considerable amount of information, in general terms, is now in the public domain and so, I hope to be able to give you a reasonably full account, but I hope you will understand that there are some limitations on the amount of detail I can go into.

SLIDE 2

Azerbaijan is a small country about the size of Scotland located in the south west corner of the Caspian Sea. To the north it is bordered by Russia to the west by Georgia and Armenia and to the south by Iran and to the East faces the Caspian Sea which in turn is bordered by Azerbaijan, Russia, Kazakhstan, Turkmenistan and Iran. Baku, the capital, a city of two million people, stands on the Apsheron peninsula which projects out into the Caspian. Azerbaijan is, therefore, a land locked country, a fact which fundamentally affects the development of its upstream oil. Not only does it make the export of oil a major issue, it also raises major logistical problems. For example, the only way to import heavy equipment is through the Volga Don canal system transiting Russia. This is closed by ice for five months each year. There are approximately seven and a half million people in Azerbaijan, of whom almost a million are refbgees from the war with Armenia over the territory of Nagorno Karabakh. This is an area of Azeri territory with an Armenian population There has been an uneasy truce in this war for several years, but over twenty percent of the territory of Azerbaijan remains under Armenian occupation. The Azerbaijanese are a Turkiq people and there are more ethnic Azeris living in northern Iran than there are in Azerbaijan itself. Azerbaijan as a whole is a Moslem country and there is some evidence of religious revival.

Politically, Azerbaijan has to tread a carefbl path between its former master Russia to the north, Turkey, the regional power to the west, with whom it has its closest ethnic affinities, and Iran, a theocracy to the south. So far, this has been done with remarkable skill. For example, LUKoil is a member of all of the major offshore PSAs, while an Iranian state company is a member of, for example, BP/Statoil’s Shak Deniz Consortium.

SLIDE 3

For much of the nineteenth century Azerbaijan was part of the Russian Empire. In 1918 in the final days of the Second World War Baku was occupied successively by the Turks, and then by the British and from a brief period fi-om 1918 to 1920 Azerbaijan was independent. From 1922 to September 1991 Azerbaijan was part of the Soviet Union. It regained its independence as the USSR broke up. The early years of it’s new found independence were dogged with reverses in the war with Armenia so that by the time the current President Heydar Aliyev came to power in October of 1993 there had already been three previous Presidents since independence from the USSR. Aliyev has successhlly stabilised the country and opened it up to Foreign Investment. He has recently been re elected for a fbrther term as President.

SLIDE 4

Azerbaijan has a long and remarkable history as an oil province. Marco Polo noted oil seeping to the surface here in the thirteen century commenting that it was not pleasant to eat but was useful for rubbing into the sores of Camels. In the nineteen century the Baku oil boom lagged behind that in the US by about ten years. In 1871 the first oil wells were drilled, in 1873 the

20f 14 Nobel family, of dynamite fame, bought a refinery in Baku, in 1878 the world’s first bulk oil tanker was in service on the Caspian and in 1883 a railway from Baku to Batum in Georgia on the Black Sea was completed by the Rothechild family. In 1891 Marcus Samual of Shell fame, bought a monopoly on the Rotheschild’s oil production and in the early years of this century Stalin learnt his trade as a political agitator by inciting insurrection in the Baku oil fields. The later development of the Azeri oil industry during the years of the Soviet Union is not well documented, but it seems that production reached a peak of 500 thousand barrels a day during the Second World War. Hitler’s attempt to take this prize from the Russians resulted in his defeat at Stalingrad in early 1943, a defeat from which he never recovered.

SLIDE 5

Today a legacy of the Soviet years is still very evident in and around Baku. Their remarkable method of developing offshore oil in shallow water by building piers mostly in the 1950s and 1960s can still be seen and in fact it is so extensive it can be seen from space, the so called “Oil Rocks” complex, consists of 220 kilometres of offshore roadways unconnected to land, but equipped with its own bus service, hotel complex etc.

SLIDE 6

Perhaps the most startling thing in Baku is the shear industrial dereliction of the Baku oil fields. It is a waste land of abandoned equipment paralysed nodding donkeys and lakes of oil.

