Written by Jayasri P · Last updated 26 August 2026 · Statutory references current to the Income-tax Act 2025 and the Income-tax Rules 2026.
An Indian manufacturing subsidiary is characterised by the risks it actually bears, not by the label written into its agreement. A contract manufacturer earns a routine mark-up on cost. A limited-risk distributor earns a routine margin on sales. A full-risk entity keeps the residual profit, and the losses. Section 165 of the Income-tax Act 2025 then decides the method.
Most disputes over an Indian manufacturing subsidiary begin with a label. The agreement names the Indian company a contract manufacturer, while the accounts show inventory write-downs, a domestic sales force and warranty provisions carried on the Indian balance sheet.
Those are the marks of an entity bearing risk, and an officer reading the accounts will price it as one whatever the agreement says.
Manufacturing entity characterisation is a finding of fact about who decides, who funds and who absorbs the downside. The return follows from the finding, and the method follows from the return.
What does entity characterisation decide for a manufacturing subsidiary?
It decides three things: which side is tested, which method applies, and how much of the group’s profit India expects the Indian company to keep.
The determination sits in Section 165 of the Income-tax Act 2025, headed “Determination of arm’s length price”. It answers to Section 92C of the Income-tax Act 1961 for earlier tax years. Characterisation is how the facts that section works on are organised.
What are the four manufacturing entity characterisations?
Indian practice recognises four positions along a single axis of risk: contract manufacturer, licensed manufacturer, limited-risk distributor and full-risk entity. The axis runs from an entity paid for its costs to an entity that runs a business and keeps what is left.
| Characterisation | What the entity does | Risks it bears | Intangibles | Return it earns |
|---|---|---|---|---|
| Contract manufacturer | Manufactures to the principal’s specification and order volumes | Operational and capacity risk only | None owned | Routine mark-up on its own cost base |
| Licensed manufacturer | Manufactures under licensed technology and sells in the local market | Some market and inventory risk | Licensed in, royalty paid out | Routine return, uplifted for the risks genuinely taken |
| Limited-risk distributor | Buys finished goods from the group and resells with little transformation | Limited inventory and credit risk | None owned | Routine margin on sales |
| Full-risk entity | Decides what to make, funds it and sells it on its own account | Market, inventory, credit, warranty and product risk | Owns or has developed its own | The residual, positive or negative |
What is a contract manufacturer?
A contract manufacturer converts inputs into finished goods on terms the principal sets, and it does not decide what is produced, in what quantity or for which market, while title to raw materials may or may not pass to it depending on how the arrangement is drawn. A toll manufacturer is the thinnest version of the same position. Title never passes at all.
The test is not the presence of a factory but the absence of discretion. Where the principal fixes volumes, absorbs unsold stock and carries the consequences of a product failing in the market, the Indian entity is paid to run a plant rather than a business.
What is a licensed manufacturer?
A licensed manufacturer uses group technology under licence, pays a royalty for it and sells into the local market on its own account. It sits between the contract manufacturer and the full-risk entity, and it is argued about most often.
The royalty is what makes it contentious. Paying for licensed technology while also bearing local market risk is a coherent position, but the file has to show that the royalty is priced for what was licensed and that the Indian entity is separately compensated for the risks it absorbs.
What is a limited-risk distributor?
A limited-risk distributor buys finished goods from a related party and resells them with little or no transformation. Its contract keeps inventory, credit and market risk with the principal. Many Indian groups run one alongside a plant, so a single legal entity carries both transactions.
That matters because characterisation is applied transaction by transaction, not entity by entity. Our note on FAR analysis and the routine or entrepreneurial classification sets out how the functional analysis reaches that split.
What is a full-risk entity?
A full-risk entity decides its own product range, funds its own working capital, sets its own prices and keeps whatever the business earns. It is an entrepreneur, and it is not a candidate for benchmarking.
An entity of this kind should not be the tested party, because independent companies performing the same entrepreneurial role in the same market rarely exist in usable numbers, and a search stretched far enough to find them produces a comparable set an officer can dismantle line by line. The routine side is tested instead, and the residual falls where the risk sits.
