Offtake agreements are arrangements whereby a buyer and a seller agree on future trade of goods based on specified prices and/or volumes. Typically, offtake agreements are signed before the construction of seller’s facility and reduce cash flow variability for seller due to contractually negotiated terms which, thus, may help seller to find financing for the construction of the facility (Reduced cash flow variability may give incentive to lenders to approve a loan to seller and provide loans at a lower cost for seller). Liquefied natural gas (LNG) and organic chemicals are examples of products traded under offtake agreements. Offtake agreements also provide buyers with contractually negotiated prices and/or supply. If the underlying product becomes popular in the future, buyer may benefit from the fixed price and/or guaranteed supply (The specifics of the offtake arrangement analyzed in this article are provided in the next section).
Because they are used commonly in practice, offtake agreements have been studied widely in literature. Hartley (2015) compares the advantages of long term agreements, i.e. increased debt capacity and reduced cash flow variability, with the future profitable trading opportunities and argues that increased LNG market liquidity is likely to encourage much greater volume and destination flexibility in contracts and increased reliance on short-term and spot market trades. Ruester (2015) analyzes the determinants of the debt ratio in project finance using data on LNG export and import projects. Ruester (2015) empirically shows that the debt ratio of an LNG project decreases with increasing risks related to future cash flows confirming that leverage increases with higher shares of a project’s capacity sold under long-term sales-and-purchase agreements. Ruester (2009) studies the trade-off between contracting costs due to repeated bilateral bargaining and the risk of being bound in an inflexible agreement in uncertain environments. Results show that the presence of highly dedicated asset specificity results in longer contracts, which aligns with the predictions of transaction cost economics, whereas the need for flexibility reduces contract duration. Masten and Crocker (1985) examine the take-or-pay provisions in contracts between natural gas producers and pipelines and analyze the efficiency implications. Shah and Thakor (1986) provide a theory of optimal capital structure related to risk, leverage, and value and explain why project financing involves higher leverage than conventional financing.
Consistent with their prevalence and importance in the market, offtake agreements are also used commonly in related-party transactions. However, they have not been analyzed sufficiently for transfer pricing purposes. This article addresses this issue, providing a general framework for offtake agreements that can be used by transfer pricing practitioners to measure such arrangements. In particular, risk adjustments are considered, because offtake agreements can be used to change the risk profile of the related parties entering into such transactions. Further, although offtake agreements are the focus of the analysis, the arguments and methodology in this article can be used to analyze other types of arrangements, such as short-term agreements.
The methodology proposed in this article follows Penelle (2012) and Penelle (2014). In particular, the methodology in Penelle (2014) used for the analysis of business restructurings and exit charges is based on a model with an infinite time horizon, i.e., perpetuity. The model in this article is based on a similar setup but considers a finite time horizon consistent with the finite terms of offtake agreements.
The next section provides a theoretical framework for the analysis, followed by a numerical example to illustrate the methodology, a discussion of some special cases, and a conclusion.
Consider an offtake arrangement between a manufacturer and a distributor that are related parties and are located in different tax jurisdictions. The manufacturer (seller) produces a product that is purchased by the distributor (buyer or offtaker) to be sold in the distributor’s local market. The distributor acts as a principal in the sense that it determines the manufacturing schedule, that is, product type and volume, and takes all the market risk because it would have to bear the cost of products that are not sold. Further, there is guaranteed demand for the seller because the offtaker commits to purchase all the products manufactured by the seller. The manufacturer also operates under a constant (and predetermined) net cost-plus markup transfer pricing policy, which is monitored throughout the year, and adjustments are made to guarantee that the seller earns the target markup on actual costs every year.
This intercompany arrangement and the transfer pricing policy may significantly reduce the seller’s risk profile since the market risk would be mitigated considerably for the seller, which earns a guaranteed constant net cost-plus markup every year. Thus, compared to a typical manufacturer in the market, the seller would have a significantly lower risk profile (In particular, all fixed costs of the seller would be converted to variable costs under a constant net cost-plus markup policy. See Penelle (2014) for details).
It is also assumed that the contractual allocation of risk based on the offtake agreement is consistent with Article 1.60 of the OECD transfer pricing guidelines (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2017), that is, the transaction is accurately delineated in respect to the risks and both the manufacturer and distributor follow the contractual terms in their conducts, exercise control over the risks they assume, and have the financial capacity to assume those risks. But for example, if the manufacturer controls more risks, then additional compensation may be necessary per Article 1.105 of the OECD transfer pricing guidelines.
Given this setup, taxpayers may attempt to apply the transactional net margin method (TNMM) to benchmark the intercompany transaction. Suppose that, in addition to having a principal role, the distributor also has nonroutine intangibles, which makes it unfeasible to select as a tested party (See Article 2.65 of the OECD transfer pricing guidelines). Therefore, taxpayers may select the manufacturer as the tested party because of its less complex functions and risks.
