Tangible goods transactions are amongst the most significant intra-group transaction groups in the manufacturing industry, and getting it right goes a long way towards an arm’s length transfer pricing model. We identify some of the key challenges and how to overcome them.
In the manufacturing industry, the widespread separation of development, manufacturing and sales functions leads to numerous transfer pricing challenges with increased complexity. Even the seemingly straightforward intra-group pricing of tangible goods, transferred from a principal or manufacturing entity as the seller to a distribution/assembly/manufacturing entity as the buyer, needs to be carefully looked at to ensure compliance with the arm’s length principle. In practice, aspects such as the use of the goods (as semi-finished or trading goods), stock keeping or the use of technology IP at the level of the buyer in particular need careful consideration.
Semi-finished vs. trading goods and the issue of stock keeping
The Resale Price Minus method (“RPM”) is a transfer pricing method commonly used to set prices for tangible goods that are transferred to a distribution entity and from there on sold to third-party customers without any significant transformation activities at the level of the distributor. The testing of prices is then commonly done using the Transactional Net Margin Method (“TNMM”) applied to the (segmented) EBIT-margin of the distributor/buyer. However, in many industries one particular item might be sold as both a trading good as described above or as a semi-finished good for further processing to the same entity. For semi-finished goods, however, the prices are often set using the Cost Plus Method (“CPLM”) and tested using the TNMM with the manufacturer/seller as the tested party. This already leads to a methodological conflict and a decision to be taken – should the RPM, the CPLM or both be applied? To further complicate things, stock keeping at the level of the buyer leads to a situation where in many cases it is impossible to tell whether the item transferred will end up being used as a semi-finished or trading good at the time the transaction is executed.
In these cases, a holistic analysis of the group’s business model and thorough financial planning and monitoring are necessary to determine the price setting and testing methods to be applied to ensure at arm’s length results. This usually requires an in-depth understanding of sales and manufacturing processes and of financial planning and reporting capabilities as well as the education and buy-in from key stakeholders in the manufacturing, sales and finance functions.
The use of technology IP related to tangible goods transactions
In certain cases, the intra-group buyer will further process items purchased from the seller and, in doing so, depend on technology IP (technical drawing, know-how, processes, etc.) owned by another group entity. Irrespective of whether the intra-group seller or another group entity is the owner of such an IP, the right to use this IP should be remunerated separately from the tangible goods purchase (if it is remunerated at all).
In determining such remuneration, e.g. by ways of a license fee, a number of factors must be considered:
- What is the value contribution of the technology IP to be remunerated?
- To which income streams does it contribute, i.e. what is the correct basis for a license fee (e.g. third-party product revenues only, total product revenues, or product revenues plus service income)?
- Does the profit allocation make sense from a holistic business model point of view after the license fee is charged?
Again, answering these questions and determining an appropriate remuneration for the technology IP requires taking on a holistic perspective, rather than simply performing a benchmarking study and solely relying on its results (even if a solid benchmarking study will usually still be part of the analysis).
For many groups operating a manufacturing business, the tangible goods transaction is one of the most significant intra-group transactions in their business model, and getting this right goes a long way to ensure compliance with the at arm’s length principle.
Surprisingly, in many cases there is room for improvement in this area and some low-hanging fruits to be harvested to establish compliance with the at arm’s length principle, increase operational efficiency and decrease complexity (and costs) with regards to transfer pricing documentation. While this may have been viewed as corporate housekeeping in the past, it’s becoming a key priority and responsibility to the personnel in charge with the focus on transfer pricing topics in tax audits and the ever-increasing transparency of international group’s tax structures.