A recent decision of the English High Court has considered a dispute regarding the splitting of an energy project into offshore and onshore contracts for tax purposes. Such structures rarely come before the courts and this case provides useful insights into the complex drafting issues which can arise when seeking to implement such structures.

Contract splitting

Contract splitting is frequently used to generate tax efficiencies in international construction and energy projects. This usually involves splitting the project into offshore and onshore elements. The offshore elements will usually comprise design and manufacturing works to be performed outside the local jurisdiction in which the project is to be delivered. The onshore elements comprise the balance of the work, including delivery of the project inside the local jurisdiction. Separate contracts are entered into for the offshore and onshore elements, usually with separate onshore and offshore contracting entities (although the procuring entity will usually stay the same).

Through this means, exposure to local taxation laws in relation to the offshore elements is sought to be reduced. In particular, the lack of a taxable nexus in the local jurisdiction may mean that the income or profits arising from fees paid under the offshore contract are not subject to corporate or income taxes in that jurisdiction. Supplies made under the offshore contract may also not fall within the scope of value added tax, sales taxes or other indirect taxes in the local jurisdiction, potentially creating a saving for the procuring entity (to whom these may otherwise represent a final cost).

A "bridge" or "umbrella" agreement is also usually agreed to deal with interface issues and to ensure that the procuring entity is not prejudiced by the splitting arrangements. This agreement may be between the procuring entity and both the offshore and onshore contracting entities, or may be between the procuring entity and a guarantor entity. The precise structure of the split contracts and any umbrella agreement will depend on the tax treatment likely to be obtained within the local jurisdiction in which the project will be delivered.

Petroleum Co of Trinidad and Tobago Limited v Samsung Engineering Trinidad Co Limited

The Petroleum Co of Trinidad and Tobago Limited ("Petrotrin") entered into construction contracts with Samsung for the construction of a new CCR Platformer Complex and Substation at one of its refineries in Trinidad. The contractual arrangements were split into two contracts, an onshore contract with a local Samsung subsidiary ("Samsung Trinidad") and an offshore contract with Samsung's principal Korean contracting entity ("Samsung Korea").

The splitting of the works in this way was purely to provide a tax advantage to Samsung. In addition to the offshore and onshore contracts, both Samsung Trinidad and Samsung Korea entered into an umbrella agreement with Petrotrin which was intended to ensure that the splitting arrangements did not cause any disadvantage to Petrotrin (referred to by the parties as a "Linkage Agreement").

Samsung Trinidad commenced arbitration proceedings against Petrotrin under the onshore contract. Petrotrin counterclaimed for delay liquidated damages. An issue arose as to the applicable cap for delay liquidated damages. The onshore agreement limited these to 10% of the contract price stated in the onshore agreement. The offshore agreement had similar wording. However, the Linkage Agreement provided that, "the maximum liquidated damages under each Contract [i.e. the offshore and onshore contracts] and this Agreement shall be an amount equal to ten percent (10%) of the Total Agreement Amount." The Total Agreement Amount was defined as the aggregate of the contract prices payable under the offshore and onshore contracts.

Which cap applied?

The arbitral tribunal rejected Petrotrin's case that the aggregate cap from the Linkage Agreement should apply to its counter-claim. The tribunal noted that the arbitration had been commenced under the onshore contract and the issue before it was therefore the proper interpretation of the cap in the onshore contract. The tribunal disagreed that the Linkage Agreement was to be taken as conflicting with and/or amending the cap in the onshore contract. In the tribunal's view, the aggregate cap in the Linkage Agreement was to be read as a "long-stop limit which sits above the lower cap applicable under a single agreement". The tribunal acknowledged Petrotrin's argument that this interpretation meant that the cap under the Linkage Agreement could never apply (i.e. it added nothing to the two caps under the onshore and offshore agreement), but considered that there was nothing unusual in such provisions being added as a precaution.

Petrotrin subsequently challenged the tribunal's award before the English High Court under section 67 of the Arbitration Act 1996 dealing with jurisdictional challenges. The challenge was rejected on the basis that the issue was one of contractual interpretation rather than jurisdiction and that, in any event, the tribunal's conclusions as to jurisdiction were correct.

Conclusions and implications

This case demonstrates the importance of careful drafting when seeking to implement a split contractual structure. The commercial intention - behind the Linkage Agreement at least - appears to have been to allow Petrotrin to recover delay liquidated damages up to 10% of the total of the contract sums payable under both the offshore and onshore contracts from either of the Samsung entities. That would have the position had both elements of the works been contained in a single contract, and had that intention been achieved it would have meant that Petrotrin had not been put at a disadvantage by the splitting of the contracts which was the very purpose of the Linkage Agreement. However, a combination of limited arbitration provisions and inconsistent drafting around the liquidated damages cap led to a finding that separate and distinct caps applied to each of the Samsung entities.

Had broader arbitration provisions been included in the three contracts, it may have been open to Petrotrin to make its counterclaim directly under the Linkage Agreement rather than seeking to rely on that agreement indirectly to influence the interpretation of the offshore agreement.

Splitting contracts introduces a considerable amount of additional legal complexity in comparison to a single contract structure. Aside from liability caps and arbitration provisions, the list of other issues to consider includes scope gaps, cross-contract claims and defences (e.g. onshore contractor relying on delays by the offshore contractor), testing and completion under the separate contracts, termination, defects liability and joint notification provisions. While the tax benefits are potentially large, and may enable a procuring entity to have a project delivered at a reduced price, the parties should ensure that proper advice and attention is given to these contractual issues to ensure that no unintended consequences arise as a result of the split structure.