INTM465060 - Transfer pricing: tax-planning structures: Solutions involving manufacturing
General overview
Manufacturing functions might also be moved between group entities.
The most common terms to denote manufacturing operations set up in such a way as to mitigate tax are referred to in this chapter as a 'contract manufacturer' and a 'toll manufacturer'. In day-to-day cases you may find these described by a different name. You may also find there are cases 'in-between' or with other subtle differences. The label is immaterial. In all cases you need to establish exactly how the structure operates in practice.
Licensed manufacturer
This is the most common form of manufacturing operation seen at arm’s length.
The licensed manufacturer will be making goods under a relatively long-term licence agreement. It will use manufacturing intangibles owned by the licensor, such as patents, industrial know-how, designs, etc. In return it will usually pay an annual royalty. It may own some of the manufacturing intangibles used in the production process. It will buy raw materials and semi-assembled goods on its own account and will hold stock of both raw materials and finished goods. It will be subject to the risks of selling the goods. It will need to invest in skilled labour and expensive plant and machinery.
Contract manufacturer
A contract manufacturer is the first step away from a licensed manufacturer. It still owns plant & machinery and employs a skilled labour force, but instead of making goods, holding them as stock and selling them to distributors, the goods are made for the principal. This means the contract manufacturer has none of the risks associated with holding finished goods, or of selling those goods. Provided it meets a specified quality, and quantity, the principal will guarantee to buy all the goods manufactured. The contract manufacturer will however still buy the raw materials (and bear the associated stock risk) and will probably hold title to the goods until bought by the principal.
Contract manufacturing is a concept recognised in the commercial world in some industries, e.g. the pharmaceutical business and the clothing industry. However in most instances third party manufacturers are not contract manufacturers, although some contract manufacturing might be carried out, ancillary to the main licensed manufacturing. In other cases, there may be independent companies who carry out manufacturing under contract (e.g. an order to make 10,000 dresses - same design, material and style, but different sizes), but will be working for a number of different principals. Everything will not rest on one particular customer. This is not indicative of a low risk contract manufacturer.
Toll manufacturer
Here the principal always retains title to the goods throughout the manufacturing process. The principal buys the raw materials or sub-assembled goods, although the physical flow of goods will be directly to the manufacturer himself. The principal bears all the inventory and selling risk. The toll manufacturer may have to buy small amounts of raw materials (E.g. the contract is to put zips in 10,000 dresses. The dresses are delivered to the toll manufacturer, but remain the property of the principal throughout. The zips are bought locally by the toll manufacturer).
How limited risk manufacturers are typically rewarded inter-group
In almost all the cases of stripped risk manufacturers (both contract and toll) the basic reward is a modest fee or margin, sometimes calculated on a cost plus basis. In a lot of cases, the raw materials are included in the cost base to be recharged, but no profit element is attached. Depreciation will also sometimes be only recharged at cost. Take the following example, where a contract manufacturer marks up costs other than raw materials and depreciation at 10%.
| Costs incurred | Recharged | Profit element | Total recharge |
| £’000 | £’000 | £’000 | |
| Raw materials | 20,000 | 20,000 | |
| Factory - labour | 2,000 | 200 | 2,200 |
| Factory - utilities | 1,000 | 100 | 1,100 |
| Factory - depreciation | 500 | 500 | |
| P & M - depreciation | 2,000 | 2,000 | |
| Administration | 1,000 | 100 | 1,100 |
| Total | 26,500 | 400 | 26,900 |
Overall, the net profit is £400,000; looking at total costs, the cost-plus element is only 1.5%.
In some cases the reward may be based on a return on capital employed, or net assets employed in the business. This can either stand-alone, e.g. the transfer price is set so that the UK makes a return on capital employed of 20%, or this may be translated into a cost plus formula. In other cases you may encounter some form of hybrid methodology, for example, as well as a cost plus return on certain costs there may also be an additional reward calculated in respect of return on capital - the cost of supporting the net assets.