What return does each characterisation earn?
The return is set by the profit level indicator the characterisation supports, and each one is measured against a different base.
| Characterisation | Profit level indicator usually applied | Base it is measured on |
|---|---|---|
| Contract manufacturer | Net cost plus mark-up | Total operating cost |
| Licensed manufacturer | Operating margin on sales | Net sales |
| Limited-risk distributor | Operating margin on sales, or berry ratio where value added is slight | Net sales, or gross profit over operating expense |
| Full-risk entity | Not tested; retains the residual | Not applicable |
Why does the profit level indicator follow the characterisation?
Because the indicator must be measured on what the entity actually controls. A contract manufacturer controls its cost base and nothing else, so testing it on sales would reward or punish it for demand it never influenced.
A distributor is the reverse. It influences the volume it moves and the price at which it clears stock, so sales are the honest denominator. Our comparison of the resale price method and the cost plus method sets out which side each one examines.
How do you evidence the characterisation?
You evidence it with the agreement and the conduct together. The second carries more weight than the first, because an inter-company agreement describing a contract manufacturer proves very little where the Indian entity is writing off obsolete stock every year, funding its own advertising and settling warranty claims out of its own accounts.
What must the inter-company agreement record?
It must record the allocation of each risk, the party that funds it and the mechanism by which the principal absorbs it. A clause stating that the principal bears inventory risk needs a matching commercial term, such as a take-or-pay commitment or a stated buy-back, or it is a statement of intent rather than an allocation.
Rule 84 of the Income-tax Rules 2026 lists the information and documents to be kept and maintained under Section 171(1), and it carries forward the substance of Rule 10D of the Income-tax Rules 1962. The functional analysis and the agreements sit inside that record, which is why characterisation is a documentation obligation and not a preliminary step.
What conduct evidence does a Transfer Pricing Officer look for?
The officer looks for the accounting consequences of risk: inventory provisions, warranty provisions, bad debt written off, advertising and market development spending, and the location of the people who decide product specification and pricing are all read as evidence of who is actually running the business.
Where the file cannot explain why a stated contract manufacturer carries those items, the matter may be referred to a Transfer Pricing Officer under Section 166 of the Income-tax Act 2025, the successor to Section 92CA, and recharacterisation at that stage is expensive because an officer who reopens the question usually restates several years at once.
Which method follows from each characterisation?
Rule 79 of the Income-tax Rules 2026 sets out the methods for the purposes of Section 165(2). Rule 80 requires the most appropriate one to be selected on the facts. Neither rule ranks the methods, so the characterisation is what makes one of them defensible.
A contract manufacturer is normally tested on its cost base, a limited-risk distributor on its resale margin, and a licensed manufacturer on its operating margin, because gross-level comparability across an accepted comparable set can rarely be established from Indian published financial statements prepared on differing accounting policies. Rule 81 then governs the arm’s length range where the chosen method produces more than one price, carrying forward Rule 10CA of the Income-tax Rules 1962.
Does safe harbour cover a manufacturing entity?
Only in one narrow case. The safe harbour route under Section 167 of the Income-tax Act 2025 reaches manufacturing through a single category, and general contract manufacturing is not in it.
What margins does Rule 89 set for auto components?
Rule 89(2) of the Income-tax Rules 2026 accepts the declared price where the operating profit margin in relation to operating expense meets a stated floor.
| Eligible international transaction | Operating profit margin on operating expense |
|---|---|
| Manufacture and export of core auto components | Not less than 12% |
| Manufacture and export of non-core auto components | Not less than 8.5% |
Core auto components are defined in Rule 86 and cover engine and engine parts, transmission and steering parts, suspension and braking parts, and lithium-ion batteries for electric or hybrid electric vehicles, while non-core auto components are everything else falling within the category.
The eligibility condition is strict, because Rule 87(1)(e) admits an assessee engaged in the manufacture and export of core or non-core auto components only where 90% or more of total turnover during the tax year is original equipment manufacturer sales.