Against this background with the coming of perestroika Azerbaijan opened up to western investment in the final years of the Soviet Union. The USSR had neither the capital nor the technology to develop the recently discovered Azeri, Chirag, Gunashli structure (“A/C/G”) located offshore or to explore the (by Caspian standards) deep water off Baku.

SLIDE 7(a)

As the USSR became accessible for Western investment, one of the first visitors to Azerbaijan was Steve Rem of Remco energy in 1989. In June 1991 Amoco was selected to operate the Azeri field, and in September Amoco formed an area of mutual interest with BP, Statoil, Ramco, Unocal and McDermott to take part in the Azeri field project. In February of 1992 Pennzoil and Ramco began negotiations for Guneshli and later that year BP and Statoil became in engaged in negotiations for Chirag. In fact Azeri, Chirag and Gunashli are a single structure and in June of 1993 SOCAR the Azeri state oil company declared a unitisation which brought the separate groups negotiating on Azeri, Chirag and Guneshli into a single unitised field and a preliminary signature bonus of eighty one million dollars was paid to SOCAR, the Azeri state oil company, by the foreign oil companies on June 21st. On June 25th negotiations were frozen. They resumed in August of 1993, and we were told to negotiate with a new negotiating team headed by a Doctor Manofov. In October 1993 part of Guneshli was removed from the negotiations and LUKoil acquired part of SOCAR’Sshare. In December 1993 the Azeri Government renounced Doctor Manofov and dismissed their negotiators. In February of 1994 President Aliyev signed a new decree authorising SOCAR to continue

negotiations and from March to September the negotiations alternated between Istanbul and I Houston. Finally the agreement was signed on September 20th 1994 followed by an unsuccesshl coup attempt against President Aliyev on October 1st 1994. I might add this rather colourfitl account of the negotiations comes from the web site of SOCAR, the Azeri state oil company.

The field has been operated since early 1995 by the Azerbaijan International Operating Company which is owned jointly by the foreign investors in A/C/G. A/C/G had already been discovered when the agreement was signed so 1995 and 1996 were spent on seismic work and appraisal drilling which was followed by the early oil scheme which has resulted in production of between eighty and one hundred thousand barrels a day, the first barrels of which reached Novorossisk on the Black Sea in March this year. The early oil scheme when complete will involve two export routes, one taken the oil north through Chechnya and Russia to Novorossiysk and the second route the so called western route through Georgia and will have a 200,000 bpd capacity.

SLIDE 7(b)

NC/G is a world class structure, with around 4 billion barrels of recoverable oil and 2.5 tcf of gas. It lies in a water depth that varies either side of 200 meters, and will be the subject of a phased development, resulting in peak production of up to a million barrels per day. A guestimate of development cost might be in the region of 8 billion dollars. It is hoped that phase one may be on stream by 2002.

SLIDE 8

Following NC/G twelve further PSAs have been signed by consortia of western oil companies. Statoil’s interests in Azerbaijan comprise of an 8.5% interest in A/C/G, here referred to as ‘AIOC’, a 25.5% interest in Shak Deniz, and a 15% interest in Alov. It is worth emphasising that A/C/G had discovered oil at the time the PSA was signed whereas all the PSAs that have followed since have been exploration plays yet to be proved. Drilling progress has been relatively slow. Until recently there was only one drilling unit in the South Caspian that was acceptable for drilling in the water depths involved. Recently BP/Statoil on behalf of a number of the PSAs in Azerbaijan completed the upgrade of a second rig which later this year will drill on BP/Statoil’s Shak Deniz prospect. We hope also next year to drill on the Alov prospect which was a subject of a PSA signed in JuIy of this year. The other offshore PSAs which have been drilIed since 1994, the Pennzoil operated Karabakh prospect and the Amoco led North Absheron prospect have been disappointing in that they have discovered quantities of gas or condensate. However hopes remain high and activity in Baku is intense.

SLIDE 9

Estimates vary considerably as to how much oil will ultimately be recovered from the Caspian Sea, one recent un-risk view illustrating the scale of the potential is shown in this overhead.

