Transfer pricing of manufacturing functions
This guidance will be updated.
In a group, the manufacturing operations can be organised in various ways between parties in the group or parties outside it. From the perspective of transfer pricing, the parties involved must ensure that the terms and conditions for the manufacturing-related intra-group transactions correspond to the terms and conditions that would have been applied by independent enterprises and that both of the group companies are able to accumulate the profits that independent enterprises would accumulate in a similar situation.
Transfer pricing of manufacturing operations must be at arm’s length
In manufacturing operations the question is of operations in which a group company manufactures products that are sold to a sales company in the same group, or another similar company, or to a party outside the group. The most pivotal aim in transfer pricing of manufacturing operations is to ensure that group companies are able to accumulate the profits that independent companies would accumulate in a similar situation. This applies to group company manufacturing the products as well as the group company responsible for selling the products.
Delineating manufacturing-related intra-group transactions
Manufacturing operations may involve different types of intra-group transactions that go within the scope of transfer pricing. The manufacturing company may, for example, buy raw materials or components from other group companies and sell finished products to the sales companies of the group. The manufacturing function may also be a service performed for another group company, which is often referred to as contract manufacturing.
When delineating manufacturing-related intra-group transactions, special consideration should be given to the intangibles used in the manufacturing process. The intangibles may relate to the products (such as patents) or manufacturing operations (such as technology). Delineating the related party transactions that involve intangibles requires that the intangibles used in the manufacturing and the group companies owning the intangibles in question are identified. The manufacturing operations may also involve substantial intra-group transactions in which manufacturing equipment is delivered or funding is obtained for investments and intra-group services provided.
In transfer pricing of manufacturing operations, consideration must be given to the functions, assets and risks of the parties to the transaction
In transfer pricing, consideration is given to the functions and assets of the companies as well as the risks assumed by the companies. When the parties involved agree on the prices and other contractual terms for intra-group transactions related to the manufacturing operations, it is important to determine the functions performed and the risks assumed by the parties. The functions and risks have an impact on how an independent enterprise is expected to perform financially. The impact of the functions and risks on the profit levels of a manufacturing company may naturally vary, depending on the sector and the markets.
Functions related to manufacturing operations may include the design and development of production lines, purchasing raw materials and components, selection of raw material suppliers and subcontractors, product design, research and development, production planning, manufacturing of products, quality control, packaging and warehousing. The ordinary risks related to manufacturing function are those related to the markets, equipment and research and development investments, inventory, defective products, warranty, bad debts, product liability and the environment.
Determining the arm's length prices in manufacturing operations
There are number of different methods for verifying that transfer pricing is at arm's length. The different methods are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted and an important source of interpretation when the arm's length principle is applied. When selecting the method, it is important to conduct a functional analysis of the parties to the transaction and select the tested party correctly.
OECD Transfer Pricing Guidelines (www.oecd.org)
Selecting the tested party
In order to determine the arm's length transfer price, one of the parties to the transaction must be selected as a tested party. The party engaged in less complex functions, or the party whose functions do not involve factors that are difficult to valuate (such as patents) and that would make it more problematic to determine the arm's length price and identify comparables, should be selected as the tested party. In manufacturing operations, the situation can be viewed from the perspective of the manufacturing company or the other party to the transaction, usually the sales company.
Examples of selection of the tested party:
- If the group's manufacturing company owns the intangibles related to the products and production, is responsible for research and development and sells the products it has manufactured to a sales company engaged in ordinary sales activities, the situation is usually assessed from the perspective of the sales company.
- If the group is expanding its operations by establishing a manufacturing company that only utilizes the intangibles already developed in the group and owned by other group companies and is not engaged in functions generating specific added value, such as research and development, the situation can be assessed from the perspective of the manufacturing company. Especially when contract manufacturing is in question, the situation is usually assessed from the perspective of the manufacturing company.
In transfer pricing, the activities of the manufacturing company are often categorised in accordance with different operating models. These include for example toll-manufacturer, contract-manufacturer and full-fledged manufacturer. However, in a transfer pricing analysis it is more essential to precisely determine the functions performed by the company, as well as the actual risks and assets related to them.
Selecting the transfer pricing method
As a rule, comparable prices are used to indicate that the prices used in the manufacturing operations are in accordance with the arm's length principle. Comparable prices are prices that are applied in transactions between independent enterprises. This method is called the comparable uncontrolled price method (CUP). The CUP method is most suitable for the sales of manufactured products or manufacturing services when the manufacturing company sells the same products or performs the same manufacturing services to group companies and third parties. The method may also be applied to selling the manufactured products if the sales company buys comparable products from manufacturers outside the group. The method is the most suitable for raw material and component sourcing if the manufacturing company also purchases the same raw materials from third parties.
However, group companies rarely engage in similar transactions with independent enterprises and therefore information of comparable prices applied between independent enterprises in similar transactions is not available. Furthermore, comparable price data is not usually directly available in external databases. In such case the arm's length transfer pricing can be verified with other transfer pricing methods of which suitability is assessed on a case-by-case basis.
When assessing the consistency with the arm's length principle of the operations from the prespective of the sales company, the level of the company's operating profit is usually being assessed. When the manufacturing company is the tested party, the ratio of the operating profit to operating costs is usually the factor being assessed. In both cases the transfer pricing method is the transactional net margin method (TNMM).
Operating profit levels of independent enterprises can be examined using the commercial databases (such as the Amadeus database of Bureau van Dijk). When searching for comparables in the database, it is important to use refined search criteria so that the companies displayed are comparable in terms of their functions, risks and for example utilization of valuable intangibles. The comparability of the individual comparables must also be carefully assessed in relation to the tested party.
Other matters to be considered in transfer pricing of manufacturing operations
In transfer pricing of manufacturing operations, it is also important to consider situations where the intangibles are shared by several companies and situations where the manufacturing functions, assets and risks change as the group's operating model is restructured.
Shared ownership of the intangibles related to the manufacturing operations
In its manufacturing operations, the manufacturing company may utilize intangibles owned and developed by other group companies and also engage in its own development activities that can be considered to generate unique intangibles. In such case, the functions of both parties to a related party transaction may involve factors that are difficult to valuate and neither of the parties can be selected as a tested party when the arm's length transfer pricing is verified. In such case, it may be advisable to examine the situation from the perspective of both parties and the profit split method (PSM), which considers both parties, may be the most suitable method.
Changes in the group's operating model
When the group changes its operating model, some of the functions and risks can be transferred from one related party to another. With manufacturing companies, this may, for example, mean the transformation from a full-fledged manufacturer to a contract manufacturer. Transfer of functions and risks may mean changes in profit expectations, which should be considered in the company's transfer pricing model.
As the functions and risks of the manufacturing company change, it must be assessed whether the manufacturing company should receive a separate compensation for the transferred functions. Such a situation may arise when, for example, the transferred functions constitute an activity (ongoing concern) that is connected with substantial profit expectations.