Contract manufacturing vs toll manufacturing in intra-group arrangements

Where a multinational group is engaged in manufacturing products, the function of manufacturing is often carried out by a legal entity (or entities) which is separate from those engaged in related functions such as product development and distribution. This creates an outsourcing type of relationship between the entities involved. As with any intra-group arrangement, the nature of that relationship and the allocation of risk must be designed and documented contractually. This is essential not just for Transfer Pricing compliance, but also to provide a focus for the directors and officers of the relevant companies, when considering whether they can properly approve the arrangements.

The terms ‘contract manufacturing’ and ‘toll manufacturing’ are often used in this context. Although these two terms are frequently used interchangeably, there are significant differences between the two types of relationship.

What is Toll Manufacturing?

In toll manufacturing, the group company supplying the manufacturing services (the ‘manufacturer’) provides the plant, machinery and labour force necessary to manufacture the relevant product. The contracting company (the ‘principal’) supplies the relevant raw materials, and will often also have ownership of all the intellectual property relating to the products, such as patents and trademarks.

What is Contract Manufacturing?

In contract manufacturing, again the manufacturer provides the plant, machinery and labour force required to manufacture the relevant product but it also sources and supplies the necessary raw materials. This implies that the manufacturer will bear related risks such as the cost, the level of stocks, and control over the quality of raw materials to be used – although of course the allocation of these risks can be adjusted contractually through pricing provisions, warranties and indemnities.

In the context of intra-group arrangements, toll manufacturing is therefore a simpler arrangement, and allows for the principal to act as the main entrepreneurial risk-taker for the business as a whole – including development and maintenance of IP, procurement of raw materials and product liability risks.

Other additional matters to consider when designing an intercompany manufacturing relationship may include the following:

• Is the principal in the manufacturing relationship also the owner of the relevant intellectual property? If not, a tripartite agreement may be required as between the principal, the manufacturer and IP owner.
• Is all the tooling and related equipment being provided by the manufacturer, or will ownership of and risk in tooling remain with the principal or IP owner?
• Does the principal bear all the risk related to manufacturing of the products or should risk of loss apportioned?
• Does the Supplier service other customers such that the Customer needs to contract for the attainment of certain service levels, staffing availability etc.?
• Does the manufacturer need to comply with any particular licensing or registration requirements in order to manufacture the products?
• Does the principal have any specific obligations that need to be documented?

Of course, the details of each intercompany manufacturing agreement will be different in every case, and the key is to design a contractual relationship agreement which is consistent with the way the group actually operates, with the fiduciary duties of the officers of each participating entity, and with the group’s Transfer Pricing compliance policies.