The major oil prospects lie in the Azeri sector. In the Kazakh sector, a Consortium, that now consists of eight western companies including Statoil carried out a seismic survey from 1993 to 1997 of the whole Kazakh sector, while negotiating a PSA that was signed in November of last year. The PSA covers a substantial part of the prospective acreage of the Kazakh sector and work is well advanced towards drilling the first exploration well, on what is very much fiontier territory. The nearest analogue being Chevron’s Tengiz field on shore to the east. Work on the remaining sectors of the Caspian is less advanced. Clearly the combined potential is very substantial, though in reality it is unlikely that all of these prospects will be simultaneously developed as shown. SLIDE 10

However much oil ultimately proves to exist in offshore Baku it will require a new main export pipeline to export it. Currently the routes under consideration are north though Russia to Novorossiysk, west through Georiga to Supsa or south through Turkey to Ceyhan on the Mediterranean. At the time of writing, a decision is expected immanently. The first two of these routes would require oil to transit the Bospherus or the construction of a bypass pipeline to avoid environmental risks associated with Bospherus. Depending on the route chosen, and which newspaper you believe, the pipeline costs could be anything between one and four billion dollars.

The routes shown here are not the only possible export solutions. Monument have succeeded . in swapping Turkmenistan oil delivered on Iran’s Caspian cost for use in its northern refinery, in exchange for oil to be collected in the Gulf. A major pipeline project is underway from Kazakhstan to Novorosisk, the CPC pipeline, and a pipeline from Kazakhstan to China has also been suggested.

SLIDE 11

One of the most important issues arises in the Caspian Sea is actually whether it is a Sea at all. The crucial question is who actually owns the oil? should the Caspian Sea be divided by drawing medium lines between the countries that border it, in the same way the UK and Norway divided the North Sea or is it actually a lake in which case the resources that lie beneath it are owned jointly by all of the states that border it and it would be developed in common ownership with a common benefit? Russia, Kazakhstan and Azerbaijan have all now declared their acceptance that the Caspian Sea is a sea to be divided by median lines so that ownership and taxing rights belong to the individual states within the sectors that are allotted to them. This agreement in principle does not go so far as to agree exactly where the lines will be drawn, but it does seem that broadly the question of the ownership of the Caspian is, as a practical matter, settled.

60f 114 the early 1990s, Azerbaijan had inherited the tax system of the USSR as it had stood as the USSR broke up. This system would have resulted in sixty percent of the gross sales price of a barrel of oil disappearing into turnover based taxes before there was any deduction for operating costs or depreciation. In the unlikely event that this left any profit at all, the profits tax that would have been charged upon it would not have been a creditable tax, at least in the US, because of a number of major items of expenditure were not deductible under the tax system of the Soviet Union. To qualifj for a deduction individual items of expenditure had to be Iisted as deductible in the extremely detailed Cost of Production Statute. If expenditure

was not specifically identified a deduction was not allowed. Deductions were also limited by I reference to norms such as four dollars a day for business trip expense. Costs carried forward were limited to five years and the concept was that in each of those years you were entitled to take one fifth of the loss on a “take it or loose it” basis. Losses and the capital value of assets would be denominated in a currency which was at risk of a hyper inflation and so they would very rapidly loose their economic value. At a purely practical level every single separate asset with a value in excess of approximately six dollars could have to be depreciated in its own separate asset account and kept a track of until its disposal. All of the assets known to Soviet Man were identified in the USSR’s “All Union Classifier”, which contained a bewildering number of classifications and generally very slow depreciation rates. For all of the above reasons it was necessary to start with a clean piece of paper and through a process of negotiation a PSA tax regime was developed. The Tax regime is described in detail in each PSA. Each of the Azerbaijan PSAs is enacted into law by the Majalis, the Azeri parliament in its entirety. As a result typically PSAs have three languages, they are negotiated in English and Russian and translated into the official legal language Azeri. The PSAs grant global exemption from the tax regime of Azerbaijan except for the payment of profits tax and certain withholdings on other tax payers.

7of 14 SLIDE 13

The profits tax provisions start by referring to a specific version of the law of taxation of profits of enterprises and organisations, so that there is a technical anchor into the law that is subject to Azerbaijans modern double taxation treaties which include treaties with both the UK and Norway. The basic PSAs amend the profit tax law extensively, they have detailed western style accounting procedures in particular designed to ensure the deduction for all business expenses.

