TP in the Manufacturing Sector: Common Challenges and Solutions

Transfer Pricing (TP) Deep Dives

Introduction

Transfer Pricing (TP) in the manufacturing sector is uniquely complex. Manufacturers operate across multiple jurisdictions, manage global supply chains, engage in intercompany procurement, employ valuable intangibles, and often follow integrated production models. Because of this, transfer pricing is one of the most scrutinized areas during tax audits especially for companies with contract manufacturing, toll manufacturing, or fully-fledged manufacturing structures.

To comply with the arm’s-length principle and avoid disputes, manufacturers must understand the key TP challenges they face and adopt robust solutions grounded in OECD principles.

This article explores the most common TP issues in the manufacturing sector and provides practical steps for addressing them.

1. Understanding Manufacturing Models Under TP

Manufacturing entities vary based on functions, assets, and risks. The TP treatment depends on the manufacturing model:

A. Contract Manufacturer

  • Performs manufacturing under instruction

  • Uses limited assets

  • Bears minimal risk

  • Guaranteed routine margin

B. Toll Manufacturer

  • Provides processing services only

  • Does not take title of raw materials or finished goods

  • Very low risk

  • Earns cost-plus return

C. Full-Fledged Manufacturer

  • Owns raw materials

  • Performs procurement, production, quality control

  • Bears inventory, market, operational, and supply-chain risk

  • Often owns intangibles

  • Earns residual profit

Each model requires a different TP method and risk allocation.

2. Common Transfer Pricing Challenges in Manufacturing

1. Inconsistent FAR Profiles

Tax authorities often challenge whether the manufacturer’s declared risk profile matches reality.

Common issues:

  • Claiming limited-risk status while bearing inventory or market risk

  • Misalignment between contracts and actual operations

  • Overstating or understating functional contributions

2. Incorrect Characterization of Manufacturing Entity

Misclassification leads to incorrect margins. Example:

  • A company acting like a contract manufacturer is incorrectly treated as a full-fledged manufacturer

  • This inflates required profitability and creates audit exposure

3. Weak Benchmarking for Routine Manufacturers

Routine manufacturers typically use TNMM with cost-based profit level indicators.
Challenges include:

  • Limited comparable data

  • Mismatched business models

  • Geographic differences

  • Outdated or poor-quality benchmarks

Authorities often challenge comparability — especially in emerging markets.

4. Inadequate Alignment Between TP Policy and Actual Results

Budget-based transfer prices often differ from actual year-end results.

This creates issues like:

  • Margins outside the arm’s-length range

  • Need for year-end true-ups

  • Mismatch between tax returns and TP documentation

5. Intercompany Procurement and Raw Material Pricing

Manufacturers rely heavily on:

  • Group procurement hubs

  • Bulk purchasing

  • IP-owned supply chains

Challenges include:

  • Ensuring arm’s-length pricing

  • Avoiding profit shifting through procurement margins

  • Managing customs valuation

6. Valuation of Intangibles Used in Manufacturing

Manufacturing may rely on:

  • Proprietary technology

  • Patents

  • Production recipes

  • Software controls

Tax authorities challenge:

  • Technology licensing fees

  • Royalty rates

  • Contribution to DEMPE functions

7. Excessive Volatility Due to Market Conditions

Manufacturers face:

  • Commodity price fluctuations

  • Global supply chain disruptions

  • FX movements

When TP policies don’t adapt, arm’s-length margins fluctuate, causing compliance problems.

3. Practical Solutions for TP in the Manufacturing Sector

Solution 1: Perform a Robust FAR Analysis

A solid FAR analysis must identify:

  • Functions performed (procurement, R&D, QC, production)

  • Assets used (machinery, IP, systems)

  • Risks borne (inventory, capacity, FX, warranty)

Misalignment between FAR and profitability triggers audits.

Solution 2: Choose the Right TP Method

TNMM for routine manufacturers

  • Cost-based PLI (Operating Margin / Cost Plus)

  • Widely accepted globally

CUP for commodity inputs or toll manufacturing fees

  • Useful when public pricing exists

Cost-Plus for toll or contract manufacturing

  • Appropriate for low-risk operations

Solution 3: Improve Benchmarking Quality

Use quality filters:

  • Manufacturing intensity

  • Asset size

  • Regional comparability

  • Functional similarity

  • Exclusion of companies with extraordinary events

A strong benchmarking set reduces exposure.

Solution 4: Implement Year-End TP Adjustments

To ensure your final margin is within range:

  • Perform quarterly margin tracking

  • Apply true-ups before closing books

  • Document adjustments transparently

This prevents audit disputes later.

Solution 5: Align Intercompany Agreements with Reality

Contracts should reflect actual operations:

  • Clear risk allocation

  • Detailed description of services

  • Pricing policies

  • Responsibilities

If agreements don’t match behavior, tax authorities will challenge them.

Solution 6: Establish Clear Policies for Raw Material Procurement

To avoid TP and customs challenges:

  • Ensure transparency in procurement margins

  • Justify central procurement fees

  • Document cost savings to beneficiaries

Solution 7: Document Use of Intangibles and Royalty Payments

Especially for:

  • Technology transfer

  • Brand-related manufacturing

  • Know-how usage

Provide:

  • DEMPE analysis

  • Royalty benchmarking

  • Benefit test

  • Licensing agreements

Solution 8: Develop Crisis-Resilient TP Policies

Manufacturers should update TP policies to account for:

  • Commodity price swings

  • COVID-like disruptions

  • FX shocks

  • Abnormal cost spikes

Routine manufacturers should not be pushed into losses unless justified by FAR and commercial circumstances.

4. Red Flags for Tax Authorities

Authorities often challenge:

  • Loss-making routine manufacturers

  • Excessive or unexplained year-over-year margin volatility

  • Lack of evidence for procurement or HQ services

  • Inconsistent application of TP policies

  • High or unusual royalty or service fees

  • Non-arm’s-length cost sharing

Any of these may trigger audits or adjustments.

Conclusion

Transfer pricing in the manufacturing sector is complex due to multiple operational models, cross-border supply chains, and increasingly strict global tax enforcement. By performing a strong FAR analysis, selecting the right TP method, improving benchmarking quality, and maintaining clear documentation, multinationals can significantly reduce audit risk and ensure compliance with OECD guidelines.

A proactive approach helps manufacturers stabilize their margins, defend their TP positions, and maintain efficient and compliant global operations.

Related Posts