Legal Angle

Understanding EPC contracts to avoid litigation

In a scenario of reducing solar power tariffs, there are increasing instances of reneging on old deals and renegotiation of contracts. As such, there is a growing focus on litigation and legal issues, underlining the importance of clearly defining and adhering to all clauses in a contract.

Litigation issues

A developer faces various legal issues at different stages of solar project development. The first issue arises during the bidding process. Each project is different and so are the legal requirements associated with it. This is reflected in the tariff variations across projects. All of this must be kept in mind while bidding for tenders. Further, there are legal issues pertaining to land procurement, which delay the process. These are especially troublesome for stand-alone projects.

In order to ensure the smooth transmission and evacuation of power from the project, adequate infrastructure and licences should be in place. Obtaining permits and consents for solar projects has become easier now as they do not require environmental clearance any more. Another obstacle pertains to the procurement of funds. Increased stress in the financial market has led banks to tighten their purse strings. Developers must ensure that the project agreements they enter into are bankable, which implies the proper allocation of risk among the stakeholders involved.

Contractual framework

The contractual framework for a solar project includes agreements for engineering, procurement and construction (EPC), financing, operations and maintenance, power purchase, and grid interconnection. The EPC contract is the most important in the entire process. Under this arrangement, the contractor is responsible for activities related to the design, procurement, construction, commissioning and handover of the project to the end user or owner. An EPC contract can be divided into two categories – split and turnkey contracts. Split contracts can be further categorised as supply contracts, erection and services contracts along with wrap/ umbrella contracts.

The primary consideration for an EPC contract is its structuring, which is a tax-led decision that involves assessing if the goods and services tax (GST) on solar equipment is less than the that on services. Before the GST regime, there was a larger list of split contracts. In fact, lender preferences from a tax perspective are still inclined towards a split contract with a full wrap.

Role of GST and import duty

Electricity has been kept outside the purview of GST, which means that the output is not taxable. However, there exists a tax on inputs under this regime, which leads to an increase in the project cost. While there is a tax rate of 5 per cent on solar power equipment, a tax of 18 per cent is imposed on services.  To resolve the confusion regarding the tax rates, the Ministry of New and Renewable Energy communicated its understanding of GST via a memorandum issued in April 2018. The highlights of the memo specified that the structural components do not qualify as “immovable property” and thus would not be classified under the “works contract”. An EPC contract could be classified as a “composite supply” contract and attract a 5 per cent GST rate if the solar power equipment is the principal supply. Meanwhile, import duties play a key role in contract structuring. These include customs duty, safeguard duty and anti-dumping duty, which can alter the overall contract structure.

Implementation challenges

One of the challenges in EPC contract implementation pertains to cost and time overruns. To keep the overruns in check, specific targets should be set along with scheduled commissioning dates based on power purchase agreements. Time extension should be allowed exclusively in case of policy or legal changes or other delays. Contract variations should be restricted to a minimum to avoid time overruns. Damages for delays should be liquidated and corresponding security should be put in place.

In the event of non-compliance, the contractor is liable to pay performance liquidated damages. However, the contractor has limited rights to rectify and perform retests. The EPC contract must also include provisions for a detailed takeover of the plant. Warranties for defects and a longer defect liability period should also be in place. Another essential consideration in the EPC contract is force majeure, which limits the consequences to only suspension and extension of time. A change in law may dictate who will bear the responsibility (typically borne by the developer). In this case, the time and cost extensions would be limited to the appropriate commission’s findings. Insurance requirements form an additional aspect, which is commercially agreed upon in the contract. The termination of the EPC contract needs to be conducted smoothly, which involves ensuring the completion of termination payments.

Based on a presentation by Pallavi Bedi, Partner, Luthra & Luthra

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