SLIDE 14

Other taxes are as follows:

Profit Oil splits - A key part of the fiscal regime is the actual division of the profit oil, the oil that is left after, broadly, the Contractor has recovered his costs. The State’s share of the profit oil hlfils the role of a super profits tax such as Special Tax in Norway or PRT in the UK. Those of you who are familiar with PSAs will know there are a number of different mechanisms which can be used to divide the oil. Generally, the objective is that the Contractor should recover his costs and earn a fair return on his investment, and once he has done so, his share of the oil progressively reduces, so that a progressive share of the super profit is captured by the State. Economically, it therefore hnctions as a super profit tax rather than a royalty. The methods differ in the degrees of risk the Contractor has that his share of production will diminish before he has recovered his costs and as you might expect, the terms in Azerbaijan differ between PSAs depending on among other things the relative state of knowledge of the area, and geological conditions. It is our understanding that in this situation, Norway would regard this amount as a creditable tax, subject of course to the usual limitations.

8of 14 The other relevant taxes are:

The social fbnd employment contributions for Azeri employees, typically around forty percent of the payroll costs Individual income tax for local and expatriate employees, the latter limited to income earned in connection with work on the territory of Azerbaijan. Including gross up the effective tax rate on expatriates tends towards 56%, in respect of locals it is 40% on income above $3,400 Customs processing fees - while these are payable, customs duties are not - the payments for the processing fees are related to the costs of providing a service and are modest in amount.

c SLIDE 15

A Foreign Subcontractor is deemed to earn a profit of between twenty and twenty-five percent of the gross payment that is due to him and he is taxed on this at the rate of tax between twenty-five and thirty-two percent depending on the generation of the PSA so that the actual withholding is between 5% and 8% of the gross payment due. The payer withholds the tax. The crucial feature of this regime is that the Subcontractors pay no other taxes and have no other filing obligations in Azerbaijan. If a Subcontractor does not like the result of this then if there is a treaty available which he thinks will be more favourable he is free to apply for a treaty override.

SLIDE 16

Although the profit oil splits of several of the Azerbaijan PSAs are in the public domain, I am not sure that it would be appropriate for me to talk about specific contracts. However, I imagine that not everyone here will be familiar, with PSAs, so I will give some generalised examples of possible methods of dividing profit oil.

In a PSA, oil is divided into cost recovery oil and profit oil. Note it is oil, not cash that is being divided. If we have a net back price of twelve dollars, of that twelve dollars the first claim is for the operating costs of the period say four dollars this leaves eight dollars available

and for the sake of example, let us assume that a hrther $4 worth of oil is allocated to cost recovery of capital expenditure. Accordingly of the twelve dollars that we started with, four have now been allocated to cost recovery of Opex and four have been allocated to cost recover Capex. This leaves an amount of four dollars to be split between the Contractor and the State Oil Company and so again let us assume that under the terms for the allocation of profit oil the Contractor takes fifty percent and the State Oil Company gets fifty percent. The Contractor then has a taxable income of the eight dollars of cost recovery oil he has received plus the two dollars of profit oil being ten dollars, and the State receives two dollars. It is our understanding that in this situation, Norway would regard this amount, the two dollars of profit oil as a creditable tax, subject of course to the usual limitations. The profit tax paid either by the Contractor, or by the State Oil Company on his behalf, depending on the Contract, would also we would expect, be creditable.

SLIDE 17

The 50/50 split of the profit oil that we have just looked at could be arrived at using a number of different techniques. The simplest would be a so called “volumetric trigger”. In that case, the Contract might say that the oil would be divided 50/50 until a billion barrels had been produced, and thereafter 75% to the State and 25% to the Contractor. Under this method the Contractor is at considerable risk of, for example, delays, since his share of the profit oil is not uplifted for the time value of money.

Another technique is the “R” Factor method. The “R” Factor is calculated as the Contractors accumulated income divided by the Contractors accumulated capital costs. In this instance so long as the ratio of accumulated income to accumulated capital expenditure is less than one point five the oil is divided 50/50. As time goes on accumulated income will increase whereas one would expect the Capex would tale off so the ratio would rise and as the ratio rises so does the State share of the oil. In can be seen that in the “R” Factor method the Contractor is not guaranteed a rate of return, and it is he rather than the State that is at risk from delays, but it broadly will increase the state’s share of profit oil as the profitability of the project increases.

lOof 114 A third method of dividing profit oil would be to use the actual rate of return of the Contractor so that instead of the Contract’s share of profit oil declining as the ‘R’factor rises, it would decline as his rate of return rose. The particular methods used in individual countries will depend on the particular situations of the host government, the Contractor and the prospect about which they are negotiating.

