In the context of the globalization of supply chains, multinational groups often segment their production processes to optimize costs and logistics. However, from the perspective of the 2022 OECD Guidelines, this segmentation must be perfectly aligned with the functional reality and the risks assumed in each jurisdiction under the Transfer Pricing framework.
One of the most common and costly errors in international taxation is failing to correctly distinguish between a tolling operation and full-fledged manufacturing. This distinction is particularly critical in markets such as Brazil, where the tolling model is widely used by companies seeking to integrate specific technical processes into a broader regional value chain.
1. Full-Fledged Manufacturing: The Autonomy and Risk Model
For Transfer Pricing purposes, a full-fledged manufacturing entity operates as an independent entity that assumes total control of its operational cycle. According to Chapter I (Section D.1) of the Guidelines, the characterization of an entity depends on an analysis of functions, assets, and risks.
- Comprehensive Supply Chain Management: The entity purchases raw materials on its own account, assuming inventory risk (obsolescence, damage, or price fluctuations).
- Strategic Decision-Making: Local staff manages production planning, advanced quality control, and outbound logistics.
- Assumption of Market Risks: If demand for the final product falls, it is the local manufacturer that absorbs the loss of profitability.
- Ownership of Intangible Assets: Often, these entities develop or maintain their own industrial processes that add value to the final product.
Impact on Profitability: Since the principle of perfect competition dictates that “higher risk, higher expected return,” these companies must report profit margins that reflect their market exposure.
2. Contract Manufacturing and Toll Manufacturing Agreements: The service model
At the other extreme are manufacturers with limited risk, a very common arrangement in the toll manufacturing operations we see in Brazil. Here, the local plant typically serves as a link that executes orders under the direct supervision of a parent company.
- The Maquilador (Toll Manufacturer): Does not own the raw materials; it only processes inputs belonging to another party. Its role is purely technical.
- The Contract Manufacturer: Although it may purchase the raw materials, it does so under strict instructions from the parent company, which guarantees the purchase of the entire production at a predefined price.
- Impact on Profitability: The OECD establishes that these entities should receive low but stable remuneration. The standard practice regarding Transfer Pricing, under the guidelines of Chapter II, is to apply the Cost Plus Method or the TNMM (Net Operating Margin) Method.
The Turning Point: The Concept of Control over Risk
The 2022 OECD update places special emphasis on the principle that risk follows control. It is not enough for a contract to state that the parent company assumes the risks; if the local entity (whether in Peru, Mexico, or Brazil) is the one actually making production decisions, the tax authority could reclassify the company.
If a company declares itself a low-risk “maquiladora” but in practice operates autonomously, the tax authority may require a Transfer Pricing adjustment so that the company pays taxes on higher profits.
How to Mitigate Tax Contingencies?
To ensure compliance and avoid adjustments by the authorities, it is vital to:
- Align the Contract with Reality: Ensure that the clauses accurately reflect who makes operational decisions.
- Document the Functional Analysis: Conduct in-depth interviews with staff to support the characterization chosen in the Local File.
- Accurate Benchmarking: Select comparable companies with the same risk profile.
The distinction between these models is not merely a matter of terminology, but of overall tax strategy.
At TPC Group, we have the methodology and technical expertise to help your organization define its functional profile in accordance with the highest OECD standards, ensuring a solid position in the event of any audit.
References:
Organization for Economic Cooperation and Development. (2022). Chapter I: The Arm’s Length Principle and Chapter II: Transfer Pricing Methods. In OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing. https://doi.org/10.1787/0e655865-en