Reproduced with permission from Transfer Pricing Forum, 14 TPTPFU 1, 10/15/24. Copyright © 2024 by Bloomberg Industry Group, Inc. (800-372-1033) http://www.bloombergindustry.com
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1. What kind of contract manufacturing operations do the tax authorities in your jurisdiction perceive as high risk, and how can MNEs safeguard their transfer pricing positions to mitigate such risks?
In Australia, a contract manufacturing operation would in general not be perceived as high risk by the Australian Taxation Office (ATO). However, where there is a mismatch between the functions performed, assets held, and/or risks assumed by the contract manufacturer and its contractual arrangement with its MNE group, then such misalignments will be perceived as high risk by the ATO.
Our experience is that the ATO would likely require a risk review of new contract manufacturing operations created as a result of a restructuring event of an MNE’s supply chain. In particular, if such events lead to a change in the entity, such that it goes from being a full-fledged manufacturing operation to a contract manufacturer, this could be a red flag to the ATO regarding the migration of intellectual property (IP), profit erosion, etc.
To safeguard against such risks, it is essential to perform a functional analysis of the operations, assets, and risks of the value chain of the relevant entities involved. It is also highly recommended to document the commercial rationale for the restructuring event at the time of the event and support this motive with robust economic analysis, including applying arm’s length comparable benchmarks.
In summary
In summary, it is recommended that the entity prepare transfer pricing documentation that is cleverly tailored to the best solution to support the position that dealings between related parties are in accordance with the arm’s length principle. To create such a solution, we suggest starting with the design of the group’s transfer pricing structure.
The design will include the standard pillars (i.e., the business description, details of the international related party dealings (IRPDs), financial performance, industry/economy relevant factors, selection of the TP method, and benchmarking) required by the Australian TP documentation guidance and the OECD Guidelines. However, it is not recommended to rely on the traditional transfer pricing analysis alone, as the nature and quality of the surrounding commercial evidence of the transfer pricing position is crucial.
Accordingly, developing a smart transfer pricing design that is a true reflection of the commercial and financial relations of the taxpayer’s arrangements and supported by robust transfer pricing and economic analysis is a solid safeguard to any ATO inquiry and future audits.
2. In your jurisdiction, what types of benchmarking studies (economic analyses) are accepted or typically applied when remunerating contract manufacturers?
In your response, consider the following:
a. Differences in the approach to benchmarking for contract manufacturers versus toll manufacturers;
b. Adjustment for a contract manufacturer with capital-intensive operations; c. Capacity utilization for the contract manufacturer and implications for
transfer pricing;
d. Any other considerations.
In Australia and similar to the OECD TP Guidelines, the selection of the most appropriate transfer pricing method and the chosen profit level indicator depend on the actual commercial and financial relations of the tested party. For contract manufacturers, where the manufacturing process is more labour-intensive as opposed to capital-intensive, the cost-plus method would typically be selected as the best option by applying a mark-up on total costs, otherwise known as the ratio of operating profit to total costs.
For toll manufacturers assuming less risk, as they would not need to shoulder the responsibility for the sourcing materials, risks associated with holding inventory, the cost-plus method is likely to be the most appropriate. However, there would still need to be some economic analysis to support the idea that assuming less risk than a contract manufacturer would imply a smaller ratio of its profit to total costs.
For contract manufacturers with capital-intensive operations, return on assets (or capital) could be more appropriate. As a rule of thumb, this is similar to the rate of interest which could be earned if all the assets were converted into cash and placed on deposit. The levels of return on assets (ROA) will vary between industries: some industries require significant assets to generate profit (e.g., mining), while others probably do not need to acquire many assets. The key issue that arises is how to value the assets, for example, at book value, market value, or some other methodology (as discussed in paragraph 2.98 of the OECD Guidelines).
Alternatively, for more capital-intensive manufacturing processes, it is common to use the return on capital employed (“ROCE”) as the most appropriate profit level indicator. Paragraph 2.97 of the OECD Guidelines states that ROCE can be an appropriate base “in cases where assets (rather than costs or sales) are a better indicator of the value added by the Tested Party, e.g., in certain manufacturing or other asset-intensive activities.”
The shortcoming of applying either ROA or ROCE is that they are not reliable methods to test whether the selected comparable companies employed leased assets. Leased assets could lower the total assets on these companies’ balance sheets and thus increase their ROA/ROCE relative to companies which employ assets that are fully owned, or which are recognized as under capital lease treatment.
In Summary
In summary, when selecting the most appropriate method for capital-intensive operations, we normally would recommend using a combination of the above measures and evaluating through qualitative considerations the most reasonable arm’s length outcome.
Other considerations for having a contract manufacturer in the value chain of an MNE include how to value capacity utilization for the manufacturer. It is likely that the MNE group would have exclusive rights to use the contract manufacturer, which would make the contract manufacturer reliant on the demand for its manufacturing services from the MNE group. This would directly impact whether it would be able to operate efficiently and at full capacity. Again, we always recommend employing an appropriate economic analysis that would support an arrangement that arm’s length comparable parties would agree to. This could result in an intercompany arrangement that would guarantee the contract manufacturer an arm’s length comparable profit regardless of the orders it would receive from the MNE group, and thereby pushing the risks to the principal or entrepreneur in the MNE for any shortfall in production.
3. What are the transfer pricing forum implications of government subsidies or grants in contract manufacturing?
We would recommend first and foremost complying with the local rules and obligations on the grants or subsidies and then employing economic analysis to demonstrate how the grants/subsidies would impact the intercompany arrangements if the parties involved were dealing at arm’s length.
4. What are the transfer pricing considerations for financing expenses as they relate to transactions involving contract manufacturers and who should bear the foreign exchange risks in these transactions? Please explain your reasoning.
Incorporating the funding of the contract manufacturing operations into the intercompany arrangement would require the same transfer pricing considerations as discussed above. We reiterate the importance of commencing with the functional analysis of the value chain to ascertain how the finance arrangement can be incorporated to ensure that it would be in accordance with the arm’s length principle.
The ATO released practical guidelines (PCGs) on finance arrangements a few years ago. The ATO has released these PCGs in areas where they perceive risk and also to provide taxpayers with their risk ranking from low to high for the ATO’s expectation of the intercompany arrangements.
Finance arrangements using a currency other than Australian dollars can cause an otherwise low-risk inbound intercompany loan to be perceived as a medium- or high-risk intercompany loan. Accordingly, in considering who should bear the foreign exchange risks in an intercompany finance arrangement, a risk-stripped contract manufacturer should not bear the foreign exchange risks in an intercompany finance arrangement, as it would be unlikely that an arm’s length party would have agreed to such under similar circumstances.
Benedicte Olrik is a Managing Director of Transfer Pricing
She can be contacted at:
Benedicte.Olrik@au.Andersen.com