One question to consider, then, is whether one can find companies that have functions, assets, and risks comparable to those of the manufacturer. Although it may be possible to find companies that have functions and assets similar to those of the manufacturer, none of those companies would have a risk profile comparable to that of the manufacturer, because all the independent companies operating in the market would have market risk to some extent. The offtake agreement and transfer pricing policy isolate the seller from the market risk significantly; therefore, it may not be possible to find reliable comparables that can be used for the TNMM. In that case, what can one do to benchmark such transactions?
This article proposes a methodology to address this question following Penelle (2014). In particular, Penelle (2014) provides a de-risking approach for a distributor and discusses the implications for exit tax in business restructurings. The methodology proposed in this article follows a similar approach, that is, it uses Penelle (2012) and a no-arbitrage condition; however, it provides the analysis for a manufacturer and in a finite time model different from Penelle (2014), who analyzes a distributor assuming perpetuity.
Details of the model are as follows.
The limited-risk profile represented by the limited-risk discount rate, rL, is obtained by the hedge due to the offtake agreement and helps the seller to find cheaper financing, thereby reducing the seller’s cost of capital.
Once the limited-risk (or de-risked) discount rate, rL, is obtained, the de-risked net cost-plus markup, NCPL, for the manufacturer’s limited-risk profile can be determined based on the no-arbitrage condition as follows:
The no-arbitrage condition in Equation 2 is the application of the realistic alternative principle provided in the OECD transfer pricing guidelines. In particular, Article 1.38 states “Independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives.”( See also Chapter IX, Section B.3 of the OECD transfer pricing guidelines)
In other words, the manufacturer would be indifferent between the two realistic alternatives — operating as a full-risk manufacturer vs a limited-risk manufacturer.
The model presented in the previous section is illustrated with a numerical example. Suppose the following projections are available for a manufacturer that enters into a 10-year offtake agreement with a distributor based on the assumptions in the previous section (Fixed and variable costs can be identified through different methods, such as functional interviews or regression analysis).
Suppose also that the following parameter values can be obtained from comparables: rH = 12%, rC = 4%, NCPH = 8%. Plugging these parameters in Equation 1 and 3 gives the following de-risked discount rate and net cost-plus markup: rL = 4.83% and NCPL = 5.70%.
The offtake arrangement converts all the manufacturer’s fixed costs to variable costs during the agreement period; thus, the manufacturer has a lower risk and cost of capital compared to a full-risk manufacturer. Accordingly, the discount rate and net cost-plus markup for the de-risked manufacturer are lower than those for a full-risk manufacturer. NCPL = 5.70% can be used as a target net cost-plus markup for the offtake agreement.
Two key assumptions in the model above are:
i. The buyer purchases all the volume produced by the seller, although the production volume can change from one year to another depending on the third-party demand the buyer faces.
ii. The seller earns a constant net cost-plus markup every year that is monitored throughout the year and adjustments are made to ensure the seller attains the target markup on actual costs every year.
The model, however, can be customized for special cases.
There may be situations in which the volume commitment is stricter; for example, the contract may include a fixed volume commitment and the buyer is obligated to purchase this fixed volume every year (In the model analyzed above, there is still an obligation for the buyer to purchase the entire volume produced by the seller; however, the volume can vary every year). From the seller’s perspective, such an arrangement is naturally less risky than the one analyzed in the model, assuming that the constant net cost-plus markup condition still applies. Fixed volume, together with the constant markup condition, further restrict the volatility of the seller’s yearly profits and thus yield a lower risk profile for the seller compared to the one in the model.
In such a case, in accordance with this lower-risk profile, one can consider using a lower discount rate than the one provided in Equation 1.
In some cases, the seller may sell to multiple related and unrelated distributors, and there may be a different arrangement for each buyer (For example, there may be offtake agreements with some related buyers, whereas for other buyers, the manufacturer may sell as a full-risk manufacturer). In that case, the production capacity is allocated between related and unrelated distributors. The model provided above can be applied based on the capacity and volume allocated to a related distributor buying under an offtake agreement. If the manufacturer sells as a full-risk manufacturer in some of these transactions, the net cost-plus markup earned by the manufacturer should be determined accordingly. Naturally, the more capacity the seller sells under an offtake arrangement, the lower the seller’s risk profile is, due to reduced volatility in returns (Note that the trade-off the seller has is that the offtake agreement reduces volatility in returns; however, the seller would have to forego any future opportunities e.g. trading in a more beneficial future spot market. Hartley (2005) analyzes this tradeoff in detail for the LNG market). The seller’s overall risk profile as a manufacturer would depend on all the transactions it enters into with related and unrelated distributors.
Offtake agreements are used widely for transfer pricing purposes. Despite their prevalent use, they have not been studied enough for transfer pricing purposes. This article provides an approach to analyze offtake arrangements accounting for their key aspects, such as the seller’s limited-risk profile. Following the methodology in Penelle (2012), a discount rate for this limited risk profile of the seller is obtained, which is then used to determine a corresponding de-risked net cost-plus markup for the seller.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kerem Toklu is a transfer pricing manager with Deloitte Tax LLP.
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The author thanks Philippe Penelle and Randy Price for their insightful comments, and also thanks Betty Fernandez for her editorial review.