Sometimes, expressions used in transfer pricing reports are so vague that they may conceal more than they reveal. One example is the term 'manufacturing services'. Here is a simplified version of a scenario that we’ve come across several times just in the last month or so.
The TP documentation refers to a group as having a principal trading company (P) in the US. The group has a number of local sales entities (LSEs) in EMEA and APAC, which act as distributors in making sales into their local markets. A Singapore subsidiary (S) is described as carrying out 'manufacturing services'. The report mentions that the group uses third-party manufacturers (3PMs), but does not explain the relationships involved.
The report outlines the functions performed by S at a very high level only, and considers the TP method which should determine its return.
The problem with this is that the transfer pricing analysis has not got to the heart of how the group’s supply chain actually works, and therefore has not delineated the actual intercompany transactions involved.
One possible scenario is that P acts as client for the purposes of the 3PMs. In other words, finished products are manufactured by the 3PMs under license and sold back to P. The Singapore entity S may facilitate these arrangements, for example by providing quality control services and monitoring support. In that case, S may simply be providing facilitation services to P, perhaps on a cost plus basis.
Another, completely different, possible scenario is that S acts as principal in engaging with the third party manufacturers. S would then be the purchaser of the finished products from the 3PMs, and may then (a) resell those products back to P, (b) sell the products to LSEs, and/or (c) on-sell the products in its own territory. In each of these scenarios, the commercial and legal relationship between S and P is completely different, and the risks to which S is exposed are also potentially fundamentally different.
The moral of the story? TP advisors need to do more than write up a superficial description of arrangements using vague terms. A clear explanation of the contractual supply chain and the physical flow of products is essential in order to start to delineate the transactions involved, both from a transfer pricing and from a legal perspective.