Outlines of the Presentation of Mr. Vadim Dmitriev,

Former Deputy Head of the Legal Department of the National Agency

of Ukraine for Development and European Integration,

at the Seminar on the Legislation

on Production Sharing Agreements,

September 14,1998

Survey of Applicable Legislation of Ukraine in the Area of Subsoil Use and Relevant Tax Legislation

Outline

I. Introduction

II. Legal Regime for Subsoil Use

A. Subjects of Subsoil Use

B. Types of Subsoil Use

C. Length of Time for Subsoil Use

D. Regime for Subsoil Use

E. Right of Ownership to Extracted Raw Materials

III. Taxes and Other Payments in the Sphere of Subsoil Use

A. Taxes Which are included in the Price of Sales Above the Prices of the Producer

B. Taxes Which are Paid out of Profit

C. Turnover Payments

D. Payroll Taxes

E. Other Payments and Fees

IV. Conclusions

I. Introduction

At the present time, the principal Ukrainian laws regulating relations with respect to subsoil use are the Ukrainian Constitution, the Ukrainian Code “On the Subsoil” (hereinafter the “Subsoil Code”), the Ukrainian Land Code, and various Ukrainian laws on taxation (e.g. the Laws “On the System of Taxation”, “On the Taxation of the Profit of Enterprises”, “On Value-Added Tax”, and others).

II. Legal Regime for Subsoil Use

The Ukrainian Constitution establishes the primary basis for subsoil use. Under Article 13, the land, its mineral resources, air, water and other natural resources located within Ukrainian territory, as well as natural resources located within Ukraine’s continental shelf and exclusive (sea) economic zone are objects the right of ownership of which belongs to the Ukrainian people. Bodies of state power and of local self-government exercise the right of ownership over such resources in the name of the Ukrainian people as set forth in the Ukrainian Constitution.

This basic concept is expressed in the Subsoil Code adopted by the Ukrainian Supreme Rada in 1994. It emphasizes that the subsoil is the exclusive property of the Ukrainian people. The Subsoil Code provides that only the use of the subsoil may be transferred (Article 4).

The Subsoil Code is the basic legal act in the area of subsoil use. It not only establishes the legal regime for subsoil use, and the rights and duties of subsoil users, it also resolves a whole series of issues connected with mining, geology, production-technology, environmental protection and other special conditions for subsoil use. Of special importance are its provisions that determine the competence of bodies of executive power in the sphere of subsoil use.

We note the most important provisions of the regime for subsoil use below.

A. Subjects of Subsoil Use

Subsoil users may be enterprises, institutions and citizens. In addition, the Subsoil Code states that foreign legal entities and individuals may be subsoil users.

B. Types of Subsoil Use

Article 14 of the Subsoil Code sets out the types of subsoil use. It identifies four types of subsoil use, depending on the purpose of such use:

n for geological research, including research-industrial development of deposits of useful minerals of an all-state significance;

n for extraction of useful minerals;

n for the construction and exploitation of subsoil structures, not connected with the extraction of useful minerals, including structures for the storage of oil, gas and other substances and materials, the burial of harmful substances and materials, the disposal of sewer (waste) waters; and

n for the establishment of geological territories and objects which have special scientific, cultural, recreational or health significance.

This list is not exhaustive. The state may make the subsoil available for other purposes as well.

C. Length of Time for Subsoil Use

Article 15 of the Subsoil Code provides that the right to use the subsoil may be permanent or temporary.

The granting of the right to use the subsoil without a previously determined time period is deemed to be permanent.

The temporary use of the subsoil may be short-term (up to five years) or long-term (up to 20 years). In the case of necessity, the length of time for the use of the subsoil may be extended.

D. Regime for Subsoil Use

World practice envisions different regimes for subsoil use, in particular, civil-legal and administrative-legal regimes. Existing Ukrainian legislation is based on the administrative-legal regime, that is, a licensing (permitting) regime for subsoil use. Relations of subsoil use arise out of the adoption of administrative acts by authorized bodies of state power.

The Subsoil Code recognizes three such acts which in aggregate give rise to a right of subsoil use:

n a special permit (license) for the use of a subsoil area issued by the Ukrainian State Committee for Geology and the Use of the Subsoil (with the consent of the Ministry for Ecological Security and Environmental Protection);

n an act on the issuance of a mining allocation, within which may be conducted subsoil use; and

n an act on the issuance of a land parcel in accordance with the rules established by the Ukrainian Land Code.

