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HMRC internal manual

International Manual

HM Revenue & Customs
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Transfer Pricing: Transactions and Structures: business structures: manufacturing: arm’s length reward

How limited risk manufacturers are typically rewarded inter-group

In almost all cases of stripped risk manufacturers (both contract and toll: see INTM441090) the basic reward is a modest fee or margin, sometimes calculated on a cost plus basis. In many 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; in terms of 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 some form of hybrid methodology may be encountered, 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) it’s important to 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 might necessarily be found in independent manufacturing companies. 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; 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, which can provide comparables (suitably adjusted).

Structures may be seen 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. INTM441140 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.

Case teams should establish the extent to which non-arm’s length profits are being returned before deciding what the arm’s length profit might have been.

Evidence that might be necessary

An early meeting with the business is advisable to help determine what information is available, the timescale in which it may be supplied, and which members of staff it would be helpful to meet. The following are examples of information which case teams may wish to consider; this list is not exhaustive. The extent and content of an information request must be considered from case to case. See INTM483040 for general guidance about information requests in transfer pricing enquiries.

  • The contract and other documentation under which manufacturing is performed
  • 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 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) and 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