Contract manufaturing and Tolling agreements

1. CONTRACT MANUFACTURING AND TOLLING AGREEMENTS
Oliver Massmann
I. VAT and Customs
In many cases, the principal in the contract manufacturing relationship owns some or all of the
raw materials, work-in-process and finished goods throughout the manufacturing process. The
principal and many of the suppliers are typically outside of the manufacturing jurisdiction.
1. Generally Speaking, What Are The VAT, Customs And Related Costs (e.g. Broker Fees)
That Arise When A Foreign Principal Has Goods Dropped Shipped Into Your
Jurisdiction To The Local Contract Manufacturer? In Particular, Is There Any Non-
recoverable VAT? If So, Are There Strategies For Avoiding Or Reducing This VAT
Cost? With Respect To Customs, Please Provide The Range For The Customs Rates
That May Apply. Also Are There Any Planning Techniques That Taxpayers
Typically Employ To Reduce Customs Costs? Please Address The Same Issues In
Connection With The Export Of The Finished Goods Outside Of The Country.
Most regulations on the Vietnamese VAT regime are included in the Law on Value Added
Tax No. 13/2008/QH12 of the National Assembly, as amended by Law No. 71/2014/QH13.
Due to Article 7.3 of the Law on Tax Management, importers are obliged to pay tax in full
and in a timely manner, including the VAT.
This norm includes the concept of drop shipping, which means an arrangement between a
seller and the manufacturer or distributor of a product that shall be sold. According to the
arrangement the product will be shipped to the buyer directly by the manufacturer or distributor
and not by the seller. This definition can be understood as an alternative form of import. The law
does not make any differences on the way that goods are delivered. Therefore drop shipping is
not subject to tax exemptions or reductions.
It should be noted that no VAT is raised for goods in transit or transshipment or crossing
Vietnamese borders as well as goods temporarily imported and re-exported and goods
temporarily exported and re-imported. There are no further special regulations for drop shipping
supplies.
2. In Many Cases The Principal Supplies Equipment That The Local Contract Manufacturer
Uses In The Manufacturing Process. This Equipment May Remain In The Local
Jurisdiction For A Substantial Period Of Time. Any Addition VAT Or Customs
Issues That Are Unique To The Capital Equipment That The Principal May Import?
Capital equipment is not subject to the catalogue of VAT exemptions. According to the Law on
Value Added Tax the following objects are exceptionally not subject to VAT: “Machinery,
equipment and supplies which cannot be manufactured domestically and need to be imported for
direct use in scientific research and technological development activities; machinery, equipment,

2. spare parts, special-purpose means of transport and supplies which cannot be manufactured
domestically and need to be imported for prospecting, exploring and developing oil and gas
fields; aircraft, drilling platforms and ships which cannot be manufactured domestically and need
to be imported for the formation of enterprises fixed assets or which are hired from foreign
parties for production and business activities or for lease.”
3. Have There Been Any Recent Developments That Impact The VAT, Customs And
Related Costs Applicable To Such Structures?
On 25 March 2015, the Ministry of Finance issued Circular No. 38/2015/TT-BTC, according to
which machinery and equipment suitable for investment field, target, and scale of the investment
project, satisfying other certain conditions, imported as fixed assets of investment projects in the
fields or areas eligible for preferential import tax are exempted from taxes.
4. To The Extent That There Are Significant VAT Or Customs Issues That Arise If The
Factory Imports And Owns The Raw Materials And Work-In-Process That Are
Contract Manufacturing Specific, Please Let Us Know.
Raw materials and supplies imported for production of goods for export shall be subject to
import duties and VAT and shall be entitled to refund of import duties and VAT corresponding
to the ratio of exported goods on the basis of the levels of use of raw materials and supplies
[Article 114, Circular No. 38/2015/TT-BTC in respect of raw materials and other supplies for
production of goods for export].
According to Point c.5) of Circular No. 38/2015/TT-BTC dated 25 March 2015, enterprises that
import raw materials for productions [“importing enterprise”] and then sell their products to
another enterprise to directly produce or process products for exports [“exporting enterprise”],
after the actual export by the exporting enterprise the importing enterprise is entitled to request
for refund of import duty tax equivalent with the materials that the exporting enterprise already
used.
5. Are There Any Additional Issues Taxpayers Should Be Aware Of In Connection With
Locally Procured Raw Materials And/ Or Finished Goods That Are Sold In The Local
Market?
Circular No. 128/2013/TT-BTC on guiding imported goods export, import, processing,
liquidation and consuming products of foreign invested enterprises dated 10 September 2013
stipulates that:
- In the case of the sale of domestic goods to an export processing enterprise, the seller shall
be exempt from export duties.
- In the case of the purchase by an export processing enterprise of domestic goods for export
(without conducting any production activity), the export processing enterprise must pay export
duties.