Return on capital can be hard to compare with that of an independent as it is based on the equity investment in the manufacturing company. However there is no guarantee that the company has the same levels of equity investment as independent companies
Establishing an arm’s length reward for manufacturing
The first task is to establish exactly what functions and activities are carried by the manufacturer. Where there has been a change from a licensed manufacturer to either a contract or toll manufacturer (or something in between) you must find out what functions and risks have been transferred, and who now carries them in practice (as well as what is said to happen in a written contract). What staff and facilities does the principal have, and what do they do?
As discussed above the structure is not what you might necessarily find in independent companies who manufacture. The two may not be comparable, although it is possible to make adjustments to reflect key differences.
The biggest risk for a manufacturer is the capital tied up in the factory, production lines and skilled labour force. If these are standing idle, or a major contract is lost, the results can be catastrophic. With an affiliated manufacturer, there are likely to be only connected customers and the contract will generally be short term; all eggs are in one basket and there is not the long-term comfort generally to be found with a licence to manufacture. In such a case, a good starting point will be to look for independent companies carrying on similar manufacturing activities, with similar sales and markets, and with similar investments in factories and plant. These can provide comparables (suitably adjusted) for your case.
You may see structures where the contracts between the principal and the manufacturer are long term, and/or are designed to indemnify the manufacturer from losses such as redundancy, or plant becoming obsolete, etc. INTM465120 discusses the extent to which risk can and would be transferred away from the principal. It is important to remember that those risks still need to be covered and managed - someone will be rewarded for this.
You need to establish the extent to which non-arm’s length profits are being returned before deciding what the arm’s length profit might have been.
This is illustrated by an example, set out in the diagram below. Bodgit & Scarper (Hands Dirty) Ltd owns a large factory in the UK, which manufactures recordable DVD players. Bodgit & Scarper companies throughout the world sell the goods. Bodgit & Scarper (Hands Dirty) Ltd used to manufacture the DVD players under licence from the parent company in Ruritania, Bodgit & Scarper.
In 2009, however Bodgit & Scarper (Hands Dirty) Ltd gave up its licence, which was transferred to Bodgit & Scarper (Call the Shots), based in a tax shelter. Under the new licence, the principal manufactures the DVDs, which it either sells on to other Bodgit & Scarper companies, or sells in it own right through commissionaires in Europe. In practice, the principal subcontracts all the manufacture to Bodgit & Scarper (Hands Dirty) Ltd .
The results for the Bodgit & Scarper (Hands Dirty) Ltd for the two years ended 31 December 2010, and the principal for the year ended 31 December 2010 are as follows.
Principal |
UK Manufacturer |
||
|
31/12/00 |
31/12/10 |
31/12/09 |
|
|
£’000 |
£’000 |
£’000 |
|
|
222,000 |
Sales |
|
204,000 |
|
(105,800) |
Manufacturing fee |
105,800 |
|
|
(71,000) |
Costs of raw materials |
|
(65,000) |
|
|
Costs of manufacturing |
(92,000) |
(85,000) |
|
(22,000) |
Royalty |
|
(20,000) |
|
|
|
|
|
|
23,200 |
Gross profit |
13,800 |
34,000 |
|
|
|
|
|
|
(10,000) |
Inventory (interest, obsolescence, insurance, management, quality control, returns) |
|
(9,000) |
|
(1,500) |
Debtors (interest, management) |
(500) |
(2,000) |
|
(500) |
Administration |
(6,500) |
(6,000) |
|
11,200 |
Net profit |
4,800 |
17,000 |
The results are shown in such a form that all the costs associated with holding and managing stock, and selling goods are readily identifiable. In an actual case these would be spread across the profit and loss account and figures such as insurance, etc. will be amalgamated with other similar costs.
In 2009, Bodgit & Scarper (Hands Dirty) Ltd manufactures recordable DVD players under a licence agreement. It pays a royalty of around 10% on sales. The direct costs incurred are marked up by 20%.
