Business Model and Expected Profitability

Defining the business model in transfer pricing follows the analysis of the value creation process within the corporate group and precedes the selection of the method for determining the arm’s length price and supports it.

We distinguish between:

• manufacturing,
• distribution, and
• service models.

The manufacturing models include:

• toll manufacturing,
• contract manufacturing,
• licensed manufacturing, and
• full-fledged manufacturing.

 

In distribution, we differentiate:

• commission agents,
• sales agents,
• limited-risk distributors, and
• full-fledged distributors.

The categories of models range from routine entities to full-risk entities making strategic decisions, based on:

• value creation,
• decision-making competencies,
• functions performed, and
• risks assumed

in the case of manufacturing, distribution and services.

Service providers can also be either limited-risk or full-risk entities.

Regarding risk assumption, the OECD Guidelines (OECD: Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations) and, in line with these, the expectations of the tax authority, emphasize the importance of examining whether the taxpayer can control the risk and has the necessary financial capacity to assume the risks. If the taxpayer considers itself or its group considers the taxpayer a full-risk entity, it may accept that losses can occur due to the risks assumed. However, the tax authority examines whether the taxpayer's financial capacity would allow for the mitigation of risks and the assumption of any risks that may arise, so the authority may take a different opinion from that of the taxpayer. If only the group, for example the parent company, exercises control over the risks and has the financial capacity to assume the risks, the tax authority may conclude that the taxpayer actually bears only limited risks, since the risks cannot actually be allocated to the taxpayer and therefore cannot be considered as a full-risk entity.

The greater the risk a company takes on, the greater its potential profit — but so too is the volatility of that profit. This means that the actual profit achieved may differ from the expected profit, or there may even be a loss.

The tax authority expects low-risk companies to generate low but stable profits, in line with the above. In our newsletter series, we present these low-risk, frequently occurring models in detail, including the contract manufacturer and limited-risk distributor models, in addition to the toll manufacturer model described in this summary.

Toll Manufacturing

Of all manufacturing profiles, toll manufacturing has the fewest functions and the lowest risk. Accordingly, the tax authorities expect toll manufacturers to have the lowest but most stable profitability.

According to Decree 32/2017 (X.18.) of the Ministry for National Economy of Hungary, regarding documentation obligations related to determining the arm’s length price, toll manufacturing is "the performance of manufacturing (assembly) activities specified by the customer on materials provided by the customer, without acquiring ownership of the materials or the finished product."

The toll manufacturer provides the production machinery and labor for manufacturing the products and can be considered a service provider overall, acting in accordance with the customer's specifications and not bearing any risks related to raw material purchasing, stocking, or sales. It is responsible for controlling the costs associated with operations. Financing requirements are also lower in connection with toll manufacturing, as they basically arise in relation to the equipment and human resources used in production. However, dependence on the customer is significant, as capacity utilization is adjusted to orders. The customer may be a member of the corporate group or an independent party with whom the corporate group, for example the parent company, has agreed on the terms and conditions of performance by the taxpayer. The toll manufacturer does not need any significant intangible assets to perform toll manufacturing activities, as these are owned by the customer. From a transfer pricing perspective, the customer base purchasing the products manufactured during toll manufacturing can also be classified as an intangible asset.  

Due to the limited scope of functions and risks, the toll manufacturer is entitled to low but stable profitability.

Why Is Proper Characterization Important?

In the Hungarian corporate tax return, there is a data reporting obligation related to determining the arm’s length price— according to the regulations currently in force, in the case of transactions with related parties exceeding HUF 100 million calculated at arm's length prices —where the transaction must be categorized. The transaction name already provides information about the business model and characterization of the parties involved. Based on the related profitability figures, the tax authority can perform various filters to easily select companies for audit where the characterization is not consistent with the profitability achieved.

There are no clear boundaries between individual business models, and not all taxpayers with the same characteristics perform the same functions or bear the same risks. However, based on the:

• comparability factors,
• contractual terms,
• functions performed,
• assets used,
• risks assumed,
• characteristics of products and services,
• decision-making capabilities, and
• financial capacities,

kept in mind in transfer pricing, it can be determined which model best describes the actual activities performed by the parties involved in the related-party transaction.

Due to the profitability expectations associated with business models, the profit potential determined based on incorrect characterization and its variability accepted by the taxpayer or the group may differ from what the tax authority expects based on the actual classification. This can lead to tax deficiencies or in the case of transfer pricing documentation prepared without due care, to penalties for failure to comply. Regarding toll manufacturing, the tax authority expects low but stable profitability in line with international practice. If a member of a group faces different expectations within the group in this regard, it is recommended to initiate a review of the approaches.