Unique Transfer Pricing Issues and Approaches for Oil and Gas June 4, 2015 kpmg.ca 1

Unique transfer pricing issues and approaches for oil and gas Performance guarantees – the missing transaction Intragroup services – not always cost plus 5% Joint ventures – creating inconsistencies with transfer pricing policies Introduction There are often many intercompany transactions of all types, product, services, intangibles and financial transactions. Focus here is some of the unique transfer pricing issues we see in the oil and gas industry, which are often not straight forward. Performance guarantees – I call it the missing transaction because not immediately obvious that payment is required, unless the tax team is aware and fully in the loop Intragroup services – misconception that services are always cost plus 5% (or 0%). Caution where the services are valuable and potentially involve intangible property Joint ventures – often unclear whether these represent comparable transactions and how to address inconsistencies between transfer pricing principles and joint venture agreements

Performance guarantee fees Identification of performance guarantee transactions Contractual terms of subsidiaries with arm’s length parties Benefit test: Would an arm’s length party pay for the guarantee? Ability to secure contract Better terms and conditions for subsidiary Parent Guarantee Guarantee Payments? Customer or Government Subsidiary Potentially missing transaction – within a multinational, often overlooked unless those involved with the transaction are concerned with the legal entity results. Very little guidance on performance guarantees. OECD guidelines focuses on identifying commercial or financial terms between associated enterprises. Not straight forward. Arm’s length principle recognizes that incidental benefit from being part of a MNE does not constitute something that AL party would pay for. We learned that in financial guarantee case for GE Capital Canada. Implicit support is not to be paid for What I am talking about is where there is a binding contract between the customer/regulator of one member of the MNE, and explicit guarantee by another member of the group So, how do we determine if there is a performance guarantee fee. Review of the contractual terms – does the contract provide the customer greater ability to seek remedy from the parent? Is the parent at great greater risk than the investment in the sub? Is there a benefit? “activity provides a respective group member with economic or commercial value to enhance its commercial position” Ability to secure a contract? Better terms for the contract

Performance guarantee examples in oil and gas Activities that may require performance guarantees for compliance with applicable laws and regulations are as follows: Well drilling, re-drilling, or deepening Well operation Well maintenance and repair Managing prevention of waste and pollution from well operations There are multiple examples where a PG is required. In all industries, they are required where there significant capital involved, which will depend on the outcome over a longer period. Such as construction of a new facility, a pipeline or a well. Another common example is for the reclamation of a drilling / production site, to be returned to natural state following decommission. For example, all companies active on the UKCS have to provide a surety for future decommissioning of their works at up to 150% of the gross decommissioning costs. Currently, the only accepted forms of security guarantee are either bank letters-of-credit (LoCs) or, in a very limited number of cases, parent company guarantees (PCGs), but only for commercial arrangements involving certain, financially strong companies

Valuation of performance guarantee fees Realistic alternatives approach Benefit to the subsidiary based on cost of alternatives to obtaining the parental guarantee Sources of comparables Letters of credit – escalating rates depending on borrower leverage Surety or performance bonds – 1% to 5% Internal comparables Expected loss approach Expected cost to the guarantor based Common approach where risk is largely financial Probability of default x expected recovery in default Return for capital at risk The most appropriate valuation technique depends on the functional analysis. Why is the customer or government demanding the guarantee? If the value is derived by the reputation of the parent for excellent service, then financial risk or expected loss may underestimate the value. Important to understand what sort of terms, if at all the subsidiary would receive If the value is derived by the deep pocket books of the parent company, then an expected loss approach would be more apporopirate Realistic alternatives – often hard to observe direct comparables to use direct CUP method. Other TP methods are not likely appropriate unless subsidiary is a routine entity What if the parent was not involved? Would it be a letter of credit? In some cases companies may be able to obtain surety bonds from specialized lenders Internal comparables may be available where there are two similar contracts, one with a guarantee and one without. In that case use the delta

Technical services example Parent company Does not have any revenue generating business or any prospects, other than through its subsidiaries Employs personnel with technical expertise and know-how related to oil and gas exploration and production Foreign subsidiary Holds oil & gas properties Does not have technical expertise to develop its own exploration and production Parent Services Canada Foreign Subsidiary Not all services are cost plus! Oil and gas industry is a perfect example, service revenue is often completely unrelated to costs Parent provides technical services to foreign operations in Latin America or Africa for example that hold the oil & gas properties and recognize all the revenue related to those properties. The technical services provided by Canco employ valuable IP in the form of know-how models, data libraries, processes etc. Foreign subsidiary is dependent upon the technical services provided by parent company – it determines where to drill based upon the analysis of proprietary data and geological models. Without an appropriate remuneration to Parent company for the technical services, the parent ends up with accumulated losses and profits are trapped in Foreign company Given Canada is a leader in shale exploration and extraction techniques – this is common fact pattern. Also, see examples where Canco is the subsidiary, with built up expertise, and acquired by foreign based MNE.

