Manufacturing transactions

Multinationals’ manufacturing operating structures are for transfer pricing purposes often described by the following commonly used terms according to their risk profiles and economic characterisations: (i) entrepreneur; (ii) licensed manufacturer; (iii) contract manufacturer; and (iv) toll manufacturer.

An entrepreneur, or a full-fledged manufacturer, may be responsible for activities such as production planning, input procurement, supply chain management, quality control, long-term capacity utilisation planning and potentially selling to third-party customers. A full-fledged manufacturer that possesses (non) routine intangibles bears a range of risks associated with those activities, such as product liability, warranty, capacity utilization, market demand and pricing risks. A full-fledged manufacturer/entrepreneur also may be engaged in significant R&D activities, bearing risks associated with development, maintenance and protection of valuable intangible property that may result from the R&D activities.

A licensed manufacturer produces goods under a license agreement, using manufacturing intangibles owned by the licensor, such as patents, product designs, manufacturing process and know-how. The licensed manufacturer pays royalties for the use of the licensed intangibles, typically buys raw materials and semi-finished goods on its own account and holds inventories of the raw materials and finished goods. Therefore, it bears the risks associated with both holding inventories and selling products, including demand and pricing risk. The licensed manufacturer typically owns plant and equipment necessary for manufacturing operations and invests in training its labor force.

A contract manufacturer is generally thought of as less risky than a typical licensed manufacturer. The contract manufacturer produces goods for a manufacturing principal that directly bears demand and final customer pricing risk. Provided the products made by the contract manufacturer comply with the principal’s product and quality specifications, the principal may guarantee to purchase the goods. Therefore, the contract manufacturer may bear relatively limited risks associated with holding finished goods and selling them, compared with a licensed manufacturer. The contract manufacturer typically owns plant and equipment and procures/owns raw materials, and thus still bears the risks associated with holding fixed assets and raw material inventory. In many instances; however, a manufacturer may perform some “contract manufacturing” activities that are ancillary to its licensed or full-fledged manufacturing activities.

Under a toll manufacturer framework, the principal retains title to the raw materials, work-in-process and final products during the manufacturing process. The related-party manufacturing principal owns raw materials and makes them available to the toll manufacturer for processing (that is, the toll manufacturer does not take title to raw materials). The toll manufacturer performs processing services, and is compensated by the manufacturing principal through a toll manufacturing fee that is typically calculated as a mark-up on processing costs. The manufacturing principal bears the risks associated with holding raw materials and finished goods inventory, as well as final demand and price risks.

In our product pages you will find some template agreements relating to the above mentioned categories of manufacturing operations.