Transfer pricing: can a manufacturer suffer losses?

Preword

Manufacturing companies within the group may experience operating losses due to various commercial factors, including adverse market conditions, increased raw material costs, supply chain disruptions, or reduced demand. However, recurring or prolonged losses often attract increased scrutiny from tax authorities and auditors. In such circumstances, tax authorities may examine whether the manufacturer’s transfer pricing characterization appropriately reflects its actual functions, assets, and risks.

The functional characterization of a manufacturing entity is a critical aspect of transfer pricing analysis. A fully fledged manufacturer is generally expected to assume significant entrepreneurial risks, including market, inventory, capacity utilization, and operational risks. Consequently, it may earn either profits or losses depending on market conditions and its business performance.

Conversely, where a tax authority concludes that the manufacturer performs only routine manufacturing functions while the economically significant risks and strategic decision-making are controlled by another group entity, it may argue that the entity should instead be characterized as a limited-risk manufacturer. Such entities are typically remunerated with a routine arm’s-length return and are generally expected to earn stable profitability over the long term.

 

Accordingly, recurring losses may increase the likelihood of transfer pricing scrutiny and potential recharacterization of the manufacturer. For this reason, taxpayers should ensure that their transfer pricing documentation, contractual arrangements, and actual business conduct consistently demonstrate which entity performs the economically significant functions, controls the key risks, and has the financial capacity to bear those risks, in accordance with the OECD Transfer Pricing Guidelines.

The functional patterns of the manufacturers

Although neither model is expressly defined in the OECD Guidelines, both theory and practice distinguish between two functional manufacturer profiles: a fully fledged manufacturer and a limited-risk manufacturer.

A fully fledged manufacturer (FFM) is an entity that carries out manufacturing activities, assumes most of the associated business risks, and owns or controls the key assets used in the manufacturing process. Within the supply chain, it operates as an independent entrepreneur.

A limited-risk manufacturer (LRM) is an entity that performs manufacturing functions on behalf of another group entity while assuming only limited business risks. It typically operates under the direction of, and in accordance with instructions provided by, the principal.

The key characteristics of both manufacturer profiles are summarised in the table below.

It is important to emphasize that there is no clear-cut definition of either type of manufacturer, and none of the characteristics discussed above is, on its own, sufficient to draw a definitive conclusion. For example, procuring products may indicate that an entity is a fully fledged manufacturer, but it may also be consistent with the activities of a contract manufacturer. Therefore, reaching a reliable conclusion requires assessing all of the above indicators collectively and mapping them against the relevant facts and circumstances.

Typical Remuneration

A limited risk manufacturer is generally compensated using a cost-based transfer pricing method (for example, Cost Plus), earning a stable routine profit regardless of the overall profitability of the products sold by the group.

A fully fledged manufacturer earns the residual profits from its business after covering all operating costs because it assumes the entrepreneurial risks associated with manufacturing.

Example: Calculating FFM and LRM prices

To compare the pricing methodologies applied under the Limited-Risk Manufacturer (LRM) and Full-Fledged Manufacturer (FFM) models, it is useful to examine the calculation on a per-unit basis.

Assume that the normal cost for a regular manufacturer operating at full capacity is 10 EUR per unit, as follows:

• Variable cost – 5 EUR
• Labour – 3 EUR
• Fixed cost – 2 (at a normal capacity of 10,000 units, the total fixed cost is 20,000 EUR).

A mark-up of 10% is applied, reflecting the median mark-up observed across the industry. Accordingly, the arm’s-length sales price would be 11 per unit.

At normal capacity, the manufacturer produces 10,000 units:

• Total cost: 10 × 10,000 = 100,000
• Total sales revenue: 11 × 10,000 = 110,000
• Operating profit: 10,000
  

Under the FFM model, the result depends significantly on the level of capacity utilisation.

Underutilised capacity. If production falls to 5,000 units, the fixed costs are allocated over fewer units. For example, if the fixed cost increases to 4 per unit, the total cost may rise to 12 per unit. If the sales price remains 11 per unit, the manufacturer incurs a loss of 1 per unit.

This undercapacity scenario demonstrates that fixed costs are over absorbed on a per-unit basis, resulting in an operating loss.

Overcapacity. A third scenario may arise where production exceeds normal capacity. Although this is theoretically possible, sustained production above normal capacity would generally require additional investment in machinery, facilities, or other fixed assets. Consequently, the fixed-cost base would also be expected to increase.

Under the FFM model, therefore, profitability may fluctuate depending on production volume, capacity utilization, market conditions, and the manufacturer’s ability to manage its fixed-cost base.

By contrast, under the LRM model, production volume is generally determined or guaranteed by the principal. The limited-risk manufacturer is compensated for its eligible operating costs regardless of fluctuations in production volume, subject to the terms of the controlled arrangement.

Because the LRM assumes fewer economically significant risks, its mark-up should generally be lower than that of an FFM. However, the return should also be more stable. In this example, an appropriate cost-based mark-up for the LRM could be 5%, applied consistently to the relevant cost base.

Risk taking – what does that mean?

The decisive criterion for distinguishing between a full-fledged manufacturer (FFM) and a limited-risk manufacturer (LRM), when assessing whether losses are consistent with the arm’s-length principle, is determining which entity bears the relevant business risks.

