by Dina YinZhao Yan and Miao Jing King & Wood Mallesons’ Mergers & Acquisitions Group

PRC tax authorities have clarified, effective July 1, 2013, that oil and gas companies producing shale gas/coal bed methane (“CBM”) or service providers related to such production will be subject to a 17% VAT when providing labor services in relation to the production of shale gas or CBM.

The State Administration of Taxation (“SAT”) issued an “Announcement on Issues Concerning the Value-Added Taxes on the Development of Coal Bed Methane and Shale Gas by Oil and Gas Enterprises (SAT Announcement [2013] No. 27)” (关于油气田企业开发煤层气 页岩气增值税有关问题的公告 (国家税务总局公告2013年第27号)) (“Announcement”), clarifying and confirming that shale gas/CBM producers and oil/gas companies providing related “production labor services” (生产性劳务) (such as geological exploration, drilling, testing, logging, etc.) are now subject to the 17% VAT as prescribed by the “Measures for the Administration of the Value-Added Tax for Oil and Gas Field Enterprises (Cai Shui [2009] No. 8)” (油气田企业增值税管理办法 (财税 [2009] 8号文件)) (“Measures”).

As long as the SAT does not make a regulatory distinction between “natural gas” (天然气) and “shale gas/CBM” (页岩气、煤层气), the Announcement indicates the SAT’s position on the following two points: (1) an oil/gas company providing labor services related to the production of oil and natural gas (including shale gas and CBM) will be subject to a 17% VAT when providing such services as prescribed by the Measures; and (2) an oil/gas company producing natural gas (including shale gas and CBM) will be subject to a 13% VAT when selling such products as prescribed by the Interim Regulations on Value-Added Tax of the People’s Republic of China (the State Council Decree No. 538) (中华人民共和国增值税暂行条例 (国务院令第538号)). However, an oil/gas company may be able to enjoy a lower VAT rate if specific approval, on a case-by-case basis, is obtained from the State Council.

Previously, the Measures only expressly applied to companies engaged in general oil and gas production in China, and it was not clear whether companies engaged in shale gas or coal bed methane production and service providers related to such production were subject to the same VAT requirement.

The Announcement is one of the measures that the Chinese Government has implemented in order to further develop and regulate the shale gas industry in China.

Background on Recent Developments in the Chinese Shale Gas Industry

Although the shale gas industry in China is still in its early stages, it is an industry with much growth activity. In an effort to rely less heavily on external sources of energy, the Chinese Government has set high shale gas production targets for the near future and amended its policies to encourage foreign investment.

(i) Development Plan for Shale Gas

On March 13, 2013, the National Development and Reform Commission (“NDRC”), the Ministry of Finance, the Ministry of Land and Resources (“MLR”) and the National Energy Administration issued the “Development Plan for Shale Gas (2011-2015) (Fa Gai Neng Yuan (2012) No. 612)” (页岩气发展规划 (2011-2015) (发改能源 (2012) 612号)) (“Development Plan for Shale Gas”). The Development Plan for Shale Gas sets a production target of 60 to 100 billion cubic meters of shale gas by 2020.

(ii) Foreign Investment in Shale Gas Encouraged but Chinese Party Must be a Majority Shareholder

Prior to January 30, 2012, exploration and exploitation of shale gas in China could only be carried out by Chinese state-owned companies. However, effective as of that date, the NDRC and Ministry of Commerce (“MOFCOM”) issued regulations allowing (as an “encouraged” activity) foreign oil and gas companies to participate in shale gas exploration and exploitation activities via either equity joint venture operations or cooperative joint venture operations. Furthermore, MLR’s Circular issued on October 26, 2012 confirms that private Chinese oil companies may also explore for and exploit shale gas, including by way of joint ventures with foreign companies. Although the regulations do not specify a maximum percentage equity shareholding that a foreign company is permitted to hold in such a joint venture, in practice, MLR’s public bidding invitation terms currently require that the Chinese party must have a majority shareholding.

For more information, see the joint update from NDRC and MOFCOM to the “Directory of Industries Guiding Foreign Investment” (外商投资产业指导目录) effective January 30, 2012 and MRL’s Circular “Strengthening the Works relating to Exploration and Exploitation of Shale Gas Resources as well as the Supervision and Administration thereof (Guo Tu Zi Fa [2012] No. 159)” (国土资源部关于加强页岩气资源勘查开采和监督管理有关工作的通知 (国土资发[2012]159号)) dated October 26, 2012.