Splitting EPC contracts for tax savings

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Splitting EPC contracts for tax savings

ANALYSIS: Split construction contracts are often used in certain Asian countries by developers to reduce their tax exposure.16 Apr 2018

The nature of these contracts consist of both supply of services and of goods, and with some portions rendered offshore and others onshore, each attracting different taxes. It is not tax efficient to pay services related tax on goods supplied, and vice versa, nor to pay onshore taxes on offshore services/goods. With careful planning, parties can achieve significant savings without drastically altering their risk profile; however, there are risks and challenges too.

Splitting such contracts may also reduce currency and exchange risks and the risk of delays in the repatriation of profits, however, the main reasons for splitting contracts are invariably tax related.

Splitting EPC contracts

Split contracts are historically deployed in large EPC (engineering, procurement and construction) contracts because the large sums involved and the extent to which specialised equipment is exported, or services rendered offshore, lend themselves to a split contract structure. Doing so avoids paying onshore tax on offshore equipment.

The EPC contract is most often split after a single EPC contract has been negotiated to a sufficiently advanced stage. The split is done on the basis parties be afforded the same contractual protection as they would have been, under a single contract.

The process may significantly increase transaction costs and will definitely delay contract signing, and these disadvantages should be balanced against the potential savings in tax.  

Loss of EPC's single point responsibility

There is a loss of the single point responsibility that EPC contract gives to developers, and their lenders, who opt for EPC 'turnkey' contracting simply because it offers them the comfort that a single contractor is responsible for all aspects of engineering, procurement, construction, installation and commissioning. This single point responsibility is now lost if there are separate onshore and offshore contractors.

Umbrella agreements

To protect the developer's interests, both the onshore and offshore contractors are usually required to enter into an overarching umbrella, or coordination or wraparound, agreement with the developer. The umbrella agreement coordinates the activities under the split contracts so as to give nearly the same benefits as a single contract.

Umbrella agreements can take the form of complex agreements or can be as simple as an enhanced parent company guarantee. The challenge of course is to do so without attracting any adverse tax consequences, especially if the umbrella agreement does not need to be registered for tax purposes on the basis that there is no monetary or fiscal consideration flowing under it.

A health warning on split contract structures

Umbrella agreements and split contract structures are very specifically tailored to a particular country, and based on the prevailing tax regulations. For this reason, parties must avoid the over-reliance on templates or project documents used in a previous project.

It cannot be overemphasised that the tax related risks and tax objectives must be clearly understood in conjunction with advice from tax specialists, before contracts are split to follow suit and not, as often happens, the other way around.

Reduction of onshore based tax

Just as the mechanics of the split/umbrella are driven by local law tax advice, the issues that arise will depend on the specific type of tax for which tax efficiency is desired. Take the case of jurisdictions where onshore indirect taxes such as VAT and sales taxes are levied on the sale of goods, services or properties.

A properly-drafted offshore supply contract may reduce such onshore taxes from otherwise being levied on the offshore elements, and reduce corporate income tax or business tax that may be levied on an onshore entity.

The offshore and onshore contractors: truly independent?

However, to minimise tax exposure parties will want to structure so that the onshore and offshore contractors are independently dealing at arms length with each other, rather than two contractors forming a joint venture or consortium with joint and several responsibilities, so as not to expose the offshore contractor to onshore taxes. 

This raises a number of questions:

  • to what extent can offshore supplier still be involved in onshore activities, for example installation and commissioning, without being exposed to onshore taxes? This would depend on a careful consideration of the tax practices in the jurisdiction.  
  • to what extent should the onshore contractor be allowed, for expediency, to rectify defective equipment supplied by the offshore supplier, without the risk of causing the tax structure in the split contracts to unravel. Would an appropriate indemnity by the offshore contractor in favour of the onshore contractor help?
  • can the onshore contract cross-refer to the offshore contract/contractor/contract price? If this is not possible, then any obligations that require a reference to both contracts would have to be covered in the umbrella agreement instead.

Division of responsibilities between the offshore and onshore contractors

A properly structured split contract should also ensure the seamless flow of responsibility from offshore design and supply to onshore installation, commissioning and handover. This means, for example, that the transfer of the risk of loss/damage and of property rights should flow from offshore to onshore without any gaps, and the insurance programme is comprehensive enough to leave no insured risks.