SLIDE 18

The Central Asian republics that broke away from the USSR have been under considerable pressure from Western bodies both academic and quasi-governmental, to introduce Western style tax systems. Kazakhstan led the way with a new tax code introduced in July 1995 which has since been amended nineteen times. Georgia has, this year adopted a new Tax Code Iargely modelled on the Kazakh version, and Azerbaijan has declared its intention to introduce a new tax code effective 1 January, 1999, though no drafts have yet been published. Kazakhstan introduced new Investment and Petroleum laws and Azerbaijan is also intending to do so. I believe that it is the intention of the Azeri authorities that the existing PSAs will be grandfathered, but that new PSAs will be subject to the new Tax Code. It is worth looking at the Kazakh and Georgian Tax Codes, as likely analogues for the new Azeri Code. Both Tax Codes are a high level document, which assumes that points of detail will be dealt with in Instructions. These Instructions are not delegated legislation but are interpretative, illustrative and administrative acts. The tax service therefore has considerable power to make the rules. The thrust of these Codes are Western but with a strong local flavour. The number of taxes is limited and it is possible to model project economics.

At first sight it may seem that there are a significant number of taxes charged, but the number is now quite modest by FSU standards. Before the new Tax Code was introduced in Kazakhstan, there were thought to be fifty four taxes. In reality the local taxes have more of a nuisance value and the key economic taxes are Income Tax on legal and physical persons, and VAT. In addition to the Tax Code there are also Customs Codes and these costs can be significant. VAT and Customs Duty on importing a drilling rig to Kazakhstan would amount to 50%. Turbulence created by the introduction of a new Tax Code is significant and the problems that it creates, particularly in terms of the need for widespread education in western accounting practices are enormous, and are generally, I suspect, under estimated by the western advisers who advocate “big bang” tax reform. Nevertheless, this is the path upon which Azerbaijan has embarked,

SLIDE 19

In each case there is a so called Income Tax which applies both to legal and to physical persons, includes a business profits tax calculated on Western lines. The tax rate in Georgia is twenty percent on business profits and in Kazakhstan is thirty percent plus an additional branch profits tax at the rate of fifteen percent on net income. Accordingly the effective Kazakh rate is between forty point five percent and thirty point four percent, depending on whether treaty relief is available. These rates compare with the current rate of Azerbaijan of thirty two percent, but it is important to appreciate that in calculating profits tax in Azerbaijan today under the general regime there are substantial limitations on the deductibility of expenditure? for example interest on long term loans and exhibition participation costs are not deductible and deductions for costs such as advertising and training are limited to local norms. In both Georgia and Kazakhstan losses are basically carried forward for five years, or in the case of upstream activity in Kazakhstan seven years. As I mentioned early in Azerbaijan today one fifth of a loss can be deducted on a use it or loose it basis in each of the five years after the loss has been incurred. It is also worth noting that this applies to Azeri legal entities, foreign legal entities do not have a loss carry forward at all in Azerbaijan.

SLIDE 20

In the Kazakh Code the Chapter that deals with Petroleum and hard rock mining (the “subsurface use” payments) envisages two alternative regimes - PSAs or a “Super Profit Tax and Licence” regime. PSA profit sharing and Super Profit Tax are mutually exclusive, which is obviously right. The provisions are largely enabling legislation, so that levels of, for example, bonuses and royalties can be set by negotiation. Note, incidentally, that bonuses are taxes in Kazakhstan. The Super Profit Tax is based on the earned, rate of return, and starts when this exceeds 20%. The equivalent section of the Georgian Code that deals with natural resources is a lot simpler and amounts to a percentage of turnover ofup to 10%. The Kazakh

12of 14 Code contains a rather odd provision that appears to say that whether you go the PSA route or the Super Profit route, the tax you pay should be the higher of the two.