In 2010, the Bodgit & Scarper (Hands Dirty) Ltd manufactures the DVD players under a contract for the principal. Looking at the combined results of Bodgit & Scarper (Hands Dirty) Ltd and principal together, overall nothing has changed - there is still a licence and a 10% royalty is still paid. The direct costs have been marked up by 20% to give a gross profit of £37 million (split £23.2 million to the principal and £13.8 million to Bodgit & Scarper (Hands Dirty) Ltd). The raw materials and finished goods are now owned throughout by the principal. Bodgit & Scarper (Hands Dirty) Ltd receives a manufacturing fee.
Bodgit & Scarper (Hands Dirty) Ltd still incurs the costs of manufacturing the DVD players, but now its reward is calculated by marking up its direct costs by 15%. The visible result is a very clear drop in profits for Bodgit & Scarper (Hands Dirty) Ltd. The principal now earns the majority of the profit.
The former operations and profits of Bodgit & Scarper (Hands Dirty) Ltd are now carried on and earned by a combination of Bodgit & Scarper (Dirty Hands) Ltd (as contract manufacturer) and Bodgit & Scarper (Call the Shots) (as principal). This is an important concept to bear in mind; you are looking at the profits earned from one activity - manufacturing goods - but those profits are split between two separate persons.
Looking at the results for the UK for 2010, is there anything not in accordance with the arm’s length principle? Bodgit & Scarper (Hands Dirty) Ltd is receiving lower profits, but has given up some functions and risks. The reduction in gross margin would give cause for concern, as Bodgit & Scarper (Hands Dirty) Ltd still incurs significant risk in the manufacturing process.
The principal now earns the profits effectively transferred from Bodgit & Scarper (Hands Dirty) Ltd. In a case like this, you might want to enquire further. The facts might show that too much weight is given to the risks and functions purportedly undertaken by the principal - it maybe that the risk still lies with the contract manufacturer. Or it may be that those risks don’t lie with the principal overseas but in the UK. See INTM465030 for a discussion on the transfer of risk. In some cases it might be possible to mount an argument that the principal is trading in the UK. As discussed in the section on commissionaires (INTM465040), the principles involved in establishing that a non-resident is trading in the UK, and the attribution of profit to that PE are complex issues.
Evidence that might be necessary
The following information will be needed to assess the extent of the profits that no longer arise to Bodgit & Scarper (Hands Dirty) Ltd, and to help inform the decision as to whether the principal is trading in the UK. Some of this information will not be in the power of the Bodgit & Scarper (Hands Dirty) Ltd. If the group is not prepared to supply the information you should consider asking CTIAA Business International to make a request for an exchange of information under the relevant double taxation agreement.
The fact gathering stage of the enquiry is very important. Think very carefully about the information you will want to see. An early meeting with the group is advisable, to help determine what information is available, and which members of staff it would be helpful to meet.
- The contract and other documentation under which Bodgit & Scarper (Hands Dirty) Ltd carries out manufacturing.
- A copy of the contract manufacturer’s accounts.
- A copy of the principal’s accounts, or alternatively management or divisional accounts if the principal carries out activities other than relating to manufacturing in the UK.
- An understanding of exactly how the remuneration for the contract manufacture is calculated.
- A detailed description of the activities of the principal and the contract manufacturer. This should include a review of the staff and their duties, premises occupied (size, nature and duration during the year), assets employed.
- Details of any personnel (and their duties) and assets that have moved from the contract manufacturer to the principal.
- Details of any employees of the principal that are seconded to the contract manufacturer (or vice versa), including duties and responsibilities.
- Evidence to demonstrate where function transferred to the principal is managed. This might involve meeting and interviewing key members of staff in the UK, and if possible from the principal.
- Evidence that shows how the respective risks and functions of the contract manufacturer and principal have been weighted.
- Evidence used to support the arm’s length nature of the profits that the contract manufacturer now earns.
- Copies of licence agreements to which the contract manufacturer used to be party.
- Copies of licence agreements that the principal is party to, relating to the use of intangible property used in the manufacture and sale of the goods produced in the UK.