Further, the split contracts must deal with risks of inter-contractor delays, such as delays in offshore shipment, demurrage incurred by the offshore contractor due to delays in onshore receiving works, and warehousing charges for delivery by offshore contractor outside of programmed periods. These all need to be carefully considered. This could, of course, be dealt with in the umbrella agreement, but since the onshore and offshore split contracts cannot refer to the umbrella agreement, those split contracts nevertheless need to provide for an initial position that is coherent and consistent with their split relationship, and with the umbrella agreement.

Services versus goods related taxes

In some jurisdictions, different taxes, or rates of tax, are levied on goods and on services, and the mechanics of the split/umbrella structure are then driven by these considerations.

For tax efficiency, the split onshore/offshore contracts could further be split between design and procurement contracts – this can lead to as many as four split contracts. Alternatively, tax efficiency could be achieved simply by retaining both design and procurement scope within the same contract, but ensuring that the technical scopes for both are clearly delineated;  pricing/bills of quantities are carefully separated, and there are separate invoicing processes for services and for supply of goods. 

Where the contract is split, the technical specifications and drawings should be prepared with care so as to allow the technical specifications and drawings to operate independently. The risk of gaps created between the split technical specifications and drawings should be allocated to a certain party so as to preserve a single point of responsibility. That party assuming the risk of 'gaps' may be the onshore contractor who is the last in line to complete the project; the parent who is providing a parent guarantee, or both the onshore and offshore contractors in the umbrella agreement. 

Other savings

Besides the savings in taxes, a split contract may well reduce the cost of complying with local licensing regulations through, for instance, having the early design such as front end engineering design (FEED) undertaken from an offshore location. 

In this situation the mechanics are once again driven by different considerations. For example, the ultimate obligation to ensure compliance with local laws, regulations and standards will inevitably be with the onshore designer/contractor, even where the design originates from the offshore designer. Cross indemnities between the onshore and offshore contractors in this respect will help ensure compliance, whilst keeping them apart at arms length basis.

Split limits of liability for the contractor

An issue that arose in a recent reported case, highlights the risk of split EPC contracts.

EPC contractors usually require limits to be placed on their overall liability – 100% of the EPC contract price being the starting position, and on their liability for delay damages – 10% is not uncommon. In this regard, how do these limits operate in the context of split contracts?

It would be considered risky in many tax jurisdictions to have direct cross references – this means for example that the limit of liability under the onshore contract cannot refer to the aggregate of the onshore and offshore contract prices.

It is tempting to say that that the cap on liability across the contracts should be split this way: onshore liability is capped at 100% of onshore price; offshore liability is similarly capped at 100% of offshore price, and overall liability under the umbrella agreement is capped at 100% of aggregate of the offshore/onshore prices.

However, this could result in significant risks for the employer.

In a recent case ruled on by the High Court in England and WalesPetroleum Company of Trinidad and Tobago Ltd v Samsung Engineering Trinidad Co Ltd [2017] EWHC 3055 (TCC) – an employer conducted an arbitration by wrongfully referring only to the onshore contract, and the onshore contract price. This meant that the contractor was entitled to the benefit of a lower limit for liquidated damages based on 10% of the onshore contract price, to the exclusion of the combined contract prices under the umbrella agreement. This means the developer was in fact put in an inferior position as a result of the split contract structure.

A safer way for the developer would have been to split the cap on liability this way: onshore liability being capped at 100% of aggregate offshore/onshore prices; offshore liability being similarly capped, and overall liability under the umbrella agreement to clarify that both onshore and offshore liability should always remain capped at 100% of aggregate offshore/onshore prices.

However, the contractor may well argue that this places the risk of arbitrations being conducted wrongly on them – his cap on liability could effectively be 200% of the aggregate offshore/onshore prices.

There is a further practical issue to consider too. Since the cap on liability under the onshore contract cannot refer to the aggregate offshore/onshore prices, because it would require a reference to the offshore contract price, the solution may be to refer to a dollar value, instead of a percentage. However, this would mean that the caps on liability would be permanently fixed and would not shift if there was a change to the contract prices.

Conclusion

As tax regimes in Asia become increasingly transparent in order to match their developing economies and to attract foreign investment, this will present opportunities for developers undertaking projects in those countries to explore options in order to achieve tax efficiency.

To split a contract is not a straightforward exercise and is fraught with many risks. Parties need to assess the pros and cons of splitting a contract before doing so. Even after this decision is made, parties need to be prepared to go through a meticulous process of determining the allocation of key risks across the onshore, offshore and umbrella contract, such that it is intended to operate as one.

Bernard Ang is a Hong Kong- based construction law expert at Pinsent Masons, the law firm behind Out-Law.com.