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Courts usually apply the arm’s-length principle. They first reconstruct the real transaction, then compare what the foreign factory and the taxpayer or purchaser actually did: the functions they performed, assets they used, and risks they controlled or assumed. A factory that follows detailed instructions with routine plant and labor will often receive a routine return. The purchaser can retain residual profit when it controls valuable design or technology, pricing, customers, inventory, financing, or product risks.
Contract wording matters, but it is not decisive. Invoices, production instructions, approvals, cost records, financing documents, and the parties’ day-to-day decisions often carry more weight than a label such as “contract manufacturer” or “entrepreneur.”
What the court is deciding
The central question is not which entity issued the invoice or where a factory is located. It is which party created and controlled the economically important activities that generated the profit, and what an independent business would have earned for performing those activities.
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For a permanent establishment, the OECD’s Authorised OECD Approach applies separate-entity and arm’s-length principles. It attributes profit by reference to “the functions performed, assets used, and risks assumed” in the jurisdiction. HMRC summarizes the economic logic this way: “Risk is attached to functions and assets and risk gives rise to the potential for profit.”
That framework produces two broad outcomes:
- A routine foreign manufacturer generally earns compensation for manufacturing capacity and execution, commonly tested with a cost-plus or comparable net-margin method.
- A taxpayer or purchaser that performs non-routine design, development, procurement, marketing, customer management, financing, or risk-control functions may keep the residual return after paying the factory an arm’s-length amount.
Neither outcome is automatic. The result depends on evidence for the particular years, products, entities, and jurisdictions involved.
Step 1: Accurately delineate the real transaction
Before selecting a pricing method, a court identifies what actually happened. The analysis should answer these questions rather than relying on a one-line description in an agreement.
Who ordered and supplied the inputs?
Review purchase orders, bills of materials, Incoterms, shipping records, and invoices. Determine who bought raw materials, who owned them while they were being processed, and who bore the loss if materials became obsolete or defective. Materials supplied and paid for by the purchaser are not automatically part of the factory’s economic cost base.
Who controlled production?
Production instructions, engineering changes, quality manuals, tooling approvals, and management emails can show whether the factory made meaningful decisions or simply executed a specification. A plant that selects suppliers, changes processes, schedules capacity, and solves engineering problems independently has a stronger claim to a broader return than one operating under constant principal direction.
Who set prices and dealt with customers?
Identify the person or entity approving quotations, negotiating terms, owning customer relationships, handling returns, and setting discounts. Customer checks, sales contracts, marketing budgets, and customer-support records can reveal whether the factory had a market-facing business or was insulated from customers by the purchaser.
Who bore defects, warranty, and inventory exposure?
Examine warranty policies, product-liability insurance, reserve calculations, return authorizations, inventory ledgers, and write-off decisions. A party that merely reimburses production costs is different from one that absorbs unsold stock, recalls, warranty claims, or sudden demand changes.
Who owned or licensed intangibles?
Trace legal ownership and practical control of designs, patents, software, manufacturing know-how, trademarks, customer lists, and product data. Registration in one company’s name is relevant, but courts also ask who developed the asset, paid for its improvement, protected it, and made decisions about its use.
Step 2: Map functions, assets, and risks
A functional analysis should show “how the business structures work in practice and the relative importance of each function in earning the profits,” as HMRC guidance puts it. Prepare separate maps for functions, assets, and risks; combining them into a vague description can hide the facts that drive the result.
Functions
- Product conception, research, engineering, and testing
- Procurement and supplier qualification
- Fabrication, assembly, maintenance, and quality control
- Logistics, warehousing, and customs coordination
- Marketing, sales, customer support, and warranty administration
- Strategic decisions about capacity, pricing, market entry, and product discontinuation
Assets
- Factories, machinery, tooling, and specialized equipment
- Workforce skills, production systems, and working capital
- Proprietary processes, designs, patents, software, and technical know-how
- Brands, customer relationships, distribution networks, and market data
Risks and control
For each material risk, identify who made the decisions that responded to it and who had the financial capacity to bear the outcome. Relevant risks include market demand, inventory, capacity utilization, product liability, warranty, foreign exchange, financing, supplier failure, and regulatory change. A contract assigning a risk to a company that neither controls the relevant decisions nor can fund the downside is weak evidence by itself.
