Foreign Investment Law
External Debt
Government Guarantees
Tax Treatment
Concessions, Licences and Contracts
Entity Selection
Security Interests
Control Accounts
The Future
Kazakhstan is potentially one of the largest oil and gas producers in the world, with expected reserves of 18 billion tons of oil and condensate, and over 6 trillion cubic metres of gas. Since it also holds nearly 90% of the former Soviet Union's total reserves of chromium and half its reserves of lead, copper, wolfram and zinc, Kazakhstan is poised to become one of the world's most robust natural resource economies.
To date, Kazakhstan has also been one of the most economically and politically stable of the former Soviet republics. It boasts the convertibility of its current account, and has acceded to Provisions 2, 3 and 4 of Article VIII of the International Monetary Fund Charter regarding foreign exchange restrictions and multiple exchange rates. The government weathered the recent financial and economic crisis of its largest trading partner, Russia, through decisive action. After a managed devaluation, the tenge, Kazakhstan's national currency, is now stable and the country's temporary current account deficit is once again a surplus.
According to the National Bank of Kazakhstan, corporate lending in 2000 was up by 60%. This resurgence of commercial lending is concentrated in commodity-based structured pre-export finance and tolling arrangements, along with some limited recourse advance purchase arrangements of oil. These transactions have limited recourse features which are illustrative of project finance techniques that carve out project revenues. In light of the financing needs of major infrastructure projects on the drawing board, strategies that organize limited recourse financing around a project company and with longer tenors are likely to draw on this evolving experience.
Project financing generally is understood to be the financing of a specified project based primarily on the earnings of the project. It is characterized by limited recourse against project sponsors, and draw down and repayment terms timed to match anticipated project cash flows.
Kazakhstan has benefited from a number of market-oriented reform initiatives that now make project finance as well as other, more sophisticated financing strategies feasible. The cornerstone of these reforms is Kazakhstan's Constitution, which guarantees the right to private property. The Law on Foreign Investments develops this right in the case of a foreign investor and foreign invested enterprises, and provides guarantees against expropriation. It also allows for international arbitration, at the investor's option, where an investment dispute arises. Kazakhstan, as a signatory to the New York Convention, is obliged to enforce international arbitral awards. However, the performance of courts is untested, making selection of the International Court for the Settlement of Investment Disputes for arbitration a 'best practice' for the moment. The Law on Foreign Investments also provides the foreign investor with assurances regarding repatriation, convertibility, choice of law and stabilization of the legal regime. Tax stabilization in the oil and subsurface minerals sector is a specialized topic addressed in the Tax Code, the Law on Oil and the Law on Subsoil. These laws compliment a number of bilateral investment treaties entered into by Kazakhstan, which provide similar assurances.
Cross-border, external debt is governed by the Law on State Borrowing. Government guarantees of external borrowing, whether in connection with the Export Credit Agency (ECA) or whether multilateral or private lending, are governed by the Law on State Borrowing and the foreign exchange regulations. The table below summarizes some of the requirements of the Law on State Borrowing, the regulations and the foreign exchange regime as applied to cross-border loans. In the past, lenders have easily complied with the requirements of the Law on State Borrowing and foreign exchange regime with respect to loan registration, even during the most recent financial crisis, and received repayment. This is not expected to change.
| External Debt Counter-party | Maturity | External Debt Law | Foreign Exchange Controls |
| Private | Short term (less than 180 days) | No registration | Appointment of agent bank and authorization from the National Bank |
| Private | Long term (more than 180 days) | Registration | Appointment of agent bank and authorization of the National Bank |
The granting of financial guarantees of external debt by the state is governed by the Law on State Borrowing and the regulations. In general, the government has adopted a restrictive policy with respect to the granting of such guarantees for private borrowings, including with respect to ECA financing. Although this policy does not apply to performance guarantees (which in many instances may have equivalent financial consequences), the government's authority to undertake such performance guarantees, depending on the sector, must be carefully scrutinized in each instance. Government guarantees to protect against devaluation (eg, in the form of benchmark commitments) have not been given and authority to make such a commitment would be a matter of first impression.
However, the impact of currency devaluation is increasingly being taken into account in local currency tariffs in the power and telecommunications sectors. This is likely to continue, subject to the exercise of discretion by Kazakhstan's Anti-monopoly Committee.