For upstream companies, the VAT which is prevalent throughout the former Soviet Union is a major problem because of the difficulty of obtaining VAT refhnds in countries which are in economic transition. Kazakhstan today deals with this by making VAT incurred on exploration and appraisal exempt but also denying the supplier the right to a VAT refund, so that effectively front end costs are increased as the supplier will on charge, as a business expense, the VAT he suffers.

One other area of concern in these Tax Codes is the prevalence of withholding tax on payments to non residents who do not have taxable branches in-country. Georgia at present attaches interest, dividends, and income from management, financial and insurance services. This was the position in Kazakhstan until July of this year, since when Kazakhstan has claimed the right to withhold tax of up to twenty percent on any amount that is deducted in calculating the profits of a permanent establishment in Kazakhstan, but is paid to a non resident who does not have a permanent establishment in Kazakhstan.

On a positive note, the Kazakh Tax Code does contain comprehensive provisions to preserve the tax regimes of contracts that had been promised specific tax terms prior to the introduction of the new Tax Code, and also preserving the tax terms of later contracts as at the date they are entered into, unless the investors agree that later changes to the Tax Code shall apply to them.

In case anyone is thinking of going to Kazakhstan, I should also mention that if you are in the country for more than thirty days in a twelve month period you acquire a Kazakh personal income tax liability.

You will appreciate from all that I have said, Azerbaijan and some of the countries that surround it have made dramatic progress in the seven years since they became independent from the USSR, and are continuing to do so. Azerbaijan is a country in transition and surrounded by countries in transition. I would expect that by early next year the Azerbaijan tax regime outside of the PSAs will have been completely replaced with a Western inspired Tax Code on lines of the Georgian and Kazakh models, but that the PSAs will remain in force for the parties to those contracts and their foreign subcontractors for the life that those contracts assigned their tax regimes. I hope that you will have found this presentation interesting and I look forward to seeing many of you in years to come in Azerbaijan.

14of 14 AZERI-CHIRAG GUNASHLI

DISCOVERED BY THE USSR

PSA NEGOTIATIONS TOOK THREE YEARS

SIGNED SEPTEMBER 1994

FIRST OIL EXPORTED FROM NOVOROSISK MARCH 1998

"EARLY OIL" PRODUCTION CURRENTLY 80 TO 400 mbd RISING

TO 200 mbd

SLIDE 7(a) Nakhichevan

0 50km TO BE ANNOUNCED 20.00

ltal Saudi 9.5% fapan 3%

Azerbaijan 34% ERBAIJA HSTAN Unrisked

OIL PRODUCTION - KBD

4000

-I

3000 -.

2000 -.

1000 -.

0 -' AZERBAIJAN - KEY PSA PROVISIONS

LEGALLY SUI GENERIS (Le. each PSA is a law independent of other Azeri Laws)

TAX LIMITED TO; PROFITTAX TAX ON EMPLOYEES SOCIAL CONTRIBUTIONS FOR AZERl EMPLOYEES

b EXTERNAL BEN EFITS FOR SUB CONTRAC TORS AZERl PSAs

PROFITS TAX

PSAs refer to Law Taxation of Profits of Enterprises

and Organizations.

PSAs amend that law by specifying in detail how

profits are calculated and setting fqf~permissible

deductions. AZERI PSAs OTHER TAXEWPAYMENTS

PROFIT OIL SPLITS

SOCIAL FUND, EMPLOYMENT CONTRIBUTIONS FOR AZERI EMPLOYEES

INDIVIDUAL INCOME TAX FOR LOCAL AND EXPATRIATE EMPLOYEES

CUSTOMS FEES AND OTHER FEES FOR OPERATING REGISTRATION AND PERMITS

EXPATRIATES - AZERI TAX LIABILITY IS LIMITED TO INCOME EARNED INSIDE AZERBAIJAN

SLIDE 14 AZERI PSAs

FOREIGN SUBCONTRACTORS

DEEMED INCOME PRINCIPLE APPLIES

DEEMED PROFIT OF 20% - 25%, DEPENDING ON PSA

TMRATE 25% - 32% DEPENDING ON PSA EFFECTIVE TAX WITHHOLDING OF BEWEEN 5 - 8% OF THEIR GROSS PROCEEDS RECEIVED IN AZERBAIJAN