Risk taking refers to the assumption and management of business risks by an entity. For transfer pricing purposes, simply being contractually allocated a risk is not sufficient. The entity that is considered to bear a particular risk must also exercise control over that risk and be able to absorb its potential financial consequences.

The OECD Transfer Pricing Guidelines set out a structured six-step process for analysing risk in a controlled transaction:

1. identify the economically significant risks with specificity;
2. determine how those risks are contractually assumed by the parties;
3. perform a functional analysis to establish which party actually exercises control over the risk and has the financial capacity to assume it;
4. determine whether the contractual assumption of risk is consistent with the conduct of the parties identified in step 3;
5. where the contractual allocation does not match actual conduct, the risk should be allocated to the party that exercises control and has the financial capacity to bear it; and
6. determine the arm’s-length pricing of the transaction taking into account the consequences of the risk allocation.

To determine which entity bears a particular risk, it is necessary to identify which entity:

• has the capability and authority to make decisions regarding that risk, meaning it possesses the necessary expertise, information, and decision-making power to assess, accept, mitigate, or reject the risk;
• actually makes those decisions, as evidenced by the conduct of the parties rather than merely by contractual terms. This includes actively monitoring the risk and deciding how it should be managed over time; and
• has the financial capacity to bear the consequences of the risk, meaning it has sufficient financial resources to absorb potential losses or fund the outcomes if the risk materializes.

In practice, the entity that controls the risk through its decision-making and has the financial ability to bear its consequences is regarded as the entity assuming that risk, even if contractual arrangements suggest otherwise. This approach aligns the allocation of risk with the actual economic substance of the parties’ activities.

For example, if the parent company sets the sales prices to the customers which binding for the subsidiary, it may be considered that the risk is assumed by the parent which need to compensate the losses, if any arises as a result of such decision. If however, the parent sets out recommended prices, but the subsidiary is eligible to renegotiate them or at the end of the day to refuse from producing loss-making goods, then apparently the pricing fluctuation risk is assumed by the subsidiary.

So in classic LRM and principal relationship the principal is making decision regarding the volume of manufacturing and has to compensate the LRM even inc as the risks are materializing.

This approach has also been supported in case law. For example, in the Czech Supreme Administrative Court decision concerning a contract manufacturer, the court agreed that where the parent company effectively determined the selling prices and the key commercial decisions, the manufacturer did not control the relevant market risk. Since the manufacturer could not influence the prices at which its products were sold and was nevertheless left with persistent losses, the court concluded that an independent contract manufacturer would have expected compensation from the group. The losses therefore reflected risks controlled by the parent company rather than risks assumed by the manufacturer.

You can then contrast this with the opposite situation:

On the other hand, case law also demonstrates that contractual designation alone is insufficient. Where the local entity actually makes the key decisions relating to pricing, production, inventory, or customer relationships, and has the financial capacity to bear the consequences of those decisions, it may be regarded as assuming those risks, even if the intercompany agreement describes it as a “limited-risk” entity. The courts and tax authorities therefore examine the parties’ actual conduct and decision-making rather than relying solely on contractual terms. This reflects the OECD principle that risk follows control, not merely contractual allocation.

Does strategic management function means taking key risks?

There is a view that the parent company may take key risks by undertaking strategic management and making key strategy functions.

Strategic management is the process of setting the long-term direction and objectives of a business and making high-level decisions that affect its overall performance and competitiveness. It focuses on what the business should achieve, rather than how day-to-day operations are carried out.

The distinction between the strategic management and routine operating decisions are provided in the table below.

Under the OECD Transfer Pricing Guidelines, the fact that a holding company performs strategic management does not automatically mean that it controls the economically significant risks of manufacturing.

For example, if a holding company approves the annual budget and the group’s business strategy, but the subsidiary independently manages production, procurement, inventory, and customer relationships, the subsidiary may still be regarded as a fully-fledged manufacturer.

Conversely, if the holding company not only sets the strategy but also determines production volumes, controls procurement, pricing, inventory, and assumes the associated commercial risks, the subsidiary may be characterized as a limited-risk manufacturer, while the holding company acts as the entrepreneurial principal.

Conclusion

Whether a manufacturer may incur losses for transfer pricing purposes depends primarily on its functional profile and the risks it actually assumes. A fully fledged manufacturer, as an entrepreneurial entity, bears economically significant risks such as market, inventory, capacity utilization, and operational risks. Consequently, it may earn either profits or losses depending on commercial circumstances, provided those outcomes are consistent with the functions performed, assets employed, and risks controlled.

By contrast, a limited-risk manufacturer performs routine manufacturing activities on behalf of a principal and is generally entitled only to a stable arm’s-length return. Persistent losses are difficult to justify unless they arise from exceptional and temporary circumstances. Where a limited-risk manufacturer incurs recurring losses, tax authorities are likely to examine whether risks have been allocated consistently with the parties’ actual conduct and may adjust the transfer pricing outcome accordingly.

Ultimately, the decisive question is not whether the intercompany agreement labels an entity as “fully fledged” or “limited-risk,” but whether the entity genuinely controls the economically significant risks and has the financial capacity to bear their consequences. In line with the OECD Transfer Pricing Guidelines and supporting case law, transfer pricing outcomes must reflect economic substance rather than contractual form. Robust transfer pricing documentation demonstrating the alignment between functions, decision-making, risk control, and financial capacity therefore remains essential to support the characterization of a manufacturing entity and the acceptability of its profitability, including periods of commercial losses.