Transfer pricing audits are being used by tax administrations as a way to collect more revenue from taxpayers to fund cash-strapped treasuries globally. This trend creates many transfer pricing risks across the entire supply chain of multi-nationals. As shown in the recent court case in the U.S. involving Medtronic, manufacturing activities can be the source of significant transfer pricing controversy. It therefore pays to be prepared for some of the transfer pricing questions that are heading toward multi-nationals as a result of the revisions to the OECD Transfer Pricing Guidelines, the OECD/G20 base erosion and profit shifting (BEPS) initiative, and the rapidly changing global tax environment.
WHAT TYPE OF MANUFACTURING ENTITIES DO YOU OPERATE?
In the past decades, manufacturers have been characterised as one of the standard forms: toll, contract or full-fledged manufacturers (owning or licensing in valuable intangible property). This characterisation is closely associated with the functions, assets and risks of the manufacturers; a manufacturer's remuneration is determined on the basis of where it sits in this continuum.
The post-BEPS OECD Transfer Pricing Guidelines provide an enhanced framework for tax authorities to question the label given to manufacturing entities based on the conduct of the parties involved. Gone are the days where a contract that is commonly seen in third party situations (such as a toll/contract manufacturing arrangement) will be respected without questions and further investigation by tax authorities. In this new world, everything hinges on what exactly is being done on the ground. If, by contract, you are operating a routine toll manufacturer (and is supposedly rewarded on the basis of a cost-plus fee), then it is critical that the functions being performed on the floor are consistent with the contractual arrangement, with particular attention to the functions that relate to control and oversight of key manufacturing risks, as well as the development of new processes and products.
Doing things as a matter of practical expediency or doing what is logical can have costly tax implications if these actions are inconsistent with the contractual relationship. Ultimately, if actions on the manufacturing floor are unavoidable and not consistent with the contractual terms, then it is time to consult a transfer pricing expert to revisit the contract and the associated transfer pricing arrangements.
WHO OWNS VALUABLE INTANGIBLES?
Manufacturing of goods will often utilise a range of valuable intangibles in production. These may be legally owned by the manufacturing entity or another entity, and depending on the type of manufacturing entity, there may or may not be a need of royalties or other payments. Furthermore, some of these intangibles may be patents or other registered IP, but other intangibles may be trade secrets, know-how or other intangibles only identified through detailed functional analyses.
Whilst legal ownership of intangibles continues to be the starting point when determining which group entity should be attributed the "profits" relating to those intangibles, the revised OECD Transfer Pricing Guidelines require that the analysis be taken further, beyond legal ownership alone. Consideration of which entities perform the socalled "DEMPE" (Development, Enhancement, Maintenance, Protection and Exploitation) functions associated with the intangibles is required, and where the DEMPE functions do not align with the legal ownership, adjustments to the transfer pricing policy may be required. A particular area of focus of tax authorities is on the performance of DEMPE functions by manufacturing entities that are purported to operate as routine, low risk operations (toll manufacturers and contract manufacturers). Where such entities are identified as performing DEMPE or related activities that contribute to intangible development and or value creation, the transfer pricing policies are often challenged by tax authorities.
ARE PRODUCT LIABILITY RISKS APPROPRIATELY REMUNERATED IN THE SUPPLY CHAIN?
We have been reminded on numerous occasions in the past year that product liability risks have significant implications on the value chain, for example in the automotive industry, mobile phone production and elsewhere. The functions that have been performed by manufacturers in managing product liability risks are critical to the entire supply chain and these functions need to be rewarded in accordance with the arm's length principle.
When unrelated parties are involved, only the party that has control over product liability risks would be prepared to take on these risks. As such, these parties are the ones who are typically expected to be rewarded for the assumption of such risks. Determining which party in a multinational group conducts the relevant functions pertaining to product liability risks (and thus should be rewarded accordingly) can be tricky. Control over product liability risks may require functions such as controlling the quality of raw material, implementing a vigorous testing process and so on. It is not always easy to determine which party is responsible (R) and accountable (A), and which parties are simply being consulted (C) or informed (I) about the important functions pertaining to product liability risks. The RACI analysis in respect of the functions, assets and risks related to product liability risks has become even more important under the new OECD Guidelines, as it forms the basis on which to remunerate entities for taking on the risks.
HOW SHOULD THE BENEFITS OF CENTRALISED PROCUREMENT ACTIVITIES BE ALLOCATED WITHIN THE GROUP?
Centralising procurement activities have been a common practice in multi-national groups for many years as it is recognised that such activities can create significant group value through bulk purchases, better supplier network management, improved efficiency and so on. However, the post-BEPS OECD Transfer Pricing Guidelines contain new rules on how to allocate the benefits associated with such centralised procurement activities.
Although the debates around this issue are not new, some tax authorities are focussing their attention in this area. For example, multi-national groups need to be careful to remunerate routine procurement activities where the savings arise mainly from purchase volumes. Under the new guidelines, benefits arising from bulk purchases may need to be passed on to the manufacturing subsidiaries based on their volume commitment. It would not be appropriate to reward such routine centralised procurement entities based on a percentage of their purchases. Instead, their remuneration needs to be based on a proper study of functions, assets, and risks (functional analyses) and an economic benchmarking analysis that reflects the functional profile.
WHAT CERTAINTY IS AVAILABLE?
Transfer pricing is notoriously an area of uncertainty for business, and the BEPS process overall has increased tax administration awareness and focus on these issues. Where transfer pricing disputes arise with tax authorities, this can result in substantial time and expense, as well as economic double taxation. Ensuring that contractual arrangements reflect actual conduct on the ground and that robust transfer pricing documentation is in place supporting the positions taken is a great first step, but the arm's length principle is one which can have wide interpretation, and there is no guarantee that local tax authorities will accept the position taken. Advance pricing agreements ("APAs"), which are a specific tool for reaching a proactive agreement on transfer pricing with tax authorities (of one or more countries), are the only real way to obtain certainty over transfer pricing arrangements in this new tax environment. In many countries, APA requests from multi-nationals are increasing significantly due to a high level of uncertainty and increased transparency.
Manufacturing operations are not exempt from the scrutiny of tax authorities that are focussing increasingly on transfer pricing audits. A RACI analysis of the key manufacturing risks, such as the product liability risks, is critical to the transfer pricing arrangement of a manufacturer in the post-BEPS era, and a DEMPE analysis provides a framework for determining where profits associated with valuable intangibles should arise. It is also important to ensure that procurement operations are appropriately remunerated and benefits allocated in a manner consistent with the functions, assets and risks. A proper review of the actual conduct of manufacturing entities through fact finding interviews and site visits can ensure that the contractual arrangements and transfer pricing policy are consistent with the activities on the ground. With some work (or an APA!) costly transfer pricing disputes for manufacturers can be avoided.