In Transfer Pricing practice, different manufacturing profiles are typically distinguished based on the functions performed, the assets used, and the risks assumed. These include the full-risk manufacturer, the contract manufacturer, and the toll manufacturer.
The OECD Guidelines analyze contract manufacturing and emphasize that the characterization of an entity must be based on the transaction actually carried out, taking into account the functions performed, the assets used, and the economically significant risks assumed and controlled by each party.
The differences depend on the functions and risks assumed
A full-risk manufacturer typically carries out manufacturing activities with a greater degree of autonomy and economic exposure. It may assume risks related to the market, inventory, production capacity, quality, obsolescence, product development, or other operational risks. Its compensation, therefore, is more directly tied to the business’s economic performance.
A contract manufacturer generally produces according to the specifications of another entity within the group and typically performs more limited manufacturing functions. Depending on the operating model, it may purchase raw materials or receive them from the counterparty. Its characterization depends not only on who holds legal ownership of the materials, but also on the set of functions, assets, and risks it actually assumes.
Meanwhile, the toll manufacturer, typically focuses primarily on the physical transformation of materials belonging to another entity. In this type of structure, the manufacturer generally does not assume the main risks related to the ownership or marketing of inventory and receives compensation for the manufacturing activities it performs.
Why is this distinction relevant?
The functional characterization directly influences the selection of the Transfer Pricing method, the profitability indicator, and the basis on which the remuneration is determined.
In certain cases, a contract manufacturer may be compensated on a basis consisting primarily of the costs associated with the processing or conversion activity. In contract manufacturing structures, however, the cost basis may include a broader set of costs linked to the functions actually performed.
However, these differences should not be applied as automatic rules. The OECD Guidelines state that, when a cost-based method is used, the basis employed must be comparable and consistent with the functions performed and the transaction under review.
Therefore, it is not sufficient to simply identify a margin percentage considered reasonable. It must also be assessed whether the basis on which that margin is applied adequately reflects the manufacturer’s functions, assets, and risks.
How can a manufacturing entity’s profile be verified in practice?
Ownership of raw materials and the product during the production process is a relevant factor, but it is not sufficient on its own to determine the entity’s classification.
The analysis should consider, among other aspects:
- who acquires or owns the raw materials;
- who controls inventory and assumes the risks of obsolescence or loss;
- who decides on production levels and installed capacity;
- who assumes the risks related to quality and production;
- who controls economically significant risks;
- which assets each entity uses; and
- how the parties actually behave during the transaction.
The classification must be based on all of these elements and not solely on the contractual designation used by the group.
The risk of a designation that does not align with economic reality
An entity described as a limited-risk or contract manufacturer may present inconsistencies if its financial statements, contracts, and conduct show that it assumes risks or holds assets significantly greater than those described in the functional analysis.
For example, the existence of significant inventory may be a relevant indicator, but it should not be analyzed independently. It will be necessary to determine who controls the inventory risk, who bears the economic burden of its fluctuations, and what functions the entity actually performs in relation to those assets.
This consistency among contracts, functional analysis, financial statements, and actual conduct is particularly important in a Transfer Pricing review, because a tax authority may compare the declared classification with the economic reality of the transaction.
At TPC Group, we help manufacturing groups assess whether the functional classification of their entities—full-risk manufacturer, contract manufacturer, or made-to-order manufacturer—is consistent with the functions actually performed, the assets used, the risks assumed, and the financial information reported.
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