Courts usually apply the arm’s-length principle: they reconstruct the real cross-border transaction, examine what each party actually did, identify the assets and risks each party controlled, and then choose a pricing method that fits those facts. A foreign factory that follows the purchaser’s specifications with routine equipment and limited risk will often receive a routine cost-plus or comparable-margin return. The purchaser can retain residual profit when it controls product design, valuable intangibles, pricing, customers, inventory, financing, or other non-routine risks.
A contract is important evidence, but it is not decisive if invoices, approvals, production records, financing documents, and day-to-day conduct show a different allocation of functions and risk. The outcome also depends on the legal setting: a tax dispute, permanent-establishment attribution case, customs valuation case, and commercial contract dispute may use similar economic reasoning but do not create the same legal rule.
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What the court is really deciding
The question is not simply which entity owns the factory or whose name appears on an invoice. The court asks which party created the economic value and which party should earn the return associated with that value. In a typical structure, a purchaser or principal designs a product, supplies specifications or materials, arranges financing, controls customer relationships, and sells finished goods. A foreign affiliate manufactures those goods. The court must decide whether the factory is an independent entrepreneurial manufacturer or a service provider operating for the principal.
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That characterization determines how much profit remains in the factory and how much can be attributed to the purchaser. The analysis is fact-intensive because two companies can use identical legal labels—“manufacturer,” “distributor,” or “contractor”—while performing very different functions in practice.
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The governing arm’s-length framework
The OECD Transfer Pricing Guidelines describe the international consensus for pricing cross-border transactions between associated enterprises under the arm’s-length principle. The 2022 edition is a 659-page publication dated 20 January 2022. It starts from the idea that related parties should be priced as if they were independent businesses dealing under comparable circumstances.
For profits attributed to 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” within the jurisdiction. That framework does not automatically give all manufacturing profit to the country where a plant is located; it assigns profit to the activity and risk actually carried on there.
HMRC summarizes the economic logic in a concise sentence: “Risk is attached to functions and assets and risk gives rise to the potential for profit.” Its functional-analysis guidance also asks how the business works in practice and how important each function is in earning profit. Those observations explain why a paper allocation of risk can fail when the people making decisions, committing funds, and responding to problems are somewhere else.
The OECD framework is an international consensus, not a replacement for a country’s domestic statute, tax treaty, customs rule, or binding precedent. A court will apply the law governing its particular dispute and use the arm’s-length analysis within that legal framework.
Six steps courts use to allocate the profit
1. Accurately delineate the transaction
Before calculating a margin, the court identifies what the parties actually agreed to do. Relevant questions include:
- Who placed purchase orders and could change production quantities?
- Who owned raw materials and work in progress?
- Who set product specifications, quality tolerances, and delivery schedules?
- Who set selling prices and negotiated with customers?
- Who paid for inventory and bore the cost of unsold goods?
- Who was responsible for defects, recalls, warranty claims, and product liability?
- Who owned or licensed brands, designs, patents, software, technical know-how, and customer lists?
- Who approved major capital spending, entered financing arrangements, or guaranteed the factory’s borrowing?
Shipping terms, purchase orders, bills of materials, and payment records often reveal the transaction more reliably than a short intercompany agreement.
2. Map every function
The analysis separates routine fabrication from functions that may create distinctive value. Manufacturing tasks can include procurement, production scheduling, machine operation, quality testing, packaging, and logistics. Other functions may include research and development, product engineering, design changes, market research, branding, sales, customer support, and strategic planning.
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3. Identify assets and intangibles
Physical assets include land, buildings, machinery, tooling, warehouses, and information systems. Working capital can also be economically significant when one party funds inventory or receivables. Intangible assets include patents, proprietary manufacturing processes, designs, trademarks, software, customer relationships, and accumulated know-how.
Legal ownership matters, but it does not end the inquiry. A company may hold title to a trademark while another company directs the marketing and makes the decisions that maintain the brand’s value. Similarly, a factory may use a process developed elsewhere without owning it. The court examines who developed, enhanced, maintained, protected, and exploited the intangible and who paid for those activities.
4. Analyze risk and who controls it
Profit follows economically significant risk only when the party assigned the risk actually controls it and has the financial capacity to bear the consequences. Courts examine who makes decisions in response to:
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- market demand and changes in customer preferences;
- inventory levels, obsolescence, and cancellation exposure;
- capacity utilization and plant expansion;
- foreign-exchange movements and interest costs;
- product defects, warranties, recalls, and liability claims;
- supplier failures and production interruptions; and
- customer credit, financing, and collection problems.
