Foreign investors look at the Philippines as one of the most preferred destinations in South Asia for offshore manufacturing due to low labor cost, large and young labor pool, manufacturing capabilities, high English proficiency, and fiscal incentives, to name a few.
Most of the manufacturing companies, if not all, are members of multinational companies (MNCs). Hence, related party transactions are common within the group.
Value chain of a manufacturing company and proper allocation of profits
Porter’s value chain model categorizes two activities: primary and secondary. Primary activities are core functions for the enterprise, creating and delivering products and services for customers. This includes inbound logistics, operations, outbound logistics, marketing and sales, and service.
Secondary activities, on the other hand, support the primary activities as these activities often play a more significant role in the success of the primary activities. This includes procurement, human resources, technology, and infrastructure.
For MNC, who is engaged in manufacturing and selling products, having a well-planned value chain can help in achieving its goals by identifying business activities that can create value and a competitive advantage for the business. Creating separate entities to perform each function in the value chain can help optimize activities to maximize output and minimize organizational expenses. This strategy was adopted decades ago and has proven to be a success.
For instance, ABC Group, which sells electronic devices globally, may set up a research and development subsidiary, a manufacturing subsidiary, a logistics subsidiary, and a sales and marketing subsidiary. In practice, these subsidiaries are established in different jurisdictions for various commercial reasons.
In this set-up, transfer pricing (TP) issues usually arise as the question of whether each entity in the group is commensurately compensated depending on the functions performed, assets employed, and risks borne in the value chain. Because these entities are usually established in different jurisdictions with different income tax rules, there is a desire by MNC to minimize their tax payments by setting up transfer prices such that profits from high tax jurisdictions are shifted to low tax jurisdictions while maintaining the desired groupwide profits.
This is where the arm’s length principle comes in. As a rule, the level of profit derived by an entity should be directly correlated to the functions performed, the assets used, and the risks assumed.
Arm’s length principle (ALP) in manufacturing
TP rules provide that transactions between related parties must adhere to ALP which means that transactions with a related party should be made under comparable conditions and circumstances as transactions with an independent party or the conditions of the commercial and financial relations between the independent parties are ordinarily determined by external market forces.
To determine the ideal transfer price or the appropriate level of profit for manufacturing companies, proper characterization of the entity is fundamental. For TP purposes, a manufacturing company is characterized as either a toll manufacturer, contract manufacturer, licensed manufacturer, or entrepreneur/full-fledged manufacturer.
A toll manufacturer processes the raw materials supplied by the principal into finished or semi-finished products based on the principal’s specification, formula, and quantity. This entity performs very limited functions, does not own manufacturing intangibles, and bears limited risks.
A contract manufacturer produces goods for a principal generally based on pre-agreed quantities and schedules. The principal guarantees the purchase of goods for the quantity agreed. This entity generally performs moderate functions, with limited manufacturing intangibles, and shoulders limited risks.
A licensed manufacturer is akin to an entrepreneur/full-fledged manufacturer, except that it does not own the manufacturing intangibles used to produce the products nor perform any research and development (R&D) functions.
Lastly, an entrepreneur/full-fledged manufacturer has a high functional profile. It undertakes manufacturing functions for its own sales, and performs significant functions in the value chain (e.g., R&D, sales, production, after-sales, logistics, and marketing). In addition, it bears significant risks such as product liability, warranty, capacity utilization, market, price, etc., and receives all residual profits or losses from the value chain.
Functional analysis is performed to obtain accurate identification on the characteristics of the entity. By knowing the characteristics, the level of the risks borne and profit which are proportional to the risks borne by the entity can be predicted. For example, a contract or toll manufacturer that only carries out production as ordered by a related party, without performing functions such as operational strategy setting, product R&D, and sales, is expected to maintain a consistent level of profitability. Should the manufacturer suffer from losses, it must prove that these losses are not a result of its transactions with a related party.
Application of ALP in manufacturing
Below are the TP methodologies that manufacturing companies can use to measure the transfer price or level of profits.
Comparative Uncontrolled Price (CUP) method
This method compares the price that a manufacturer charges its related party (controlled transaction) with the price charged to an unrelated party (uncontrolled). This method requires the highest degree of similarity (i.e., type of product, volume of transactions, geographical market, period of transactions, terms of agreement, FAR analysis, specific features, etc.).
If the manufacturer has sales to both related and unrelated parties where the product and other terms are comparable, the internal CUP may be used. To illustrate, Mfg. Corp., a manufacturer of semiconductors, sells its products primarily to third-party customers at P10,000 per piece. If Mfg. Corp. sells comparable products to related parties with comparable terms and conditions, ideally, the price should also be P10,000 per piece.
On the other hand, external CUP may also be used by comparing the selling price charged to the related party with that of the selling price between two independent parties. Say, Mfg. Corp., a company that manufactures plastic molds, sells its products solely to its related parties. If one of its competitors also manufactures comparable plastic molds to third-party customers and charges P11,000 per piece, then Mfg. Corp. should ideally charge P11,000 per piece to its related parties provided that the terms and conditions are also comparable.
Again, the CUP method requires the highest degree of comparability of the manufactured product as well as the terms and conditions of the transactions. With that said, a comparability analysis must be performed first between the related and independent transactions. If material differences exist such as quality of the products, credit terms, transport terms, etc., which affect the price, reliable adjustments should be made to eliminate the differences.
Cost Plus Method (CPM)
CPM compares the gross profit mark-up on the costs incurred by the manufacturer with the gross profits realized by the same manufacturer (internal CPM) or comparable independent manufacturers (external CPM) in uncontrolled transactions.
For instance, Mfg. Corp. manufactures packaging materials. The total cost of goods manufactured is P100 per unit. Mfg. Corp. bills third-party customers at a 40% mark-up on the cost of goods manufactured thus, P140 per unit. If Mfg. Corp. sells comparable products to related parties, ideally, the price should also be P140 per unit.
On the other hand, if there are independent and comparable manufacturing companies whose gross profit mark-up is 50%, then Mfg. Corp. should ideally charge its related parties a 50% mark-up on costs of goods manufactured.
In using CPM, companies should bear in mind there may be substantial variance in the classification and accounting treatment of items of expenses as either cost of goods manufactured or operating expenditure among different manufacturing companies. Hence, these differences should be taken into consideration.
The Transactional Net Margin Method (TNMM)
TNMM compares the profit level indicator (PLI), net profit relative to an appropriate base (e.g., cost, sales, assets), realized by the manufacturing company from controlled transactions with the same PLI realized by independent and comparable manufacturing companies.
The TNMM is based on the economic concept that similar firms operating in the same industry would tend to yield similar returns over time.
As compared to other TP methods, TNMM allows for some degree of tolerance in minor differences between the functions and products of the comparable manufacturing companies and the taxpayer. Hence, the total profits of the companies can be tested even if there are some minor differences in the products and functions.
Takeaway
A Bible verse says “…. Whoever sows sparingly will also reap sparingly, and whoever sows generously will also reap generously.” The same is true in applying the ALP in manufacturing companies – the more functions performed, assets employed, and risk borne, the higher benefits, and rewards that it should reap.
Let's Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 26 September 2023
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