OT43450 - Non-residents working on the UK continental shelf: transfer pricing: bareboat charter - profit split method

This is the fifth of the methods referred to in OT43320. Paragraphs 3.5 - 3.25 of the OECD Guidelines outline the benefits and drawbacks associated with this method. It may be considered where transactions are very interrelated such that they cannot be evaluated on a separate basis.

The third party oil company is paying for both the supply and operation of a rig as one integrated transaction. The relationship between a rig owner and an operator can be a complicated one, and a wide spectrum of functions, risks and rewards may be embraced within it. It is important to carry out a full functional analysis to understand the relationship fully. What the Guidelines are trying to achieve is to replicate the dynamics of market forces in the dealings between the two associated entities.

HMRC’s view is that some sort of profit split is likely to be the most appropriate methodology to determine the profit arising to each party from the third party contract. Whilst the precise circumstances will vary from group to group an appropriate methodology would ideally involve a three step approach:

• the basic function of the rig owner is to lease a capital asset, albeit a very valuable and specialised one. The usual starting point to calculate the reward of such an activity is by looking at the expected rate of return on capital originally invested;
• the basic function of the rig operator is to provide services, albeit technical and specialised. In 2013 HMRC accepted during consultation on decommissioning that cost plus 10% is an acceptable level of mark-up for oilfield planning and project management activities (CAA 2001/s165C). HMRC therefore considers that cost plus 10% represents a routine return for the rig operator;
• if there is a residual profit from the day-rate contract, this should then be apportioned between the rig operator and the rig owner in proportion to the economic contribution that each party makes to the enterprise.

It may also be appropriate to build in a floor to the profit split calculation (perhaps using cost-plus to calculate this) in order to recognise that at the very lowest level the operator is a service provider and an independent enterprise carrying on such an activity would set its compensation at a level to ensure profitability, since it would not stay in business if it continually made losses.

All of the other approved methodologies consider only one side of the connected transaction. So if another methodology is proposed HMRC will consider the profits arising to both parties as a counter-check to ensure that it does not attribute to either an implausibly high or low level of profit.