Opportunities and challenges for Chinese companies with EPC contracts

By Santosh Pai and Raunak, D H Law Associates
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In the past few years Chinese companies have become synonymous with engineering, procurement and construction (EPC) contracts in India. Their revenue share in the EPC market has been rising steadily at the expense of domestic and foreign competitors from countries like Japan and Germany. Yet these are early days, and Chinese companies still have limitless opportunities to pursue in India.

Santosh Pai D. H.律师事务所 合伙人 Partner D.H. Law Associates
Santosh Pai
D. H.律师事务所
合伙人
Partner
D.H. Law Associates

China’s dominance

In certain sectors like thermal power, which is the main source of electricity in India, the share of equipment supplied from China has reached 40%. In several other sectors such as hydropower, solar and wind, Chinese companies are fast catching up with their competitors. The rising dominance of Chinese companies is attributable primarily to four factors: lower cost of equipment; shorter lead times for orders; attractive financing from Chinese financial institutions; and lack of capacity among other manufacturers.

Instances of Chinese dominance include Power Construction Corporation of China’s US$2.4 billion contract with India’s IL&FS in south India, Shanghai Electric’s US$8.3 billion agreement with Reliance Power in western India and SEPCO III’s US$9 billion worth of contracts in India since 2005. The cumulative overall turnover realised by Chinese companies from contracts in India has risen from US$1.99 billion in 2007 to US$29.78 billion in 2012.

Rise in infrastructure investment

Raunak D. H.律师事务所 合伙人 Partner D.H. Law Associates
Raunak
D. H.律师事务所
合伙人
Partner
D.H. Law Associates

The National Development Council in India has recently approved the Twelfth Five Year Plan, which has earmarked a total investment of US$1 trillion for infrastructure development in India in the next five years. This represents an almost 100% increase compared to the outlay in the Eleventh Five Year Plan, and a substantial chunk of this expenditure will be channelled into EPC contracts.

The infrastructure investment outlay includes allocations of 31% to the power sector, 25% to the telecommunications sector, 12% to roads, 9% to irrigation and 7% to railways. This distribution is aimed at ensuring the Twelfth Five Year Plan’s targets of maintaining India’s GDP growth at a steady 8% and generating 50 million new jobs are met. A few years ago, Chinese participation in government projects was thought to be difficult. However, if recent trends are to be believed, most private Indian EPC contractors also depend heavily on Chinese suppliers. As such, regardless of whether the investment occurs in the public or private sector, Chinese participation will be an integral part of India’s economic growth.

Structure of EPC contracts

EPC contracts in India can be broadly categorised into two types: package-based and turnkey contracts. Package-based EPC contracts place less responsibility on the contractors, since the project owners bear the risk on price, timeline, design, etc. On the other hand, in turnkey projects, the EPC contractor is expected to guarantee the price, timeline and design.

Each EPC contract comprises three distinct workflows: a) engineering, which might also include designing the project; b) procurement, which includes supply of capital equipment; and c) construction, which includes erection and commission of the project. From a legal perspective, such workflows can be further divided into offshore and onshore elements, depending on where the supply of services or goods is undertaken, payment structure and risk allocation between parties. While many EPC contracts are issued and executed in a consolidated form, only a detailed review of their terms will reveal whether such contracts are fully or partially divisible into individual elements.

Tax avoidance

Indirect taxes applicable to various elements of an EPC contract include customs duty (up to 27%), service tax (10.3%), excise duty (10.3%), VAT (5-15%), sales tax (2%) and various other minor levies. Since the tax authorities always seek to maximise tax revenue, the divisibility of an EPC contract plays a crucial role in determining the incidence of tax on the parties, and hence their profitability.

There are multiple ways to optimise the tax incidence, depending on the nature and scope of the EPC contract. For instance, levy of Indian taxes on the offshore supply of equipment can be avoided if the sale meets certain conditions such as: the transaction occurs between two principals; title of ownership is transferred on high seas – this means the ownership in the equipment is passed from supplier to buyer on high seas (i.e. international waters); sale consideration is received outside India, meaning the purchase price for the sale of goods and services is received by the seller outside India; and sale occurs at arm’s length, an accounting principle that means the price is the same as market price and no special conditions attach to the transaction depending on their relationship. Similarly, other segments of the EPC contract can also be structured to optimise tax incidence.

Permanent establishment

A further complication that Chinese companies need to circumvent in relation to taxation of EPC contracts in India are provisions relating to a “permanent establishment”. Although the concept of a permanent establishment is not alien to several jurisdictions across the world, its application in India is fraught with difficulties due to the ambiguous and non-comprehensive nature of elements that might give rise to a permanent establishment.

Taxability of revenue earned by foreign companies under EPC contracts in India has long been a subject of debate and controversy, so Chinese contractors looking to enter the Indian market would do well to obtain reliable legal and tax advice before committing themselves to any prospective project.

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