In this system of administrative acts, the license is the most important. The right to use the subsoil is based on the existence of such a license. The remaining acts are supplemental; they are only formalize the right of subsoil use – in practice it is not possible to exercise one’s rights without the issuance of a mining allocation and land parcel. Consequently, as a whole, the system of subsoil use as envisioned by existing Ukrainian legislation is best characterized as a licensing-permitting system.

The essence of a licensing-permitting system is that the state represented by the appropriate body adopts a decision on the granting of a subsoil area for use and on the issuance of a permit (license) for its exploitation. The conditions of use of the subsoil are determined by the state in the license in a unilateral process. The license by its nature is an administrative-legal act which defines the relationship between the state and the subsoil user – in particular setting out their rights and obligations.

Article 16 of the Subsoil Code provides that a license shall be issued to subjects which have the appropriate qualifications, material-technical and economic capabilities for subsoil use. Ukrainian Cabinet of Ministers Decree No. 709 “On the Approval of the Procedure for the Granting of Special Permits (Licenses) for the Use of the Subsoil”, dated August 31, 1995, establishes that during the adoption of a decision on the issuance of a license to subsoil users, the effectiveness of their work in subsoil areas where they already have undertaken their activity must be taken into account. These provisions establish requirements applicable to potential subsoil users and are directed at an orderly issuance of licenses. However, requirements for subsoil users are not defined which may lead to subjective decision-making by state bodies on issues such as whether a person seeking a subsoil license has met the applicable requirements. In this connection, a potential subsoil user encounter certain difficulties at this stage of receiving the license.

This provision formulates the requirements applied to a potential subsoil user and is aimed at the orderly issuance of a license. However, the requirements for a subsoil user are not defined. This can lead to subjective determinations by the authorities with respect to persons seeking to receive subsoil licenses. As a result, a potential subsoil user may experience certain difficulties in the process of obtaining a subsoil license.

In addition, the state has the right in a unilateral procedure to adopt a decision on the termination and revocation of a subsoil license. Article 26 of the Subsoil Code lists grounds for the termination of the right to use the subsoil. The seven grounds identified are:

n if the necessity for the subsoil use ends;

n in the event of the expiration of the period for the subsoil use;

n in the event of the termination of activity by the subsoil user to which was transferred the right of use;

n if the subsoil use is being conducted with the application of methods and means which negatively affect the condition of the subsoil and cause pollution of the environment or harmful consequences to the population;

n in the event of the use of the subsoil not for that purpose for which the right to use the subsoil was granted, or the violation of other requirements envisioned by the permit (license) for the use of the subsoil area;

n if the user without justification does not begin to use the subsoil within a period of two years; and

n in the case of the withdrawal in the procedure established by legislation of the subsoil area granted for use.

Several of these grounds are sufficiently general so as to allow the authorities a great deal of discretion in adopting a decision to terminate the right of subsoil use.

It is understandable that the administrative-legal system for subsoil use existing in Ukraine today produces conditions where there are serious delays in investment in mining-extracting operations which require significant material expenditures and entail major risks.

These negative characteristics of the existing system of subsoil use are mitigated to an extent by certain provisions of Article 26 of the Subsoil Code. In a series of cases, the subsoil user is given the right to appeal a decision of the state authorities to terminate its right to use the subsoil in a judicial procedure. This right arises in cases when such a decision was taken for one of the following reasons:

n in the case of use of the subsoil with the application of methods and means which negatively effect the condition of the subsoil or causes pollution of the environment or harmful consequences to the population;

n in the event of the use of the subsoil not for that purpose for which the right to use the subsoil was granted, or the violation of other requirements envisioned by the permit (license) for the use of the subsoil area; or

n if the user without justification does not begin to use the subsoil within a period of two years.

E. Right of Ownership to Extracted Raw Materials

Under the licensing regime of subsoil use, the issue of the right of ownership of the useful minerals being extracted arises. Who do they belong to: the user or the state? In world practice, the right of ownership to extracted useful minerals belongs to the owner of the license – that is, the land user.

The Subsoil Code avoids this issue and does not directly state who has the right of ownership to extracted useful minerals. Point 2 of Article 24, however, states that the subsoil user has the right to dispose of extracted useful minerals. Under Ukrainian law, the right of disposal is one of the elements of the right of ownership (possession, use and disposal). Moreover, the right of disposal is the principal expression of the right of ownership.

As a result, it is logical to assume that the right of ownership belongs to the subsoil user. But it would be better if it were explicitly stated in the Subsoil Code that the subsoil user has the right to ownership to extracted useful minerals.

