CHINA needs to rethink its taxation policies on domestic oil companies to promote expansion of oil and gas supplies and avoid heavier reliance on imports for its petroleum needs, analysts said.

At present, upstream crude oil production in China is subject to a windfall income levy, a resource tax and mining resource compensation fees.

The government is studying a revision of these taxation policies amid criticism from industry executives like PetroChina Chief Financial Officer Zhou Mingchun that they overlap to the detriment of energy producers.

"Right policies can drive a potential re-rating in the energy sector, including oil-field services," said Gordon Kwan, head of regional energy research at Mirae Asset Securities.

Chinese oil companies are being threatened by the higher upstream resource and windfall taxes as they struggle with downstream refining losses from fuel price ceilings.

Speculation about the need for tax revision intensified after the government said it would defer approval for new nuclear power plants pending safety reviews, following the Japanese nuclear crisis, and a newspaper reported that China may double a price-based resource tax, being imposed on a trial basis, to 10 percent.

The windfall tax - officially known as the special oil gain levy - was introduced in 2006 after oil prices above US$40 per barrel were deemed a source of "windfall" profit for the industry. Under the formula, crude oil produced and sold in China is subject to a tax of between 20 percent and 40 percent, based on the portion of oil companies' realized prices above US$40 a barrel. The windfall tax was intended to compensate for losses in refining and to subsidize the vulnerable farming, fishing and public transport sectors.

Oil companies, especially upstream players, have long called on the government to raise the threshold for the windfall tax, citing higher crude prices, improvement in the refining sector and the stronger Chinese currency.

Crude was quoted above US$100 a barrel in New York yesterday, compared with about US$64 a barrel when the windfall tax was first imposed.

The worst days of China's refining sector passed after the government in late 2008 introduced a cost pass-through mechanism indirectly linking domestic prices to international crude prices. Still, oil firms reported refining losses in the first quarter of this year as increase in fuel prices lagged the free-market price of crude.

A stronger yuan has also effectively lowered the trigger point for the imposition of the windfall tax.

The country's three oil majors, PetroChina, Sinopec and CNOOC, paid almost a combined 90 billion yuan (US$13.8 billion) in special upstream oil levies last year, according to their annual results. Also, the trio's upstream capital expenditure amounted to 250 billion yuan.

If these companies were relieved of the special levies, they could increase their proven oil and gas reserves by another 1.4 billion barrels of oil equivalent, assuming a US$10 a barrel cost of finding and developing those resources, according to Mirae's Kwan.

The extra reserves would equate to a giant oil discovery, almost equal to the entire domestic oil reserves of CNOOC, he added.

China International Capital Corp analyst Guan Bin said he expects the government to raise the trigger point for the windfall tax sometime this year.

China trialed a new price-based resource tax last year in its western provinces, shifting from a volume-based tax, to help raise funds to develop the resource-rich but economically poor region that missed out on the price rally in commodity prices of recent years because of the tax structure.

The experimental rate was set at 5 percent, and it seems the government may be moving slowly to expand the new policy nationwide. Guan said the delay may signify the government is concerned that the new tax might curb output in oil and gas fields in central and eastern China.

PetroChina, the nation's largest oil producer, increased crude oil production by 1.7 percent last year while Sinopec, the second largest, produced only 0.1 percent more.

The Shanghai Securities News reported this month that the eventual resource tax rate could be set at 10 percent. Analysts have cast doubts on its feasibility. "The extra heavy tax would probably curb production in central and eastern China and further increase the nation's reliance on crude imports," Guan said. "To impose such a higher tax rate nationwide won't be conducive to stable energy supplies."

Mirae's Kwan said that if China were to implement higher resource tax rates, at the very least, the government should not apply a flat-rate regime because that could kill the economics of many smaller, marginal oil fields.

Kwan said one solution is to have a progressive tax structure in which more profitable fields will pay higher rates while marginal, smaller fields pay lower rates. He cited a new study by the University of Aberdeen in Scotland that said increased tax rates recently announced in Britain will reduce exploration investment and oil and gas production.

Guan said the government is unlikely to change its view toward tight energy supplies in the long term, which could pave the way for lower taxes on oil firms.

He said his opinion takes into account the fact that lowering taxes for state oil companies, which have raked in huge profits, in part because of their monopoly status, may cause discontent among consumers who are now paying ever higher prices for gasoline.

PetroChina's net profit in the first quarter rose 13.9 percent from a year earlier to 37 billion yuan, while Sinopec earnings jumped 25 percent to 20.6 billion yuan.

"The first quarter earnings may not be sustainable and don't represent long-term trends in the industry," Guan said.

In the United States, Exxon Mobil accused the American government of "political theater" after it proposed eliminating tax breaks for big oil firms. The effort was eventually quashed in the US Senate, after a heavy lobbying campaign by oil companies.

Raising taxes could cost jobs and hike gasoline and other consumer prices, while actually unintentionally cutting US tax revenues by discouraging investment, Kwan said.