Toll or Contract Manufacturing? VAT-wise, The Devil is in the Details.

From the offset, Toll Manufacturing and Contract Manufacturing arrangements generally serve the same goal: To efficiently scale production, control costs, and focus on core strengths by using external manufacturing expertise and resources.   

At a closer look, however, the two agreements show nuances that affect their VAT treatment and may result in foreign VAT registration liabilities and sticking costs for the Principal, if not identified in due time and treated correctly.

So what are, roughly speaking, the differences between the two manufacturing arrangements?

Under a Contract Manufacturing arrangement, the Contract Manufacturer purchases the raw materials himself, manufactures the goods, and then sells these finished goods to the Principal. As such, the Contract Manufacturer takes ownership of the raw materials and the finished products during the manufacturing process and ultimately invoices the Principal for the finished products as a sale of goods.

In Toll Manufacturing, on the other hand, the Principal provides the raw materials to a manufacturer (the “Toller”) who then processes these materials into finished products for a fee. The ownership of both the materials and the finished goods remains with the Principal throughout the manufacturing process and the Toller invoices the Principal for his manufacturing services.

From a VAT perspective, the different ownership structures may have a crucial impact on risks and liabilities for the Principal.   

The transactions under the Contract Manufacturing agreement generally qualify as straightforward sales of goods from a VAT perspective: The Principal typically ‘only’ need to know the VAT treatment of these sales and the potential import/acquisition in any ship-to location(s), and if this triggers any foreign VAT registration liabilities.

The transactions under the Toll Manufacturing agreement, on the other hand, are typically more complicated VAT-wise. Not only should the VAT treatment of the fee for the manufacturing service itself be determined, but more importantly, the Principal’s ownership throughout the production process generally raises concerns from a VAT perspective since the Principal will own inventory at the Toll Manufacturer’s site and be liable for the transport of the goods to any ship-to location(s).

This typically raises multiple questions under the Toll Manufacturing agreement, such as:

• What information should the paperwork for the shipments include?

• What value should be applied for the shipments?

• How does the Principal prevent the goods from being blocked at the border during customs clearance?

• Does the Principal need a VAT number in the country where the Toll Manufacturer is located?

• Does the Principal need a VAT number in any of the ship-to locations?

• What VAT reporting obligations does the Principal have?

• Can the Principal mitigate incurring sticking costs in this regard and if so, how?

Is your business defining its manufacturing strategy properly?  Understanding the different VAT consequences of Toll Manufacturing versus Contract Manufacturing is essential for your informed decision making.

Avoid taking risks. Discuss with a VAT specialist up front.