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| Analytical point | Routine contract-manufacturer indicators | Principal or entrepreneurial indicators | Likely effect on profit allocation |
|---|---|---|---|
| Production | Follows specifications; limited process discretion | Develops products or controls major engineering choices | Routine return versus potential residual return |
| Customers and pricing | No customer ownership; prices set by principal | Controls customer access, discounts, and market strategy | More market-facing profit remains with principal |
| Inventory and capacity | Principal owns stock and guarantees volumes | Entity funds inventory and bears excess capacity | Risk-bearing party needs compensation for downside and upside |
| Intangibles | Uses routine plant and licensed instructions | Owns or controls valuable designs, brands, or technology | Unique contributions may require a profit split or higher return |
| Financing and risk decisions | Little discretion; principal funds operations | Approves financing and has resources to absorb losses | Control and capacity support allocation of related risk returns |
Step 3: Choose a method that fits the facts
The method must match the economically relevant characteristics and the available evidence. A method that produces a neat percentage but ignores the parties’ actual contributions is vulnerable.
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Cost-plus for a routine manufacturer
A cost-plus analysis starts with the manufacturing costs actually incurred by the tested party and adds an arm’s-length markup. The base commonly includes direct materials purchased by the factory, direct labor, machinery depreciation, and related production overhead. Comparable uncontrolled manufacturers determine the markup range.
The cost base requires careful definition. If the purchaser supplies expensive components, owns them during production, and bears their obsolescence risk, applying the factory’s markup to those components can overstate the factory’s return. A comparison is reliable only when the tested company and the comparables include costs on a consistent basis.
Comparable net-margin methods
Where reliable gross-profit data are unavailable, a comparable net margin may test operating profit against a measure such as costs or sales. Adjustments may be needed for accounting classifications, capacity, geography, and working-capital differences. The denominator must still reflect functions and risks the tested party actually bears.
Profit split for integrated contributions
If both sides own unique intangibles or perform economically significant, interdependent functions, neither may be reliably tested as routine. A transactional profit-split method can first determine the combined profit and then divide it using contributions such as relative development expenditure, asset use, personnel, and risk control. The evidence burden is higher because the allocation key must reflect value creation rather than arbitrary percentages.
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In Control Data Corp. v. United States (U.S. Court of Customs and Patent Appeals, 1974), the dispute involved a foreign factory assembler’s profit in a constructed-value calculation. The court rejected applying the assembler’s percentage of profit on its own labor and overhead to materials supplied by the United States. It explained: “The percentage which his profits bear to his expenses will be much larger than if he were the actual manufacturer and had to purchase the materials.”
The lesson is narrower than a general transfer-pricing rule because the case arose under U.S. customs valuation. It nevertheless illustrates a recurring judicial concern: a percentage calculated on labor and overhead cannot automatically be multiplied by another party’s materials and risks. The analyst must identify the assembler’s real expense and risk base before computing a return.
Evidence of actual conduct can outweigh labels
Courts reconstruct operations from contemporaneous records. Useful evidence includes:
- Intercompany agreements, amendments, and side letters
- Bills of materials, Incoterms, purchase orders, invoices, and payment records
- Production instructions, engineering-change notices, quality reports, and factory approvals
- Inventory ownership records, financing agreements, insurance, and write-off decisions
- Pricing authority, sales forecasts, marketing plans, customer contracts, and return records
- Intangible registrations, development budgets, licensing terms, and technical personnel records
- Board minutes, risk-committee papers, budgets, and management approvals
- Segmented financial statements and data for uncontrolled comparable companies or transactions
The most persuasive record connects a risk to a decision-maker and then to a financial result. For example, a policy saying the purchaser bears warranty risk is less persuasive if factory managers approved warranty settlements, maintained the reserve, and paid claims from their own funds.
Illustration from L & Leung Leatherware
A 2021 Southern District of New York record concerning a Hong Kong company and handbags made in China shows the type of reconstruction a court may undertake. The U.S. operation designed, marketed, and sold the handbags. The record described a revenue flow in which the manufacturing company deducted operating expenses and cost of goods sold before distributing the remaining profit to the U.S. operation.
