One innovation that has become more prevalent in international energy projects such as power, utilities and LNG projects, involves an extension of the build-operate-transfer (BOT) model whereby the works under an engineering, procurement, and construction (EPC) contract are 'split' into two separate contracts. A split structure may offer reduced taxation exposure in some jurisdictions for the Contractor, with the savings leading to a lower contract price to the Project Company.
With careful consideration and management of the legal issues involved, under a split EPC structure, a Project Company's legal and contractual positions can be protected to the same extent that they would be under a single turnkey EPC structure, whilst at the same time ensuring that the taxation and other commercial benefits obtained by splitting the works are not jeopardised in the process.
- EPC Contracts
A construction contract under the BOT model for major infrastructure projects usually takes the form of a turnkey construction contract or an EPC contract. Most international projects today are procured on the basis that one contractor assumes total responsibility for the design and execution of the works, including all engineering, procurement, and construction, so that the Contractor effectively provides a fully equipped facility ready for operation at 'the turn of a key'.
- The concept of splitting EPC Contracts
Under the classic split, an EPC contract is divided into two separate contracts - an 'Onshore Contract' and an 'Offshore Contract'.
The responsibilities of the Offshore Contractor are limited to the supply of design and engineering services ‘offshore’ (i.e., outside the country where the project is located) and the supply of offshore plant, equipment and materials ('Equipment').
Typically, the responsibilities of the Onshore Contractor are limited to:
- the installation of the above offshore Equipment once that Equipment has come ‘onshore’;
- the supply of Equipment sourced from within the host country; and
- the construction, testing, commissioning and other onsite activities (including some onshore design and engineering services) associated with the works.
To complete the split structure, an agreement is drafted to 'wrap' the obligations of the Onshore and Offshore Contractors to the Project Company, so that any gaps that arise as a result of the split structure are appropriately covered. Normally the parties to that agreement - often called a ‘Co-Ordination Agreement’ or a ‘Wrap Around Guarantee’ (WAG) - are the Project Company and the Offshore Contractor or its parent. The Project Company's recourse in the event of a failure in the performance of either the Onshore Contractor or the Offshore Contractor will only be to the counterparty to the WAG.
The following illustrates a split structure:
- Why split EPC Contracts?
In a word: tax. The split structure is designed to reduce exposure to local taxes on offshore Equipment, or any design work performed outside the host country, becoming subject to local taxes. The classes of taxes, both direct and indirect, that an EPC Contractor and a Project Company may be exposed to in the host country include: value added taxes, withholding taxes, technology transfer taxes, import and stamp duties, local construction and property license fees and duties, and onshore income or profits tax. Other commercial considerations may drive the split structure, such as avoidance of local 'red tape' requirements and costs associated with obtaining permits, approvals, and submitting designs to local government authorities in the host country.
Splitting EPC contracts is not appropriate for every project. Indeed, in some jurisdictions a mere reference in an Onshore Contract to an Offshore Contract (or vice-versa) can defeat the tax advantages that the split structure is intended to achieve. This scenario may normally be avoided through careful drafting. Appropriate local taxation and legal advice should always be sought before deciding whether to split an EPC contract into two or more contracts to take advantage of taxation savings and other commercial benefits.
For projects procured in countries that have previous experience in splitting EPC contracts, increasingly it is as the sponsor level where the split is planned. Sometimes contractors will offer to split, particularly where they have experience in the sector and country. A reduction in contract price under the split approach is typically attractive to a Project Company, but this reduction must be weighed against the costs and risks involved in splitting.
A split structure can be initiated at any time prior to execution of the project documents. Ideally a Project Company and an EPC Contractor would reach agreement on the terms of the single EPC contract (and scope of work) and then the arrangements split into onshore and offshore components. This can lead to hastily drafted split contracts, as the project parties have concluded their commercial deal and wish to start work as soon as possible. Sufficient time should always be allowed to draft the WAG and split contracts and to ensure that, when added together, there are no gaps in responsibility or scope.
As the Project Company is the major beneficiary of the split structure (lower contract price), on its face the Project Company is better placed to assume the risk of the split structure failing. By failing, this means that the structure is unwound for tax reasons or there is a gap in the responsibility or scope of the contractors. On the first point, both parties should seek appropriate advice and the Project Company should seek indemnities for any tax imposts or other penalties arising from the structure. On the second point, well drafted contracts (particularly the WAG), should eliminate the risk of scope gap.
