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 Tax Regime Steve C. Martin Tax Partner, Ernst & Young Azerbaijan Accounting Method Taxpayers may use either the cash method or accruals method of accounting, provided that they use the same method used for bookkeeping purposes and use the same method consistently throughout the year. Joint Activity Taxpayers can engage in a joint activity without the creation of a separate legal entity and without incurring a separate level of tax. Income and expenses from the joint activity are allocated to the participants in proportion to the percentage of their participation in the activity, and the resulting taxable incomes are taxed directly to them. Long-term Contracts A taxpayer using the accrual method of accounting must use the "percentage of completion" method to account for long-term contracts. The method is based on the percentage of estimated total expenses incurred in the tax year. A long-term contract is any contract for a project spanning two or more tax years and lasting more than six months. Financial Leases In the case of a financial lease, the lease is treated as a purchase, the lessee is treated as the owner of the property, and lease payments are treated as payments on a loan. A financial lease is defined to be any lease under which: the leased asset transfers to the lessee at the end of the lease the residual value of the asset at the end of the lease is less than 20% of the asset value at the start of the lease the net present value of the lease payments is more than 90% of the asset value at the start of the lease the asset is customized for the lessee Like Kind Exchange If assets are involuntarily destroyed, liquidated or sold and the proceeds are reinvested in assets of the same or a similar nature within two years following the close of the year of sale or disposal, no tax applies to the disposal, and the replacement assets will take a substitute basis equal to the basis of the assets that were disposed of. The law provides relief for taxpayers facing an involuntary disposal of assets by treating the disposal as a non-taxable transaction. Corporate Liquidation Liquidation of a subsidiary into a company owning 100% of the liquidated entity is not a taxable event. Rather, the assets transfer to the parent company with a substitute basis, and any tax is deferred until the assets are subsequently disposed of by the parent company. Formation of Company A transfer of assets to a company in exchange for 100% ownership of the company immediately after the exchange is not a taxable event. Rather, assets carry over to the company at cost and the transferors take a substitute basis in the shares that they receive in exchange for the contributed assets. Corporate Reorganization The tax code introduced the concept of tax-free corporate reorganizations, including the following restructurings: Merger Split-up Spin-off Acquisition of more than 50% of the assets of a resident entity solely in exchange for non-preferential voting interests in the acquirer Exchange of 50% ownership in a resident entity solely for ownership in another entity The new tax law introduces concepts consistent with those of international practice and recognizes that no tax consequences should result from a mere restructuring of an investment. Change of Control In the case of a change of ownership of at least 50% of a legal entity, the entity's tax attributes will not carry forward unless the entity conducts the same activity for three years following the change and does not begin a new activity for one year after the change. This provision presumably aims to prevent corporate takeovers from occurring simply for purposes of acquiring the tax benefits that a target company may have accumulated. Tax Audits A tax audit conducted from tax authority facilities can be conducted annually and must be conducted within 30 days of submission of a tax return. A tax audit conducted at a taxpayer's site may be regular or extraordinary. A taxpayer cannot undergo a regular audit more often than once every two years, and tax authorities cannot take more than one month to complete a regular audit. Extraordinary audits may be conducted only in cases of irregularities on the part of a taxpayer. Documents requested for audit must be submitted within 5 days of the request. Thereafter, documents may be confiscated by the tax authorities on the basis of a court order. Reports of findings in tax audits must cite specific provisions of tax legislation that have been violated. Assessment of financial sanctions must be reviewed and effected by a court order. Charges of violations of tax law must be reviewed by a court of law. Taxpayer innocence is presumed; doubts are to be resolved in taxpayer's favor. At the suggestion of the tax authorities, taxpayers can correct an error detected in an audit within 30 days of the suggestion and face no sanctions. Voluntary disclosure and correction of a tax law violation will not be subject to financial sanctions (though interest is still applicable). This provision eliminates the prior disincentive for taxpayers to come forward upon the detection of their own errors in tax reporting.
