1. Unique Transfer Pricing Issues and Approaches for Oil and Gas
June 4, 2015
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2. 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

3. 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

4. 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

5. 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

6. 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.

7. 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

8. 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.

9. 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 § : 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 § : US transfer pricing regulations requires
Contract with specific contingency and basis for payment
Economic substance

10. 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

11. 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

12. Thank you! Jason Evans Partner, Transfer Pricing 403.691.8108