- Specific legal issues associated with splitting EPC Contracts
Where a split structure is adopted and two separate Specifications are prepared, a Project Company should thoroughly review the Specifications to ensure that there are no inconsistencies between the split Specifications and that when combined, they cover the entire works. Any 'gaps' produced as a result in splitting the Specification should be covered in the WAG.
If one Specification is adopted to cover the whole of the works, then it should be made clear that the Offshore Contractor's scope of work includes all activities associated with the supply of design and engineering services and the supply of Equipment sourced from outside the host country. The Onshore Contractor's scope of work will include all remaining activities necessary for the proper completion of the works.
Timing and performance issues
Where a split structure results in split liquidated damages ('LD') regimes for delays and non performance, a Project Company will need to scrutinise the regimes in each contract to ensure they are consistent and interact logically and correctly. Two options are commonly adopted:
- Draft the LD provisions so that they only appear in the Onshore Contract. In this way the Onshore Contractor is responsible for any delays or substandard performance irrespective of which Contractor is at fault. The calculation of LDs should be in proportion to the contract price of the Onshore Contract, and allow for the 'topping up' of the balance LDs owing under the WAG so that the Project Company recovers the same amount of LDs as it would under a non-split EPC Contract.
- Require both the Onshore Contractor and the Offshore Contractor to work to the same overall schedule and to share in any LDs. The same 'topping up' provisions should appear in the WAG along with provisions denying the Contractors the right to claim horizontal defences (see below).
The extension of time ('EOT') clauses in the Onshore and Offshore Contracts will also require close attention. If one Contractor is granted an EOT, then the other contractor should not be entitled to claim an EOT for its affiliate’s act or omission (unless it is a qualifying EOT).
To protect itself against design risks, a Project Company should ensure that the overall design obligations are assumed by one Contractor - usually the Onshore Contractor that has established a presence in the host country. The Guarantor under the WAG should then provide a guarantee for the Contractors' design obligations. Further, if the Offshore Contractor performs specific offshore design services based on receipt of the Onshore Contractor's design brief, the Onshore Contract should contain provisions requiring the Offshore Contractor to warrant the fitness for purpose of that design brief.
A provision should be included in the Onshore Contract and the WAG providing that the Onshore Contractor (Guarantor) is responsible for all offshore Equipment from the moment the Offshore Contractor ceases to be responsible for that same Equipment and in the same way that the Offshore Contractor is responsible under the Offshore Contract for the Equipment. Again, the point is to eliminate gaps and provide seamless integration.
Residual legal Issues
A Project Company should also address the following issues with a split structure:
- caps on liability and LDs;
- termination & suspension;
- variations/change orders;
- confidentiality issues; the governing law; and
- force majeure.
- The Wrap Around Guarantee
The most important document, in terms of providing the necessary legal protection to a Project Company, is the WAG. Correctly drafted, a WAG will provide a Project Company with a single point of responsibility for the whole of the works. In addition, it will prevent the split Contractors from relying on each other's defaults to avoid performing their contractual obligations - a tactic known as a 'horizontal defence'. The WAG will also prevent a Contractor from relying on a Project Company's default where the default was a result, either directly or indirectly, of the non-performance, inadequate performance, or delay in performance of any of the other Contractors under their respective contract.
In addition to horizontal defences, the WAG should:
- address LDs (see the toping up provisions above);
- include a performance bond from the Guarantor;
- address liabilities and limitation of liability of the Guarantor;
- expressly permit a Project Company to pursue remedies against the Guarantor (and not have to exhaust its options against the split EPC contractors first); and
- contain similar force majeure and dispute resolution provisions as the split EPC contracts.
The splitting of works between two or more contracts is usually driven by tax and other red tape considerations that are specific to a host country. The splitting exercise can be fraught with danger for the uninitiated and the legal complexities and co-ordination required by the parties may be enough for to revert to a more traditional turnkey structure.
Provided appropriate taxation and legal advice is sought and received, and provided all associated legal issues are adequately addressed in the split contracts and 'wrapped' in the WAG, the benefits offered under a split structure can be substantial.
This article is an update on an article written by the author and published in the International Bar Association’s Asia Pacific Forum Newsletter Vol 8 No. 2, September, 2000.