3. - In the case of the purchase by an export processing enterprise of domestic goods for the
production of goods for export, the export processing enterprise shall be exempt from export
duties upon export.
II. Permanent Establishment
1. As Noted Above, The Principal May Own Raw Materials, Work-In-Process And
Finished Goods In The Local Jurisdiction. Is There Any Significant Risk That The
Principal Could Have A Local PE Due To The Fact That It Has Such Inventory In
The Country? Does It Matter Whether The Principal Has A Local Warehouse?
In Vietnam companies overseas conducting business activities through resident establishments in
Vietnam are liable to pay corporate income tax.
According to the definition in Article 2.3 of the Law on Corporate Income Tax, Resident
establishment means a business establishment through which a company overseas conducts all or
a part of its business activities in Vietnam which earn income. A resident establishment of a
company overseas can take different forms that are listed as well in the Law on Corporate
Income Tax.
This list includes a representative in Vietnam in a case where it has authority to enter into
contracts in the name of a company overseas or a representative which is not competent to enter
into contracts in the name of a foreign company but regularly delivers goods or provides services
in Vietnam.
This very broad reference might also include principals with assets as named above. These
elements are not likely to form the risk of a permanent establishment in Vietnam but the
authorities decide about permanent establishments on a case by case basis.
Where a treaty on avoidance of double taxation to which the Socialist Republic of Vietnam is a
signatory contains different provisions relating to resident establishments, such treaty shall
prevail.
2. Does The Answer Change If The Principal Also Owns Capital Equipment That It
Has Provided To The Local Contract Manufacturer?
Also the ownership of capital by the principal does not necessarily bear the risk of a permanent
establishment.
3. In Many Cases The Local Contract Manufacturer Purchases The Raw Materials
(Either In Its Own Name Or As A Purchasing Agent Acting On Behalf Of The
Principal) Because It Knows The Production Schedule Better Than The Principal. In
Addition, In Some Cases The Contract Manufacturer May Have More Leverage With
The Suppliers. Please Address Any Additional PE Issues That May Arise If The
Contract Manufacturer Also Acts As A Purchasing Agent On Behalf Of The
Principal.

