TAX REGULATIONS IN CONTRACT MANUFACTURING

TAX REGULATIONS IN CONTRACT MANUFACTURING

Contract manufacturing refers to a company outsourcing its production to another manufacturer based on its specific requirements.

In contract manufacturing, the principal company (the one outsourcing the work) typically provides the raw materials, including primary and essential components, while also assuming the operational risk and organization of the production process. Companies offering contract manufacturing services must possess an industrial registry certificate related to their field of manufacturing.

VAT Regulations in Contract Manufacturing

• General VAT Rate: Contract manufacturing service fees are subject to 18% VAT.

• Reduced VAT Rate:

  • Textile and apparel manufacturing, bag production, and shoe stitching services are subject to 8% VAT.
  • Additionally, 5/10 of this VAT is subject to withholding tax, which is applied by the company outsourcing the contract work.

Documentation Requirements

Due to contract labor services, specific notations must be included in delivery notes (waybills):

• For materials sent for contract work, the waybill must state:

  • "Sent for contract labor processing, no invoice will be issued."

• For finished goods returning from contract work, the waybill must state:

  • "Dispatched as a product that has undergone contract labor processing."

Contract Manufacturing in Free Zones

Manufacturing companies operating in free zones can also outsource part of their production to contract manufacturers under certain conditions:

1. The contract manufacturing must fall within the scope of production activities listed on the industrial registry certificate or operating license.
2. Since tax exemptions in free zones apply only to production within the zone, the majority of the production process must be conducted by the free zone company itself.
3. The taxable income eligible for exemption is limited to the company’s actual capacity utilization.
4. The principal company must assume the operational risk and organization of the contract manufacturing process.
5. The raw materials and auxiliary materials must be supplied by the principal company.

Under Income Tax and Corporate Tax Exemption Regulations, manufacturing activities must take place within the free zone. However, outsourcing certain stages of production does not disqualify companies from tax exemptions.

Contract Manufacturing and Export-Registered Goods

Manufacturers that outsource contract labor under the above conditions and sell export-registered goods can still be considered as the original manufacturer. As long as their production remains within their capacity report limits, these outsourced goods are treated as if they were produced by the principal manufacturer.

Withholding Tax in Contract Manufacturing Services

Some VAT taxpayers provide brokerage services for contract manufacturing, including:

• Connecting companies seeking contract manufacturers with companies offering contract manufacturing services.
• Helping contract manufacturers find clients in need of outsourcing production.

These brokerage firms do not assume any direct responsibility for the contract manufacturing process but simply act as intermediaries. These brokerage services are subject to withholding tax under VAT regulations.

If a company subcontracts the entire contract manufacturing job to another company, both transactions will be subject to withholding tax at each stage of the process.