Theatre of Young Spectators Statute of Limitations These articles create an internal contradiction within the tax code, because one article stipulates that no liability for tax law violation can arise more than three years after the date of violation, while another article stipulates that the tax authorities may demand the payment of tax, interest and financial sanctions within five years after the lapse of the tax year in which an error occurred. Financial Sanctions The following sanctions may be assessed for violations of tax law: The penalty for late submission of a tax declaration is 1% of the unpaid tax per month (up to a maximum of 12%) The penalty for understatement of a tax is 20% of the amount of the understatement (40% for a repeat violation) The penalty for misstating VAT, incorrectly charging VAT or failing to undertake a required VAT registration is 40% of the misstatement or amount of VAT that should have been charged The interest charge on a late payment of tax is 0.05% of the late paid amount per day of delay for the first 90 days, rising to 0.1% thereafter Filing Deadlines If a stipulated filing deadline falls on a non-working day, the deadline becomes the next following business day. An automatic three-month extension of a filing deadline is permitted if an extension request is filed and the tax is paid by the normal deadline. Tax Refunds The tax authorities may apply tax overpayments against any other tax liabilities that a taxpayer may have. If no other liabilities exist, tax overpayments are to be applied against future liabilities unless the taxpayer requests a refund, in which case the tax is to be refunded within 45 days following a taxpayer's application for refund. An individual who is not required to file a tax return may choose to file a tax return to request a refund of previously withheld taxes. Likewise, a legal entity that has no permanent establishment in Azerbaijan and has been subject to income tax withheld at source may elect to file a tax return and be subject to profit tax on its net profit. Advance Tax Payments Both legal entities and individual entrepreneurs must pay advance taxes quarterly in an amount equal to either one-fourth of their total tax liability for the prior year or the tax on their actual revenues for the quarter as measured at the effective rate of tax (as a percentage of revenues) for the prior year.
"Karavansarai"-hotel in Sheki OIL AND GAS TAX REGIME As mentioned above, companies operating under a PSA are subject to a special tax regime in Azerbaijan. Each PSA contains a tax section that outlines the general regime for that particular agreement, but all PSA tax regimes are relatively similar. PSAs and the associated tax protocols that supplement them typically provide a specific treatment for five types of tax: profit tax on the contractor parties to the PSA, taxation of foreign subcontractors, value added tax ("VAT"), import tariffs, and personal taxation of expatriates working under the PSA. The following sections provide a discussion of each tax. Profit Taxation of Contractor Parties The profit tax rate applicable to contractor parties is fixed in the PSA and is based on the prevailing statutory rate in effect on the date of signature of the contract. Currently, all ratified PSAs provide for a profit tax rate of either 25% or 32%, depending on when the agreement was signed. Typically, PSAs provide protection against future increases in the effective profit tax rate. Taxable income is calculated in accordance with internationally accepted accounting practices in the petroleum industry rather than in accordance with Azerbaijani statutory accounting procedures. Losses incurred by contractor parties during the period of preliminary exploration are deductible once production starts. Activities that are not connected with hydrocarbon activities in relevant contract areas in Azerbaijan are deemed to be outside the scope of a PSA and the corresponding tax regime. If a company engages in both PSA-related activities and unrelated activities, separate books of account in accordance with statutory rules must be maintained to reflect income and expenses generated in connection with the activities that are not related to a PSA. Operating companies that administrate a PSA are not taxable and allocate all income and expenses to the contractor parties in proportion to their participating interests in the PSA. Taxation of Subcontractors A foreign subcontractor (defined as a subcontractor incorporated, legally created or organized outside of Azerbaijan) that operates under a PSA in Azerbaijan is generally subject to a tax regime that is much simpler than the statutory tax regime. Under this simplified tax regime, foreign subcontractors are in most cases subject to income tax withheld at the source of payment, and this tax at source satisfies in full their profit tax obligations in Azerbaijan. Accounting requirements are simplified, because the need to track revenues and expenses is greatly curtailed. The rate of tax to be withheld ranges from 5% to 8%, depending on the applicable PSA. Likewise, a foreign subcontractor must withhold tax on any payments it makes to its own lower-tier foreign subcontractors. A few of the newer PSAs stipulate that foreign subcontractors working under a contract, the duration of which is more than six months during the production and development stage of the PSA, are subject to domestic taxation. However, most of the PSAs in Azerbaijan are still in the exploration phase, so this domestic taxation does not affect most companies at present. Azerbaijani legal entity subcontractors ("ALEs") operating under a PSA cannot benefit from this simplified tax regime. ALEs are subject only to domestic tax law. No taxes are withheld at the source of payment to an ALE. Rather, corporate profit tax at the standard rate of 27% applies to an ALE's net profits. In addition, tax must be withheld on any profit remittances from the ALE to a foreign investor. Value Added Tax Hydrocarbon activities conducted under PSAs are exempt from VAT. The mechanism for achieving this is a VAT exemption certificate to be obtained from the tax authorities. Though PSAs do not clearly exclude ALEs from obtaining such exemption certificates, the tax authorities often refuse to grant exemptions to domestic subcontractors. Contractor parties and foreign subcontractors issue these certificates to their suppliers to absolve them of the liability for