On again, off again: managing split onshore/offshore construction contracts
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Summary: Imagine you are involved in the development of a large renewable power facility. During negotiations, the parties agree to use a split onshore/offshore contract structure for the project (an onshore/offshore contract). Using this structure should result in a lower tax burden overall, which will lead to savings for both parties. On paper, that sounds fine – but how does it work, and what are the risks?

The theory

The aim of using an onshore/offshore contract is to move part of the contractor’s scope of work out of the jurisdiction in which it is being carried out, and into another jurisdiction, in order to produce tax efficiencies. An onshore/offshore contract is therefore most appropriate for projects where there is a significant proportion of the contractor’s scope that does not need to be carried out at site, such as design and procurement. For this reason, it is most common to see onshore/offshore contracts being used under an EPC contracting model. In order to effect an onshore/offshore contract, the contractor’s scope must be split into “onshore” and “offshore” elements.

The onshore element is comprised of those parts of the scope that must be carried out at site, or in the country where the project is located – that is, the construction works, the testing and commissioning, as well as some of the procurement. The onshore element is usually carried out by a wholly-owned subsidiary of the contractor incorporated in the jurisdiction of the project or, in some jurisdictions, a joint venture with a local construction company (the onshore contractor).

The offshore element is comprised of those parts of the scope that can be carried out in another jurisdiction, including the design of the works and much of the procurement. This work is commonly carried out by the contractor’s main operating company, or an offshore subsidiary (the offshore contractor).

Instead of preparing a single contract covering all of the contractor’s scope, an “offshore” contract and an “onshore” contract are prepared. Although they have different works obligations, the two contracts closely mirror one another, with parallel provisions for liquidated damages, dispute resolution, and so forth. These two contracts are then tied together by a coordination agreement signed by the employer, the onshore contractor, the offshore contractor and in some circumstances, the contractor’s parent company as guarantor. This agreement provides that the two contracts will be jointly administered and operated as though they were one, and can also provide a “wraparound” guarantee in favour of the employer. Despite the split, the contracts are intended to work seamlessly together, with all of the contractor’s scope of works falling under one or the other of the contracts.

The reality

That all sounds very neat and straightforward. However, in practice things can quickly become much more complex. A recent case before the English courts provides a timely example of how using onshore/offshore contracts can lead to unexpected results if not carefully drafted and administered (Petroleum Company of Trinidad and Tobago Limited v Samsung Engineering Trinidad Co. Limited [2017] EWHC 3055 (TCC)).

The employer used an onshore/offshore contract for an oil refinery project in Trinidad. The onshore contractor brought arbitration proceedings against the employer under the onshore contract only. The employer counterclaimed for liquidated damages. The arbitral tribunal granted some of the onshore contractor’s claims, but awarded a larger sum in liquidated damages to the employer. However, the tribunal decided that the employer’s liquidated damages should be capped at a lower sum, meaning that the onshore contractor was the overall “winner”.

The reason for this was that the onshore contract, offshore contract and coordination agreement each contained their own cap on liquidated damages, with the cap in the coordination agreement being the total of the caps in the onshore and offshore contracts. The tribunal decided that, because the onshore contractor’s claim and the employer’s counterclaim were both brought under the onshore contract only, the lower cap in the onshore contract should apply. As a consequence, the onshore contractor was awarded US$1.1m overall. If the higher liquidated damages cap in the coordination agreement had applied, then the employer would have been awarded US$1.1m instead.

What could go wrong?

This is just one example of how, in reality, using an onshore/offshore contract can be significantly different from using a single contract. In this case, the contractor benefited at the employer’s expense; however, a similar scenario could easily arise between the contractor and one of its sub-contractors.

In any main contractor/sub-contractor relationship, one of the key considerations will be to ensure that any obligations in the main contract relating to sub-contract works are properly “back to back” in the sub-contract. However, this issue is particularly pressing when using onshore/offshore contracts. In some cases, a sub-contractor’s scope will include both onshore and offshore elements (for example, a supply and installation sub-contract). In these circumstances, it is essential to ensure that the sub-contract structure matches the main contract structure as closely as possible – otherwise the main contractor may find that there are liabilities from the employer which it cannot pass down to the sub-contractor, and vice versa. Even where a sub-contractor’s scope is entirely offshore, or entirely onshore, it is nonetheless crucial to ensure that the respective obligations of the contractor and sub-contractor match their intended responsibilities.