4. The Law on Corporate Income Tax provides that the business conducted by a company overseas
can be regarded as a resident establishment if the company has an agent that has authority to
enter into contracts in the name of the company overseas. Given this the situation above might
likely rise a PE.
4. In Certain Cases, The Principal Will Have Its Own Employees Or Agents In The Factory
To Supervise The Contract Manufacturer, Provide Quality Assurance And Sometimes
Technical Information. To What Extent Would Independent Or Dependent Agents (That
Do Not Have Contract Concluding Authority) Providing Such Services, Combined With
The Other Facts Set Forth Above, Result In A PE For The Principal. To The Extent That
Actual Employees Or Staff May Result In A PE, Can The Principal Avoid The PE By
Forming A Local Subsidiary To Employee The Staff? If So, Can The Subsidiary Be
Compensated On A Cost Plus Basis?
Article 1.4.b of Decree No. 24/2007/ND-CP (as amended and partially superseded by Decree
No. 218/2013/ND-CP and Decree No. 12/2015/ND-CP) (“Decree No. 24/2007/ND-CP”)
stipulates that a business is considered as resident establishment if it takes the form of a “location
of supervisory activities for construction, construction works, or installation and assembly works.
If the principal wants to be safe regarding the avoidance of a PE, he might establish a
Representative Office [“RO”] to perform the tasks named above. This is possible as long as the
RO is not doing business. Article 13.1.c of Decree 45 on Representative Offices allows to
“monitor and activate the implementation of signed contracts of the foreign business entity or
foreign tourism enterprise for which it acts as a representative.” This covers the activities named
above.
According to Article 37 of the Commercial Law and Article 5 of Decree 45 any foreign business
entity or foreign tourism enterprise which has lawful business registration in accordance with the
law of the foreign country and has operated for at least 05 (five) years shall be issued with a
license to establish a representative office in Vietnam.
5. To What Extent Do The Answers To These PE Questions Change If The Factory’s Sole
Activity Is Acting As A Contract Manufacturer For A Single Principal.
This constellation is not directly addressed in Vietnamese Laws. Contract manufacturing for only
one single principal might give rise to a PE if tax authorities interpret the business activities of
the overseas company according to Article 1.4.b of Decree No. 24/2007/ND-CP [pls. see above
under point II.4] as a form of “installation and assembly works”.
6. Assume An Extreme Set Of Facts Where In Addition To The Factors Set Forth Above
The Principal Has A High Degree Of Control Over The Operations In The Factory.
Assume For Instance That The Principal Hires The Employees And Its Employees In The
Factory Have The Power To Stop Production To Correct Problems. At What Point Does
The Principal’s Control Over The Factory Activity Give Rise To A PE?

5. We refer to point II.5 above. These business activities will be even more likely be considered as
PE.
7. To The Extent That A PE May Arise In Any Of The General Fact Patters Described
Above, Comment On Whether Additional Income Would Be Attributable To The PE.
Can The Principal Argue That It Has Paid An Arm’s Length Gee Such That There Is No
Additional Income That Such Be Taxed In The Jurisdiction? If So, What Transfer
Pricing Methodologies Would Typically Be Used To Determine The Amount Of Income
Attributable To The PE?
If there are no special rules in tax agreements, the principal can calculate on an arm’s length’s
basis.
The Ministry of Finance has released a Circular on Transfer Pricing which requires companies to
make a full self-assessment of their profits, calculated on an arm’s length’s basis. According to
this circular, companies will be required to declare the related party transactions in a prescribed
for and submit it within 90 days from the year end. Furthermore, the Circular provides an
obligation for companies to maintain transfer pricing documentation to set out the evidence that
they have taken place on arm’s length’s terms.
If companies fail to comply with these terms they risk double taxation and penalties.
III. Local Incentives
In many of your jurisdictions, the government grants tax incentives or holiday for taxpayers that
invest in the local economy and manufacture within the country. In many contract
manufacturing structures, however, the contract manufacturer receives a cost plus return, and the
contract manufacturer generally does not own intangibles.
1. Is The Taxpayer’s Ability To Obtain A Tax Incentive Or Holiday Diminished By
Operating Under A Risk-Stripped Structure Where The Local Entity Receives Cost
Plus Remuneration?
Exemptions from and reductions of Corporate Income Tax are based on Chapter V of Decree No.
24/2007/ND-CP on Corporate Income Tax.
Tax incentives are provided in cases of encouraged investments. This term covers enterprises
located in special export processing zones, enterprises that export a certain percentage of the
manufactured goods or enterprises with a certain number of Vietnamese employees or laborers.
The contract manufacturer may carry forward their losses of a financial year to offset against
future profits for a maximum of 5 years after the year incurring loss. The enterprise can freely
choose how to allocate the loss to the later 5 years. When the 5 years period has lapsed but the
loss has not been fully carried forward, the loss is not allowed to be carried forward to the next
year.