charging VAT on their supply. Thus, these companies pay no VAT to their suppliers, charge no VAT if and when they have output, and suffer no cash flow consequences. Import Tariffs Imports of goods and services for use in PSA hydrocarbon activities are also exempt from import VAT and customs duties. Similar to the VAT exemption, this exemption from import tariffs is achieved through the use of exemption certificates to be obtained from the customs authorities. This certificate is then presented to the customs authorities at the time of each import, and no import tariffs apply to the import. As in the case of VAT, domestic subcontractors often encounter difficulties in obtaining these exemption certificates. Employee Taxes PSA typically provide that foreign employees who are tax residents are subject to Azerbaijan personal income tax on their income earned as a direct result of their employment in Azerbaijan. The term "tax resident" is defined to include: 1. an individual who is present in Azerbaijan for any period exceeding 30 consecutive days (such an individual is subject to Azerbaijan personal income tax only on income earned as a direct result of employment in Azerbaijan and only on income earned after the 30th day of presence in Azerbaijan); 2. an individual whose presence in Azerbaijan does not exceed 30 consecutive days in any calendar year but whose presence in Azerbaijan does cumulatively exceed 90 days in such calendar year (such an individual is subject to Azerbaijan personal income tax only on income earned as a direct result of his employment in Azerbaijan and only after the 90th day of presence in Azerbaijan); 3. in the case of rotating employees, an individual whose presence in Azerbaijan exceeds 90 cumulative days in a calendar year (such an individual is subject to income tax on income earned as a direct result of employment in Azerbaijan, including income earned during the first 90 days of employment in Azerbaijan before tax residency is established). Foreign employees working under a PSA are not subject to social taxes. Local employees are treated differently than foreign employees with respect to personal income tax, because local nationals are subject to domestic tax law. Local national employees are therefore subject to the graduated personal income rates that reach a maximum of 35%, and their employers must make social insurance contributions in an amount equal to 33% of gross payroll. A further 1% employee-paid contribution should be withheld from each local employee's salary. Other Taxes PSAs specify that no other taxes other than those outlined in the PSA apply to hydrocarbon activities conducted under the PSA. Thus, contractor parties and foreign subcontractors working under a PSA should face no other tax burden or tax compliance costs. In contrast, ALEs are potentially subject to all taxes that exist under domestic legislation and must comply with the reporting obligations for a number of taxes. They must file tax declarations, including nil declarations for any taxes that do not apply to the taxpayer, and pay any taxes that do apply. MEP HOST GOVERNMENT AGREEMENT TAX REGIME Azerbaijan's HGA stipulates that MEP participants (i.e. contractor parties) are subject only to the taxes outlined in the HGA, which are profit tax, VAT and employee taxes. No other taxes should apply. The following sections provide a discussion of the taxes applicable under the HGA. Profit Tax The tax rate is 27%. Taxable losses can be carried forward indefinitely for offset against future profits. Income and deductions are recognized according to the cash method of accounting. Profit is defined as income less deductions, where income includes both tariff income and other income. Tariff Income is cash received from tariffs for transport though the pipeline. Other income consists of other cash received by MEP participants, including insurance proceeds, exchange gains and interest income, but specifically excluding proceeds from the disposal of any or all rights or obligations arising under the MEP system, dividends and amounts received as reimbursements of expenses in excess of deducted expenses. Deductions include all costs incurred during the year in connection with the project, within or outside of Azerbaijan. Costs related to the overall activities of the MEP system should be allocated in part to Azerbaijan according to kilometers per country, capital expenditures per country or some other reasonable method. Fixed assets are depreciated at rates that vary from 7% to 25% (depending on the type of asset) on a declining balance basis. No tax applies to any subcontractor, to any payment to any entity established outside of Azerbaijan or to any individual who is not an employee of the payer. In addition, no tax applies to any payment made by an MEP participant, operating company or affiliate in reimbursement of costs incurred on behalf of the payer. Further, no income tax at the source of payment is required on payments of interest, dividends, royalties, service fees or other profit remittances. Value Added Tax All goods and services sold to or imported by an MEP participant, contractor, operating company or shipper are subject to 0% VAT. Any input VAT that such a company does pay is creditable and offsetable for the company that pays it. The procedure for avoiding VAT is similar to that for PSAs. In other words, the tax authorities should issue VAT exemption certificates to companies working on the MEP, and these certificates would absolve suppliers of the obligation to charge VAT on their supplies. Employee Taxes Foreign employees are subject to tax only on income earned from employment in Azerbaijan and only if they spend more than 182 days in Azerbaijan during the year. Personal taxes apply only after the time in the year when an employee becomes subject to tax. Personal tax applies at the standard domestic tax rates. Foreign employees are not subject to social taxes Local national employees are subject to all payroll taxes in Azerbaijan. As discussed above with respect to the statutory tax regime, these include personal income tax at graduated rates that reach a maximum of 35%. Employers are also required to pay for social insurance for employees who are citizens of Azerbaijan, and this results in a total burden of 32% of local gross payroll. The further 1% employee-paid social tax must be withheld from each employee's salary.
 
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