Split EPC Contracts: half the contract, double the risk?
What is a Split EPC Contract?
As the name suggests, a split engineering, procurement and construction (EPC) contract is a standard EPC contract which has been split between “onshore elements" and “offshore elements”. The “onshore” elements are undertaken by a local contracting entity that sits in the same group of companies as the contractor registered in an offshore jurisdiction undertaking the “offshore” elements. The majority of split EPC contracts are negotiated and then split rather than drafted for this purpose.
Typically, the offshore contractor takes responsibility for the design and engineering services and procurement of materials and equipment, with the onshore contractor taking responsibility for the construction works, local supply of materials and equipment, testing and commissioning and the remedying of defects.
The extent to which the offshore and onshore contracts can cross-refer to each other, i.e. to clarify the split of responsibilities or include a shared cap on delay damages based on the overall project price, is dictated by local tax legislation and disclosure requirements. In most jurisdictions only minimal cross referral is possible and there will inevitably be some gaps which cannot be closed without the structure unravelling. The parties will enter into an “umbrella agreement” in an attempt to get the risk profile of the split contracts as close as possible to a single EPC contract. The umbrella agreement would be between the employer and the two contractors and possibly a guarantor for the contractors. Given that the umbrella agreement is more akin to a guarantee, it is not always possible for it to contain strict obligations, so risks may be covered off by way of indemnities. This creates the obligation to make good a loss, rather than to prevent the loss in the first place, which is not as strong a position contractually as having single point responsibility.
During the performance of an EPC contract, contractors are exposed to a wide range of onshore taxes, including import and export duties, VAT, tax on its profits, property tax and withholding tax. In splitting the contract, the contractor’s exposure to local taxes fees and charges is limited and in principle should result in cost savings which ultimately should flow back to the employer in the form of a lower project cost.
Parties may also seek to split an EPC contract where currency exchange controls are in place which prevents a contractor from repatriating profit without losing a large proportion to currency exchange fees. If the majority of the contract price is payable offshore then local currency restrictions will not apply.
International energy projects lend themselves to this type of structure as a large component of their costs are in sophisticated plant and materials and specialist equipment, which are procured offshore. However, we are seeing this structure spread to construction projects in other industries. Those new to the concept will need to be alert to the following considerations.
The jurisdiction is likely to dictate exactly how the works and services will need to be split. Any gaps in the works to be carried out are likely to manifest themselves in the scope, with the potential for neither contractor to be responsible for parts of the works.
Parties can reduce this risk by giving one contractor responsibility for “sweeping up” any missing works.
This can be dealt with in the contracts or the umbrella agreement, as appropriate. In some jurisdictions it may be possible to have one scope of works which the contractors are jointly and severally liable for under the umbrella agreement, but in other jurisdictions this could cause the contracts to be seen as interrelated, which may incur local taxes on the whole project and as a result splitting the contract may not be commercially viable.
As the contractor parties are in principle controlled by the same entity, consideration should be given as to how delays under one contract which have an impact on the other contract should be dealt with. We would suggest that contractor delays under one contract should expressly not permit the contractor under the other contract to claim an extension of time. Similarly, any entitlement to time and money under either contract should not be applicable where the entitlement has arisen due to a breach or omission by the other contractor.
Limitations of Liability
In the majority of split EPC contracts, the split will be heavily weighted offshore, drastically reducing the potential liability of the onshore contractor. Consideration should be given as to whether caps on liability or delay damages should be by reference to a fixed value or a percentage of the project price, rather than a percentage of the onshore or offshore contract prices, and how these should be implemented.
Parties should consider which contractor is best placed to deal with any defects in materials, plant or workmanship, which contractor will have primary responsibility for testing and commissioning and whether representatives of both contractors will need to be present at tests and inspections.
Consideration should be given as to whether there should be a mutual contract termination clause so that a termination event under one contract would entitle the terminating party to automatically terminate the other contract. There may well be circumstances where the terminating party may not wish to terminate the other contract. The parties should agree at the outset what the consequences of such termination should be under both contracts.
Indemnities are likely to be a key feature of an umbrella agreement. There may be risks which cannot be covered off fully, so the contractors or the guarantor might agree to indemnify the employer for the loss it incurs as a result of the split structure, for example where a contractor benefits from the breach of the other contractor. There may also be situations where the employer agrees to indemnify the contractors.
Cross Set-Off Clauses
With single point responsibility, if a claim arises, employers are usually able to withhold sums due to a contractor rather than having to seek payment. In a split structure, the payment under the offshore contract is often frontloaded in comparison to the project programme. As such, a defect in the design may be discovered but the employer has no payments due to the offshore contractor on which to withhold sums. The parties could consider including a cross-set off clause to give the employer the ability to withhold sums due to the onshore contractor, instead of seeking a payment from the offshore contractor.
The parties should ensure the dispute resolution mechanisms in both contracts and the umbrella guarantee are aligned. They may also want to allow for consolidation so that any disputes can deal with all three contracts together, as one project.