6. 2. Is The Taxpayer’s Ability To Obtain A Tax Incentive Diminished By The Lack Of
Locally Owned Intangible Property?
This case is not addressed by the Vietnamese tax law.
3. Are There Any Other Aspects In Contract Manufacturing Structures That May Impact A
Taxpayer’s Ability To Obtain A Tax Incentive Or Holiday?
Chapter V of Decree No. 24/2007/ND-CP provides detailed regulations on all CIT incentives.
Investment projects in certain industries and sectors listed in an appendix to the Investment Law
shall be entitled to incentives as well as projects employing average numbers of employees, that
are defined in Article 41.
According to the project type and the region of its location the tax rate can be 10, 15, 20 or 50
per cent.
IV. Conversion And Transfer Pricing Issues
In many cases, U.S. and European multinationals initially establish their local manufacturing
operations in Asia as buy/sell entities because they have a local income tax holiday or exemption
of some kind for a period of years. The local entity may even own intangibles and bear risk.
When the local holiday or exemption ends (or the CFO decides the tax rate is too high), the
parent may wish to convert the local entity into a contract manufacturer for a principal in a low-
tax jurisdiction to reduce the income earned locally.
1. If There Are Locally Owned Product Intangibles, Is There A Capital Gains Tax On The
Sale Of These Intangibles To A Foreign Owner And If So What Is The Rate?
Assume The Local Contract Manufacturer Sells The Intangibles For Cash And Then
Declares A Dividend Equal To The Amount Of The Sales Proceeds. Any Dividend
Withholding Tax? If So, What Is The Rate? If There Is A Capital Gains Tax Or A
Dividend Withholding Tax, in Addition To Discounted Cash Flow, What Other
Valuation Approaches, If Any, Are Commonly Used? Are There Other Strategies
For Reducing These Costs?
The taxation of the sale of intangibles is addressed in Article 32 of Decree No. 133/2008/ND-CP
as amended by Decree No. 120/2014/ND-CP on technology transfer. This norm provides that the
transferor has the obligation to pay tax on the amount of money generated from the technology
transfer.
2. In Some Jurisdictions, The Local Authorities May Find That The Local Entity Owns
Some Goodwill Or Going Concern Value As A Result Of Its Historic Operations.
The Authorities May Assert Capital Gains Tax And Possibly Dividend Withholding
Tax On Value Of The Goodwill Or Going Concern Value On The Theory That The
New Principal Is Somehow Acquiring The Goodwill Or Going Concern Value In

7. Connection With The Conversion. Is This An Issue In Your Jurisdiction? If So,
What Planning Steps Can Be Taken To Minimize This Cost?
This issue is not relevant in Vietnam.
3. Assume The Local Entity That Historically Manufactured Goods On A Buy/Sell Basis
Also Performs R&D And Marketing Activities. In Connection With The Conversion,
Should These Activities Be Moved Into Separate Subsidiaries? If So, What
Additional Issues Arise In Connection With This Conversion?
Please see point IV.2.
4. In Many Cases, The Local Contract Manufacturer Is A Wholly-Owned Subsidiary Of
The Principal. In Such Cases, The Principal May Wish To Compensate The Contract
Manufacturer On A Cost Plus Basis, With The Uplift Being A Percentage Of The
Manufacturing Costs (And Not The Value Of The End Product). Is This Approach
Viable In Your Jurisdiction and What Issues/Exposures Arise In Connection With
The Use Of Cost Plus Transfer Pricing?
Transfer pricing rules in Vietnam require that the enterprise pays and Vietnam receives a
reasonable rate of return on its activities as if the parties were unrelated [the arm’s length
principle].
Vietnamese tax law does not provide special rules regarding cost plus transfer pricing. Please see
point 2.7 for further information on the Circular on Transfer Pricing.
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Please do not hesitate to contact Oliver Massmann under omassmann@duanemorris.com if you
have any questions or want to know more details on the above. Oliver Massmann is the General
Director of Duane Morris Vietnam LLC.
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THANK YOU VERY MUCH