The case was a contract and business dispute, not a transfer-pricing judgment, so it does not establish a universal tax allocation. Its evidentiary value lies in the questions a court had to answer: who designed the products, who solicited orders, whose name appeared on customer checks, which expenses were deducted, and how the remaining profit was distributed. Similar documents can determine whether a factory was an independent profit center or a production arm of the purchaser.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Restructuring: routine reward versus surrendered profit potential
Changing a full-fledged manufacturer into a low-risk contract manufacturer creates two separate questions. First, what routine remuneration should the factory receive after the change? Second, did the factory give up valuable profit potential, customer relationships, workforce capabilities, or intangibles when the business was restructured?
The post-restructuring cost-plus return does not answer the second question. A court may examine forecasts, termination payments, redeployment of assets, employee transfers, customer migrations, and the value of rights that were discontinued. Any arm’s-length indemnification must be supported by the rights and opportunities that actually existed before the change, not by a retrospective claim to every future profit.
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In Commissioner of Income-Tax v. B.N. Elias & Co. (P.) Ltd. (Calcutta High Court, 1986), the court considered whether payments to a foreign company for technical assistance, know-how, and royalties were revenue or capital expenditure. In the arrangement discussed, payments that enabled the existing manufacturing business were treated as revenue, while cases involving an enduring exclusive right or acquired asset were distinguished.
This is related to, but distinct from, allocating manufacturing profit. The characterization of a know-how payment can affect the purchaser’s cost base, the value of an acquired intangible, and the amount of profit left for each party. Agreements should specify what knowledge is delivered, the duration and exclusivity of rights, improvement obligations, and who controls later developments.
A practical court-ready workflow
- Define the years, products, entities, and jurisdiction. Separate tax, customs, permanent-establishment, and commercial-law issues instead of assuming one rule controls all of them.
- Build a transaction timeline. Record design approval, sourcing, production, shipment, sale, warranty, payment, and any restructuring event.
- Interview decision-makers. Identify who approved prices, capacity, suppliers, inventory purchases, credit, warranty settlements, and engineering changes.
- Reconcile accounting to conduct. Tie segmented profit-and-loss accounts to invoices, inventory ledgers, payroll, depreciation, and intercompany settlements.
- Prepare a functions-assets-risks matrix. Assign each material activity and risk to the entity that actually controlled it and had financial capacity to bear it.
- Test the cost base. Remove costs that belong economically to another party, and align the treatment of materials, freight, depreciation, and overhead with the comparables.
- Select and document the method. Explain why cost-plus, a comparable net margin, profit split, or another transactional method fits the evidence and why alternatives are less reliable.
- Stress-test the conclusion. Model inventory write-offs, demand shocks, currency changes, warranty claims, and capacity shortfalls to see whether the proposed risk allocation matches actual behavior.
Common errors and how to avoid them
- Relying on the contract title. Correct it with evidence of who made decisions in practice.
- Applying a markup to every factory cost. Verify ownership and risk for purchaser-supplied materials and pass-through items.
- Treating legal ownership as control. Document development, protection, exploitation, and improvement decisions for each intangible.
- Ignoring financial capacity. A party cannot credibly bear a major risk if it lacks funds, insurance, or authority to respond.
- Using a method because it is easy. Method selection must follow the functions, assets, risks, and quality of available comparables.
- Mixing legal regimes. A customs valuation decision or commercial dispute can illuminate economic reasoning without becoming a universal income-tax rule.
Limits of the framework
The OECD Guidelines represent an international consensus, not a substitute for the domestic statute, treaty, administrative guidance, or binding precedent in the relevant country. The current OECD edition and local law should be checked for the year under review. Courts may also apply different standards of proof, discovery rules, and accounting conventions.
No reliable cross-case statistic establishes how often courts award profit to factories rather than purchasers. Outcomes turn on the transaction’s facts and the quality of contemporaneous evidence. The strongest position is therefore a fact-specific one: identify the economically important functions, assets, and risks; show who controlled them; and calculate the return on the costs and risks that party actually bore.
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