Tax treatment of cross-border and domestic lending is an important consideration for both sponsor and lender when developing the project strategy. Withholding tax rates between Kazakhstan and other countries are now governed by a network of bilateral tax treaties, with dividend withholding of between 5% to 15%, interest withholding of between 10% to 12.5% and royalty withholding of 10% to 15%. The table below summarizes some preliminary tax issues that lenders and sponsors should consider.
| Transactional Dimension | Tax Issue |
| Hard currency loans | Allowable interest deductions are up to twice the London Interbank offered rate. Deductibility of other financing costs is permitted, as long as they fall within the allowable limits for business expenses. Authorities are entitled to adjust taxable profits where financing costs between related parties exceed an 'arm's length' rate. |
| Repatriation / double taxation treaties | Extensive number of treaty jurisdictions from which to choose, including the United States, the Netherlands and the United Kingdom. Note the treaty jurisdiction's 'thin capitalization' rules. |
| Finance leasing (cross-border) | Defined under Tax Code, with leased assets capitalized and depreciated in accordance with depreciation rate applicable to the respective asset group, and withholding tax typically reduced to the royalty rate where provided by treaty. |
| Value Added Tax (VAT) | Financial transactions not subject to VAT (bank transactions, securities transactions, bills of exchange, finance leasing, lending transactions). |
Concessions, Licences and Contracts
Efforts to develop a law on concessions have not yet borne fruit, although there is a strong view in the legal community that such a law is needed. Kazakhstan's Civil Code provides a rudimentary definition of a 'concession' as a form of operating lease. An investor granted a concession outside the scope of traditionally licensed activities (eg, the recent GSM licences(1) or the well-established laws on oil and mineral development regimes) must ultimately rely on this Civil Code definition. Where the concession includes both the right to assets and a grant of concession rights (eg, exclusivity), care must be taken to confirm that the government has the statutory capacity to grant the particular rights.
An initial structuring issue confronted by project sponsors is selection of the appropriate project entity. It is possible in Kazakhstan to select an offshore vehicle and use a registered Kazakh branch to conduct operations. This structure has a number of important repatriation, currency control and tax benefits. However, this option is not always available, for example, where (i) there are local participants who cannot hold offshore interests, an activity is licensed and a local entity is required to hold the licence, or (ii) the government requires that a project entity be onshore (eg, in the case of a concessionaire). Allocating functions between a Kazakh legal entity that acts as licensee and an operating offshore entity with a branch is also possible, but a number of tax and regulatory issues are typically implicated, particularly if there is a VAT-taxable operating lease of assets.
Legal entities available in Kazakhstan include limited liability companies, limited liability partnerships, open joint stock companies and closed joint stock companies. Selection from among these forms of legal entity depends on a number of factors, including the preferred choice of security sought by the investor/sponsor, rules regarding profit distributions, the proposed form of capitalization of the entity, management and control issues, and the investor's exit strategy. Kazakh legal entities have a number of limitations. For instance, none is entitled to avoid tax through treatment. Although Kazakhstan's Civil Code makes allowance for a joint activity agreement similar to a general partnership, there is little statutory elaboration of this organizational form and its tax treatment is unsettled. If an investor is forced to use an onshore partnership strategy, it would be advisable to receive a binding ruling on partnership tax treatment from the authorities, a task which has been attempted and achieved in the past, but only with great effort.
In contrast to offshore vehicles, Kazakh legal entities are also subject to Kazakhstan's insolvency laws, giving rise to a number of risk factors associated with the definition of 'insolvency' and the creditor remedies available under Kazakhstan's insolvency regime. In addition, open and closed joint stock companies do not anticipate the issuance of more than one class of common stock, and are less flexible than corporate entities in other jurisdictions with respect to convertible and preferred securities. Consequently, certain project funding strategies are impeded, particularly where project sponsors and lenders wish to carve out different revenue streams (and pledge interests therein) in the same project vehicle to finance different projects.
Further, Kazakh legal entities have no statutory provision for callable capital. Enterprise capitalization is therefore generally undertaken by foreign investors through shareholder loans. However, domestic investors cannot finance on this basis. Rather, they are not permitted to make loans other than through an agent bank, since all domestic lending is restricted to banks. This differential treatment of domestic and foreign parties, and the absence of callable capital provisions in Kazakh legal entities, make it more complicated to implement sponsor support agreements that contemplate equity injections (eg, coinciding with loan draw-downs) to maintain specified debt-equity ratios.