TAX TREATIES CAN APPLY IF MORE FAVORABLE

a SLIDE 15 SLIDE 16

XYZ PSA PRODUCTION SHARING CONTRACT FLOW DIAGRAM

ONE BARREL OF OIL (Net back price)

$12.00 Contractor Government/ Share Share Cost Recovery Opex (say $4) -$4 c $8 Capex (say $4) $4 $8.00 - Profit Oil Split $2.00 $2.00 - (say 50/50)

$2.00 $10.00 SLIDE 17 XYZ PSA

“R” Factor = Contractor’s Accumulated Income Contractor’s Capital Costs

Contractor’s Income = Cost Oil plus Contractor’s share of Profit Oil and deemed interest

If R < 1.50 50 50

1.50 5 R < 2.00 50 + X 50-X

2.00 5 R <2.25 50 + 2X 50 - 2X

2.25 5 R <2.50 50 + 3X 50 - 3X

etc. SLIDE 18 TAX ]REGIME - KAZ~STAN/GEORGIA

GE

NATIONAL TAXES 1) Income tax from legal entities and physical persons 1) Income tax 2) Value-added tax 2) Value-added tax 3) Excise (duties) 3) Excises 4) Levy for registration of securities issues 4) Property tax 5) Special-purpose payments and taxes of users of the 5) Land tax subsurface. 6)Tax on ownership of motor vehicles 7) Tax on transfer of property 8) Social security tax 9) Tax on use of natural resources 10) Tax on polluting the environment with harmfkl substances 11) Tax on bringing cars onto the territory of Georgia

~ ~ ~

LOCAL TAXES 1) Land tax 1) Tax on entrepreneurial business 2) Tax on property of legal entities and physical persons 2) Tax on gambling business 3) Tax on transport vehicles 3) Resort tax 4) Levy for registration of physical persons who engage in 4) Hotel tax entrepreneurial activities and of legal entities 5) Advertisement tax 5) Levy for right to engage in certain types of activities 6) Car parking tax 6) Levy on auction sales 7) Tax on use of local symbols 7) Levy for use by legal entities and physical persons of symbols of the City of Almaty in their business names, service marks and trade marks. SLIDE 19

BUSINESS PROFITS TAX

AZERBAIJAN KAZAKHSTAN GEORGIA RATE 32% 34.5 - 40.5% 20% (including branch tax)

TAX BASE Significant restrictions in Broadly Western Bro ad1y We stern deductions

LOSS CARRY FORWARD One fifth per year for five 5 - 7 years 5 - 7 years years (Azeri legal entities). No loss carry forward for BranchesPEs.

I SLIDE 20

SUPER PROFITS TAX

______. ___I-

Profit Sharing Internal Rate of Return (20%+) or Turnover based, up to 10% of turnover. Production Sharing SLIDE 21

AZERBAIJAN

NEW DRAFT TAX CODE

On the 28th of October the New Draft Tax Code was published for comment. As yet an English translation of it is not available and so my comments on its content are based on the very preliminary answers I have received to questions I have put to Ernst & Young’s office in Baku. As expected the Tax Code is similar to the Georgian one.

Paragraph 9 of Article 1 specifically provides that where a Production Sharing Agreement (“PSA”) or a similar agreement is ratified by the Parliament of the Azerbaijan Republic and = such an agreement provides for taxation rules other than those specified in the Code the rules contained in the ratified agreement shall be applicable. Accordingly, existing PSAs will be grandfathered. As regards new PSAs it appears that these also may contain provisions at least in respect of the Contractor Parties to those PSAs, which provide for the tax regime that differs from that in the Code. However, it would appear that it is the intention of the new Code that subcontractors of new PSAs should be taxed exclusively under the new Code and that new PSAs should not contain tax provisions in respect of them. The Code provides for nine main taxes which I shall return to in a moment. There is no special mineral extraction tax regime of a type that is found in the Kazakh Tax Code, but mineral extraction royalties are provided for and will vary depending on the geological conditions.