In addition, the Subsoil Code states that in other legislative acts or in the license itself may be envisioned another procedure for the disposal of extracted useful minerals. The procedure for the disposal of extracted precious metals and precious stones established by the Ukrainian Law “On the State Regulation on the Extraction, Production and Use of Precious Metals and Precious Stones and the Oversight over Operations with Them” serves an example of this.

III. Taxes and Other Payments in the Sphere of Subsoil Use

The Subsoil Code embodies the general principle of compensation of the subsoil user. In accordance with Article 28 of the Code, a fee is levied on the use of the subsoil. The amounts for the payment for the use of the subsoil and the procedure for its levying is established by the Ukrainian Cabinet of Ministers.

Moreover, this same article establishes that the payment for the use of the subsoil does not exempt the user from the obligation to make other payments envisioned by Ukrainian legislative acts.

A subsoil user in Ukraine as a subject of entrepreneurial activity must pay the taxes and obligatory payments envisioned by Ukrainian legislation that are briefly described below.

A. Taxes Which are Included in the Sale Price Over the Price of the Producer

Value-added tax - at a 20% rate of the taxable base (the cost of goods (works, services) taking into account excise tax, import duties, other taxes, fees and obligatory payments).

Excise tax – at rates for specific types of goods subject to excise tax.

Import duties - at rates set out in the Unified Customs Tariff.

B. Taxes Which are Paid out of Profit

Tax on the profit of enterprises - at a 30% rate of the sum of profit which is determined as the difference between gross income, gross expenditures and the sum of amortization payments.

Payment (tax) for land – as a percentage of the monetary value of 1 hectare of a land parcel: a) for land having an agricultural designation - 0.181% or 0.0543%, and b) for land within the boundaries of population centers – 1.81% taking into account the relevant zonal coefficient.

Rent payment for oil and natural gas which are extracted in Ukraine - at specific rates: for 1 ton of oil – US$ 19 and for 1000 cubic meters of gas – US$ 23.

Tax on owners of transportation means - at specific annual rates for 100 cubic centimeters of engine volume, for 1 kilowatt of power of the motor, or 1 centimeter of length of the vehicle.

C. Turnover Taxes

Payments and fees for construction, reconstruction, repair and maintenance of automobile roads for public use - at the rate of 0.4 -1.2% of the volume of production, fulfillment of works (services).

Fee to the State Innovation Fund - at the rate of 1% of the sales of products, (works, services).

D. Payroll Taxes

Fee to the Fund for the Liquidation of the Consequences of the Chernobyl Catastrophe and the Social Protection of the Population - at the rate of 5% of the actual expenditures of the payer of the tax on the wage fund.

Fee for mandatory social insurance - at the rate of 5.5% of the actual expenditures on the wage fund.

Fee for mandatory pension insurance – at the rate of 32% of the actual expenditures on the wage fund.

E. Other Taxes and Fees

State duty – at specific rates for actions for which is levied the state duty.

Import duties - at specific rates as a percentage of the customs value of separate types of goods.

Fees for the use of natural resources (payment for the special use of the subsoil during the extraction of useful minerals, payment for the special use of fresh water resources, payment for the special use of forest resources) – in accordance with norms established by legislation.

Payment for the pollution of the environment – in accordance with norms and limits on releases of polluting substances and the placement of wastes.

Fees for geological research works performed at the expense of the State budget - at specific rates in accordance with the type of useful mineral.

Payment for the licensing of separate types of entrepreneurial activity – as a percentage of the minimum non-taxable income of citizens.

Communal tax – as a percentage of the of the minimum non-taxable income of citizens, but no more than 10% for each average paid worker.

Other local taxes and fees.

IV. Conclusions

The above information constitutes a short survey of applicable Ukrainian legislation the area of subsoil use and permits the following conclusions:

The existing system of subsoil use is complex and unreliable. The development of the mining-extraction branch requires large material-financial resources which the state does not have and entails significant risk. In a majority of countries, both developed and developing, the basis of this branch is private capital. The Ukrainian subsoil system discourages private capital from participation in the extraction of useful minerals for two reasons: (i) the administrative-authoritative nature of the system which leads to uncertainty and instability of the investor’s position, and (ii) the unstable, volatile tax legislation.

As a result, current Ukrainian legislation does not ensure the attraction of private capital to mineral resource extraction which may and should become an importance source of the replenishment of the state budget and of economic growth.