A signed clause saying that the factory bears market risk is weak evidence if the purchaser controls prices, decides production volumes, owns the inventory, and reimburses losses. Conversely, a factory that can reject orders, choose suppliers, sell to other customers, and absorb downturns may be more than a routine service provider.
5. Select a method that matches the facts
The court then chooses a pricing method and comparables. A method that fits a routine manufacturer may be inappropriate where both parties contribute unique intangibles or economically important risks.
| Method | When it usually fits | What must be tested |
|---|---|---|
| Cost-plus | A manufacturer performs defined production services with routine assets and limited risk. | The factory’s actual direct and indirect manufacturing costs and an arm’s-length markup observed in comparable arrangements. |
| Comparable net margin | Reliable gross-margin data are unavailable but independent companies with similar functions and risks can be identified. | The tested party’s operating margin, accounting classifications, geographic and business differences, and comparability adjustments. |
| Profit split | Both sides contribute unique intangibles or are operationally integrated so that one-sided comparables are unreliable. | The parties’ relative contributions, allocation keys, and the reliability of the combined profit pool. |
| Another transactional profit method | The economically relevant characteristics call for a method other than a simple markup or one-sided margin. | Whether the selected method reflects the actual transaction and available evidence better than alternatives. |
The method is not selected because it produces a preferred result. It must be consistent with the functions, assets, risks, accounting data, and reliable uncontrolled comparables available in the case.
6. Test the cost base and any restructuring
A markup is meaningful only when its denominator contains costs actually incurred by the tested party and is measured consistently with the comparables. Direct labor, factory materials purchased by the factory, machinery depreciation, utilities, and production overhead may belong in a manufacturing cost base. Materials supplied and paid for by the purchaser may not.
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When the foreign factory usually receives a routine return
A factory is more likely to be treated as a contract manufacturer when it follows the principal’s instructions, uses ordinary plant and workforce, lacks valuable proprietary intangibles, has little discretion over customers and prices, and does not control market or inventory risk. HMRC’s description of a contract manufacturer similarly places manufacturing under the principal’s instructions while the principal controls market and inventory exposure.
Under a cost-plus approach, the starting point is generally the factory’s direct and indirect manufacturing expenditure—such as materials it purchased, labor, machinery depreciation, and related production overhead—plus a markup supported by independent manufacturing comparables. The markup compensates the factory for the routine functions and assets it actually supplies; it does not automatically give the factory a share of profit attributable to the purchaser’s designs, brand, customer access, or financing.
The factory can still earn more than a bare cost reimbursement if it owns valuable process technology, performs substantial engineering, assumes warranty or capacity risk, or makes independent decisions that comparable manufacturers are paid to make. “Routine” is a conclusion from the evidence, not a label that follows from the existence of an intercompany contract.
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When the purchaser can retain residual profit
The purchaser is more likely to retain residual profit when it performs non-routine design or research, owns valuable brands or technology, controls pricing and customer access, funds and manages inventory, guarantees financing, bears market or product risk, or directs the factory’s economically important decisions.
Residual profit is not a reward for being incorporated in a particular country. It is what remains after each party receives an arm’s-length return for the functions, assets, and risks it contributes. If the purchaser owns the customer relationship and makes the decisions that create demand, while the factory provides standardized labor and equipment, the purchaser may be entitled to the larger share. If the factory independently develops a sought-after process and bears the commercial consequences of its decisions, more profit may stay with the factory.
What Control Data shows about supplied materials
In Control Data Corp. v. United States, decided by the U.S. Court of Customs and Patent Appeals in 1974, the dispute concerned 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 material costs supplied by the U.S. party. 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 practical lesson is narrow but important. An assembler that supplies labor and overhead does not automatically earn the same percentage on materials purchased and supplied by the purchaser. A court must identify the assembler’s real cost and risk base before applying a percentage. The case arose under U.S. customs valuation, not as a universal income-tax transfer-pricing rule, so its reasoning should be used as an illustration rather than a substitute for the governing statute.
What the L & Leung record illustrates
A 2021 Southern District of New York record in L & Leung Leatherware involved a Hong Kong company whose handbags were made in China and a U.S. operation that designed, marketed, and sold them. The manufacturing company deducted operating expenses and cost of goods sold before distributing the remaining profit to the U.S. operation.
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The matter was a commercial contract and business dispute, not a transfer-pricing judgment. Its value as an illustration is evidentiary: a court may need to reconstruct who designed the products, who solicited orders, whose name appeared on customer checks, which expenses were deducted, who manufactured the goods, and how the remaining proceeds moved between entities. Bank records, customer documents, production files, and accounting entries can therefore matter as much as legal terminology.