Lenders usually insist on having security interests in the project company, its assets and revenues. Fixed assets can be mortgaged and movable assets pledged in Kazakhstan. Special considerations affect pledges of local bank accounts, securities (eg, the shares in a project company) and subsoil use rights (eg, the rights under a petroleum or mineral exploration and production licence). It is also possible to take a security interest in contract rights, including receivables. Difficulties can arise where security interests are taken in documents of title (eg, oil in the pipeline), given the absence of reliable documentary title and warehousing systems.
Kazakhstan's mortgage and pledge registration system is increasingly reliable as a mechanism for establishing priority based on a first-in-time rule. Unlike Russia and other jurisdictions in the former Soviet Union, registration fees are not based on the estimated value of the collateral and therefore are not onerous. However, restructuring of collateral packages or facilitating a transfer of security interests to coordinate mortgage documentation with credit agreements is difficult, due to a flawed mortgage certificate system and the practice of requiring cancellation of the original mortgage followed by a full re-registration in lieu of the registration of mortgage amendments.
Finally, the courts and registration authorities have little experience with inter-creditor arrangements involving priorities among different levels and varieties of subordinated debt. Increasingly, banks are adopting a number of collateral administration strategies, depending on the type of collateral and the nature of the competing interests for that collateral.
The law of Kazakhstan permits taking security in money, which the Civil Code treats as movable property. Typical bank pledge agreements in Kazakhstan therefore treat an account pledge as a pledge of funds in the account. Such a funds pledge can be coupled with an assignment of account contract rights (eg, the deposit account agreement). Account management arrangements, such as those providing for a waterfall account structure, cannot involve the concepts of agency or escrow if governed by Kazakh law, since these do not exist under local jurisprudence. In addition, custodial accounts have limited scope.
Kazakh tax authorities retain the capacity to freeze and confiscate funds from accounts, frequently doing so without judicial process in violation of Kazakh law. Account pledge, management and custodial arrangements must therefore be given careful consideration in light of this practical problem.
Another issue arises where domestic accounts are used to provide credit support for hard currency-denominated obligations. For instance, where local currency funds stand as security (eg, securing standby letters of credit) for hard currency-denominated obligations, consideration must be given to the fact that banks have only limited capacity to hedge with tenge deposits in dollar-denominated Kazakhstan government securities.
There are a host of issues under Kazakh law that must be given careful consideration in the case of a project financing, and where the prevailing practice should be carefully re-evaluated. There are many examples where legal practice has evolved in the rough-and-tumble environment of Kazakhstan's early days, when there were few laws and fewer precedents, but which are now unsuited to the role for which they are offered. For instance, many creditors relying upon the prevailing practice of using a pledge of shares (or participating interests) to take control of a company or partnership in the event of default are now finding this strategy flawed. It does not give the pledge holder the ability to control the company, but instead requires the liquidation of the security interest through sale of the collateral shares - the very outcome sought to be avoided by the lender.
Direct agreements, similar to those used in other countries, which provide for 'step-in' and 'substitution' of a contracting party where there has been default are now possible under local law. These must be crafted carefully so as not to contravene the statutory corporate governance provisions that apply to Kazakh legal entities.
Nevertheless, this can be achieved through an assignment of contract rights to operate the project upon the occurrence of a contractually defined event of default. Practices such as these, with their origin in other countries, can be a guide to appropriate legal strategies in Kazakhstan. However, this cannot be a substitute for careful analysis and testing of the strategy under local law.
Bank country exposure limits and the reported concentration of banking business in shorter term commitments also underscore the importance of ECA, bilateral and multilateral lender participation to arrange classic limited recourse project finance in Kazakhstan. One can anticipate that this necessary role will bring with it many of the precedents and the experience gained in other countries, particularly Russia, where finance experience in oil and gas projects such as Sachalin will have particular relevance, ultimately leading to a tailoring of project lending strategies to the Kazakh environment.
For further information on this topic please contact Jonathan Cahn at Coudert Brothers by telephone (+7 3272 51 18 28) or by fax (+7 3272 58 18 80) or by e-mail ([email protected]).
Endnotes
(1) Global system for mobile communication.
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