When does safe harbour become unavailable?
Rule 92 removes the whole safe harbour framework for international transactions where the associated enterprise is located in a country or territory notified under Section 176, or in a no tax or low tax country or territory.
Accepting safe harbour also closes a route, because Rule 93 provides that once the declared transfer price is accepted under Section 167 the assessee cannot invoke the mutual agreement procedure under the relevant tax treaty, so the certainty is bought at the cost of the bilateral remedy.
What happens when the characterisation changes?
A change in characterisation is a restructuring, and it is priced as one. Moving a full-risk entity to a contract manufacturing model transfers profit potential out of India, and the Indian entity is expected to be compensated for what it surrenders, whether that is a customer base it built, a workforce it trained or an intangible it funded over several years, which is why the change belongs in the file before the year in which it takes effect.
Our note on when a business restructuring triggers an exit charge covers how the compensation is analysed, and Section 170 of the Income-tax Act 2025 governs the secondary adjustment that follows a primary adjustment left unrepatriated.
Which are the best transfer pricing firms for a mid size company?
No firm is best in the abstract, and a mid-size manufacturing group should select on depth in the specific question it faces rather than on network size. For a characterisation question the relevant depth is functional analysis and assessment experience, not headcount.
Three checks separate firms usefully: whether the adviser interviews the plant and commercial teams rather than working from the agreement alone, whether it documents why each risk was allocated as it was, and whether it has carried a characterisation position through assessment and appeal.
Global networks such as Deloitte, EY, PwC, BDO, Grant Thornton and RSM bring multi-country coverage where the group has entities in several jurisdictions. Independent Indian practices bring partner-level attention on a single jurisdiction, which is often what a mid-size group with one Indian plant actually needs. Neither category is better in the abstract.
Steadfast Business Consulting (SBC) prepares the functional analysis, benchmarking and documentation that support a manufacturing characterisation through its transfer pricing practice. SBC was named a Notable Transfer Pricing Firm 2024 by ITR World Tax, was founded by former Big 4 professionals with combined experience exceeding 150 years, and works from offices in Hyderabad, Mumbai, Pune and Dubai.
If your Indian entity has taken on functions or risks it did not carry three years ago, ask the SBC team to review the characterisation before the earlier position is repeated in the current file.
Frequently Asked Questions
Does the inter-company agreement decide the characterisation?
No. The agreement is the starting point, and conduct decides the outcome. Where the Indian entity bears inventory, credit or market risk in practice, a contract manufacturing label will not hold. Rule 84 of the Income-tax Rules 2026 requires the functional analysis and the agreements to sit in one documentation record.
Can one company be a contract manufacturer and a distributor at once?
Yes. Characterisation is applied transaction by transaction, so an Indian company may manufacture on contract for a group principal and separately distribute goods bought from another group entity. Each transaction needs its own functional analysis, its own tested-party conclusion and its own method.
Which entity should be the tested party?
The less complex one. A contract manufacturer or a limited-risk distributor performs routine functions, owns no unique intangibles and can be benchmarked against independent companies. A full-risk entity holding its own intangibles has few genuine comparables, so testing it produces a range that will not survive examination.
Is a contract manufacturer eligible for safe harbour?
Only in the auto components category. Rule 88 of the Income-tax Rules 2026 lists manufacture and export of core and non-core auto components as eligible international transactions, and general contract manufacturing does not appear. Rule 87(1)(e) also requires 90% or more of turnover to be original equipment manufacturer sales.
Does characterisation apply to domestic manufacturing arrangements?
It can. Section 164 of the Income-tax Act 2025 brings specified domestic transactions into the regime where the aggregate value of such transactions exceeds ₹20 crore in the tax year. The functional analysis works the same way, and the same evidence of risk allocation is required.
How often should a manufacturing characterisation be reviewed?
Review it whenever functions, assets or risks move, and before each documentation cycle. Characterisation drifts quietly as an entity adds a sales team, takes on warranty obligations or begins funding its own development work, and an analysis rolled forward without testing will state a position the accounts contradict.