SLIDE 22

The main taxes are as follows: Personal Income Tax would appear to be charged on persons who are tax resident, that is persons that are present in Azerbaijan for 182 days in any consecutive twelve month period. The top tax rate is 40% and would be charged broadly on income in excess of $3 10. VAT would be charged broadly in a way that we would recognise at a rate of 20%. Business profits tax will be charged at a rate of 30%. Generally expenses of doing business will be deductible. Interest will be deductible subject to a limitation on the rate of 150% of the National Bank of Azerbaijan’s interest rate as used in bank credit auctions. Entertainment expenses and expenses for the provisions of meals and housing for employees would not be deductible. There would be a five year loss carry forward for both Azeri and foreign legal entities with no limitation on the amount of loss that can be deducted in any one year, and depreciation will be calculated using western asset groupings. Cars and computer equipment would be amortised at 20%. Rolling stock, trucks, buses, construction equipment, electronic equipment and office fbrniture will be amortised at 15%, rail, sea and river transportation vehicle, power machines and equipment, generators, electricity and communications transmission facilities and pipelines will be depreciated at 8%, buildings and structures will be depreciated at 7% and other assets will be depreciated at 10%. I would expect that other assets will include exploration costs.

c

SLIDE 23

The remaining main Taxes proposed are:

Excise Tax Payers: Legal entities and Physical persons producers or importers of excisable goods. Rates: The list of goods subject to the excise tax is to be adopted by the appropriate executive government body.

Land Tax Tax Payers: Physical persons and entities having land in their possession. Rates: Different rates are provided based on the region, area, location, type of use, etc.

Property Tax Tax Payers: Physical persons and legal entities having taxable property. Rates: For physical persons - not clear, some rates are left blank; entities - 0.5% of the value of fixed assets.

2 of3 Tax on Purchase of Vehicles Tax Payers: Physical persons and legal entities. Rate: 2% of the sale price.

Tax on Vehicle Owners Tax Payers: Physical persons and legal entities. Rate: For legal entities - 5% * horse power of the engine * minimum salary (currently 5,500 manat); For physical persons - small vehicles, as above but the tax rate is 2%, trucks 5%.

Tax on Road Use (for vehicles belonging to foreign countries, transit) Tax Payers: Physical persons and legal entities having vehicles in transit Rate: For small vehicles - $15.

Customs Duties are the subject of a separate Code.

Finally, it is probably worth highlighting that including in the penalty regime are the old Soviet administrative penalties such as, in the event of a tax violation, the personal penalty of two months salaries for the representative and chief accountant of the enterprise concerned. It is also worth noting that there is no mention of the creation of an environmental tax as is contained in the Georgian Tax Code, and there appears to be no new appeals procedure set out in the new Code. On the information available at present, it would seem that the new Azerbaijan Tax Code has to a larger extent materialised in the way that was anticipated. However our experience in Kazakhstan and Georgia has demonstrated that new Tax Codes tend to raise more questions than they answer and I imagine once a translated text becomes available, which I believe will be at the end of this week, there will be an opportunity for intensive lobbying on those aspects of the Code that may create problems for foreign investors, I am sorry I have not be able to give you a filler account of the New Draft Tax Code but you will appreciate that it was due to circumstances beyond my control.

3 of3 AZERBAIJAN - NEW DRAFT TAX CODE (Preliminary comments courtesy of Ernst & Young, Baku)

Draft published 28 October 1998 Similar to Georgian Code Existing PSAs are grandfathered New PSAs may contain their own tax provisions for Contractor Parties, but NO '7 Subcontractors. Nine main taxes No special mineral extraction regime, but mineral royalties are provided for.

SLIDE 21 AZERBAIJAN - NEW DRAFT TAX CODE (Preliminary comments courtesy of Ernst & Young, Baku) Main Taxes (1): - Personal Income Tax 182 day residence test Top rate 40% on income in excess of $310 (approx.) -VAT

B- 20% - Business Profit Tax Rate 30% Interest deductible, subject to a rate test Entertaining, and feeding and housing employees are not deductible 5 year loss carry forward Depreciation uses Western Groupings - most business equipment would qualify for 20%, 3.5% rates. or SLIDE 22 AZERBAIJAN = NEW DRAFT TAX CODE (Preliminary comments courtesy of Ernst & Young, Baku)

Main Taxes (2):

Excise Tax

B Land Tax

Property Tax

Tax on Purchase of Vehicles

Tax on Vehicle Owners

Tax on Road Use SLIDE 23