Likewise, it can be a challenge to ensure that the scope is correctly divided up between the onshore and offshore contracts. For example, if both the onshore contractor and the offshore contractor have obligations to procure plant and materials which will form part of the works, in theory each party’s remedial works obligation only relates to the plant and materials that it has supplied. However, this could lead to uncertainty over whether a defect in the works is the responsibility of the onshore contractor or the offshore contractor. It may be simpler just to make the onshore contractor solely responsible for remedying all defects in the works.

In order to avoid outcomes such as this, there can be a temptation to use an identical contract for both the onshore and offshore scope. However, this approach means that the offshore contract may contain numerous redundant or irrelevant provisions relating to site works, inspection, commissioning, and so forth. The same may be true of the onshore contract. For this reason, some contractors and sub-contractors may be unwilling to agree to this approach. Additionally, there may be a greater risk of the onshore/offshore structure being unwound by the tax authorities if the onshore and offshore contracts are identical, as this might indicate that the structure is a sham.

Lessons to learn

In our experience, one of the most important documents (and one which often receives the least attention) is the coordination agreement. These can be as short as a few pages, even for very complex, high-value projects, although more detailed agreements are common. The main function of the coordination agreement is to place the employer in the same position, from a contractual perspective, that it would have been in if there had only been one contract, with one contractor responsible for the whole of scope of works. This is achieved through provisions relating to the management and interpretation of the two contracts, the allocation of liability and, in some cases, a parent company guarantee.

There is no one-size-fits-all coordination agreement template which can be used for every onshore/offshore contract. However, some common provisions which should usually be included are:

• “Sweep-up” responsibility: when splitting a scope of works into two, there is a risk of ‘gaps’ appearing – items of work for which neither the onshore contractor, nor the offshore contractor, is explicitly responsible. In order to avoid this outcome, the coordination agreement may include a provision that the onshore contractor and offshore contractor are jointly and severally liable for the entire scope of works. Alternatively, there may be a provision that one of the two contractors will automatically be responsible if there is any doubt over who is responsible for a particular item of work. As the onshore contractor is usually a subsidiary of the contractor’s main operating entity or local JV entity, and the main operating entity itself may be acting as offshore contractor, it may be more appropriate to designate the offshore contractor as having this “sweep-up” responsibility.
• Parent company guarantee: if both the onshore contractor and offshore contractor are subsidiaries of the contractor’s main operating entity, the employer may request that the main operating entity is party to the coordination agreement and provides a guarantee. Likewise, if the main operating entity is itself part of a larger corporate group, this guarantee may be provided by a parent of the main operating entity.
• Joint notice provisions: for simplicity, and to avoid any doubts that a notice was not properly served under either contract, it is worthwhile including a provision that a notice served under one contract is treated as being served under both contracts.
• No cross-liability: it is important to prevent the onshore contractor from being able to claim additional time and money for delay against the employer, where that delay was caused by the offshore contractor, or vice versa. The coordination agreement should explicitly state this.
• Joint termination: in almost all cases, if the employer terminates the onshore contract, it will also want to terminate the offshore contract, and vice versa. At the very least, the employer should have the option to do so if it chooses.
• Joinder of disputes: if separate disputes arise under the onshore and offshore contracts, it is likely to be much less expensive and time-consuming to have them heard jointly, and can avoid the risk of inconsistent decisions if the disputes are heard separately. It is therefore good practice to include a power, exercisable by the employer, or by all parties, to join related disputes under the contracts.

In short, using onshore/offshore contracts can bring significant tax advantages to the parties involved. However, it is essential not to enter into them lightly. We have seen examples of parties reaching a very advanced stage in negotiations, before deciding to ‘convert’ a single EPC contract into an onshore/offshore contract. Whilst it is possible to do this in a short space of time, it is not always straightforward and problems are more likely to arise if the process is rushed. In addition, the financial benefit of using an onshore/offshore contract comes with a higher administrative burden, not only in preparing the contracts, but also in operating them and (as can be seen from the case mentioned above) in bringing claims.