Typical pricing for technical services fees Typical approach for services Determine cost base for service provider Allocate costs to service recipients Add a mark-up Limitations Timing of services does not match the benefit Cost does not reflect the value or alternative cost to service recipient Inconsistent profit split relative to the value chain for the entire group Typical approach Determining the cost base: identifying costs of providing services – carving out SH costs, splitting out reimbursement and cost of services Common allocation keys include time spent or revenue Mark-ups typically range from 5-10% Limitations Timing – costs are now, revenues are later TPM 15: “Auditors should refrain from accepting the proportion of sales revenues as a single allocation basis for management fees”. If sub is in start-up, revenue is zero. If time based, service fee does not reflect the risk or value Sub’s realistic alternative is to give up some of its future profit potential BEPS requires consistency between profit split (or at least potential) and relative contribution to the MNE value chain. If exploration is key, cost plus will lead to disporporitonate

Alternative pricing for technical services fees Revenue based fees for services Determine cost based fees as usual Add contingent service fee component Benefits of alternative pricing Timing of services fees matches the benefit Pricing reflects the value to service recipient Consistent profit split relative to the value chain for the entire group % of Revenue Value-added Success Fee Total service fee Cost + % Typical service fee Deductibility of the value-added success fee component. Potential withholding tax that could apply if the value-added success fee is deemed to be a royalty. Not for the risk adverse client since a significant increase in the service fee from one year to the next could raise questions of the tax authorities.

Support for value based technical services fees Arm’s length evidence Base Erosion and Profit Shifting (BEPS) Simplified approach for low-value services specifically excludes exploration and extraction Amendments to Chapter VI of the Transfer Pricing Guidelines 6.99: Method for services are not always cost plus and method for IP is not always complex 6.103: Geological data/analysis, software or know-how to be considered in comparability analysis Theme to revised transfer pricing guidelines is matching the pricing policy to the value creation and value chain of the MNE Reg §1.482-9: US transfer pricing regulations requires Contract with specific contingency and basis for payment Economic substance Edgar search identifies contracts where individuals are paid regular fee (consistent with a salary – often ex-employees) plus a % of all future revenue on oil and gas produced. BEPS IP part I: 6.99 It should be emphasised that the characterisation of the transaction as the provision of products or services or the transfer of intangibles or a combination of both does not necessarily dictate the use of a particular transfer pricing method. For example, a cost plus approach will not be appropriate for all service transactions, and not all intangibles transactions require complex valuations or the application of profit split methods. 6.103 As another example of the use of intangibles in connection with a controlled transaction, assume that an exploration company has acquired or developed valuable geological data and analysis, and sophisticated exploratory software and know-how. Assume further that it uses those intangibles in providing exploration services to an associated enterprise. Those intangibles should be taken into account in the comparability analysis of the service transactions between the exploration company and the associated enterprise, in selecting the most appropriate transfer pricing method for the transaction, and in selecting the tested party. Assuming that the associated enterprise of the exploration company does not acquire any rights in the exploration company’s intangibles, the intangibles are used in the performance of the services and may affect the value of services, but are not transferred. Reg §1.482-9: US transfer pricing regulations requires Contract with specific contingency and basis for payment Economic substance

Joint venture example for intragroup transactions Parent company Does not have any revenue generating business or any prospects, other than through its subsidiaries Employs personnel that provide services to joint venture Foreign subsidiary Holds interest in joint venture Joint venture Holds revenue producing assets Agreement to pay portion of revenue specified percentage of G&A Parent Canada Services/IP Foreign 3P Subsidiary Services/IP 50% 50% Joint venture Parent company Does not have any revenue generating business or any prospects, other than through its subsidiaries Employs personnel that provide services to joint venture Foreign subsidiary Holds interest in joint venture Joint venture Holds revenue producing assets Agreement to pay portion of revenue specified percentage of G&A

Joint ventures – implication intragroup service fees Issues to manage where foreign operations are held by joint ventures Agreement by joint venture partner Duplication of typical intragroup services with specified G&A reimbursement Consistency with other transfer pricing policies for provision of similar services or IP Issues to manage where foreign operations are held by joint ventures Agreement by joint venture partner Duplication of typical intragroup services with specified G&A reimbursement Consistency with other transfer pricing policies for provision of similar services or IP

Thank you! Jason Evans Partner, Transfer Pricing 403.691.8108 jqevans@kpmg.ca