Technical know-how and enduring rights
Commissioner of Income-Tax v. B.N. Elias & Co. (P.) Ltd., a 1986 Calcutta High Court decision, considered whether payments to a foreign company for technical assistance, know-how, and royalties were revenue expenses or capital expenditure. The court treated payments connected with enabling the existing manufacturing business as revenue in the arrangement before it, while distinguishing situations in which the taxpayer acquired an enduring exclusive right or asset.
This is related to, but distinct from, the question of who earns manufacturing profit. The characterization of a know-how payment can change the purchaser’s cost base, the assets recognized in the accounts, and the amount of profit left for each party. A court must read the license, the scope of exclusivity, duration, transfer rights, and practical use of the technology rather than assume that every technical payment has the same character.
Comparing common operating structures
| Business structure | Typical factory activities | Likely profit pattern | Facts that could change the result |
|---|---|---|---|
| Routine contract manufacturer | Produces to specifications, uses routine equipment and workforce, and has limited pricing or customer discretion. | Routine cost-plus or comparable operating margin. | Proprietary process development, independent customer sales, warranty exposure, or control of capacity and inventory. |
| Full-fledged manufacturer | Buys materials, plans production, develops processes, sells or negotiates with customers, and bears commercial volatility. | Higher entrepreneurial return, potentially including residual profit. | Evidence that the purchaser still controls key decisions or guarantees losses. |
| Integrated parties with unique contributions | Both sides supply valuable intangibles or make interdependent strategic decisions. | Profit split or another transactional profit method may be more reliable than a one-sided markup. | Strong independent comparables that isolate one party’s contribution could support a different method. |
Evidence that can decide the case
Parties should preserve contemporaneous records showing both the written arrangement and actual conduct. A useful file includes:
- intercompany agreements, amendments, and board or management approvals;
- bills of materials, Incoterms, purchase orders, invoices, shipping records, and payment trails;
- production instructions, engineering-change notices, quality reports, warranty claims, and recall records;
- inventory ownership schedules, warehouse records, borrowing documents, guarantees, and insurance policies;
- pricing authority, customer contracts, sales forecasts, marketing plans, commission records, and customer-support logs;
- patent, trademark, design, software, and know-how ownership or licensing documents;
- budgets, risk policies, investment committees, capacity decisions, and records identifying who approved responses to losses; and
- segmented financial statements and reliable uncontrolled-company or uncontrolled-transaction data used to support the selected method.
Accounting entries should reconcile to operational facts. A ledger showing that the purchaser bears inventory risk is less persuasive if the factory’s managers actually decide production quantities and absorb obsolete stock.
Common analytical mistakes and how to correct them
Relying on the contract label
Problem: The agreement calls the factory “low risk,” but the factory sets prices, chooses suppliers, and bears warranty costs.
Correction: Trace decisions, approvals, and cash consequences. Explain any mismatch between the contract and conduct.
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Problem: A factory markup is calculated on purchaser-supplied materials or costs that comparables do not include.
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Correction: Define the tested party’s denominator, document each cost category, and make the comparable companies’ accounting treatment consistent.
Assuming legal title proves economic ownership
Problem: A party is treated as owning an intangible solely because its name appears on a registration.
Correction: Identify who funded development, made enhancement decisions, protected the right, and exploited it commercially.
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Problem: The analysis lists market risk but not who funds inventory, approves expansion, or absorbs idle-plant costs.
Correction: Map the decision-maker, financial capacity, and actual loss-bearing arrangement for each major risk.
Using a method that cannot capture unique contributions
Problem: A one-sided routine margin is applied even though both parties contribute distinctive intangibles.
Correction: Test whether a profit split or another transactional profit method better reflects the integrated contributions and available evidence.
What is not established by the available cases
There is no reliable cross-case statistic showing how often courts award more profit to factories rather than purchasers. Results depend on the jurisdiction, legal issue, years at issue, evidence, accounting definitions, and comparables. The cases discussed here illustrate reasoning and proof; they do not create a universal percentage or automatic allocation.
Bottom line
Courts allocate foreign-factory profit by following the economics of the transaction: who performs the important functions, uses the relevant assets, controls the risks, and has the financial capacity to bear them. A routine factory generally earns a routine return on its own manufacturing cost base. A purchaser that designs the product, owns valuable intangibles, controls customers and pricing, and carries market or inventory exposure may keep residual profit. The strongest position is the one supported by contemporaneous operational evidence, a cost base that matches the tested party, and a pricing method suited to the parties’ real contributions.
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