What is the cost-plus method to assess the transfer price

There are three traditional transaction methods to ascertain the transfer price, two of which we have already discussed in detail. The cost-plus method is the third one that we have covered in this article.

As the name suggests, the transfer price under the cost-plus method is the cost plus a comparable markup based on the functions performed and risk involved, and the same has been defined in the transfer pricing guidelines issued by the Organisation for Economic Cooperation and Development (OECD) as follows:

“A transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus markup is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction”.

Under this method, the actual cost involved in the controlled transaction is calculated. The cost can be direct and indirect costs related to the transaction. Direct cost is the cost that is incurred specifically for producing a product or rendering service, such as the cost of raw materials, and this cost can be directly traced to the related product and service. While indirect cost is a common cost like the costs of a repair department that services equipment used to produce different products, and this cost is allocated to the respective product and service by applying various methods like high low method.

An appropriate markup is added to the above-calculated cost based on the functions performed, risk involved, and market conditions involved. A comparable markup should be added to the comparable cost basis. Like, if one supplier conducts business with the leased assets, its cost base would be different from the supplier who conducts its business through the owned assets, and this factor should be considered while adding the mark up.

The cost plus markup of the supplier in the controlled transaction should be compared with the cost plus markup of the same supplier in the uncontrolled transactions (internal comparable). This means the cost plus markup earned by the supplier from the related party should be compared with the cost plus markup earned from any unrelated party. If there are any differences, an adjustment should be made.

In addition, the cost plus markup that would have been earned in comparable transactions by an independent enterprise may serve as a guide (external comparable). External comparable is the cost plus markup that have been or would have been earned by the external supplier who is in the same business-like an internal supplier and selling the same goods and services under the same terms and conditions to any third party.

While comparing with cost plus markup of the uncontrolled transaction, if there are no differences, then the existing cost plus mark up should be considered an arm’s length price. However, if the material differences have been identified, then a reasonable adjustment should be made to eliminate the material effects of such differences. So, we can say that “transfer price under the cost-plus method = external/Internal comparable + adjustment (if any)”.

We should not ignore the level and type of expenses – operating expenses and non-operating expenses. If there are higher expenses due to more assets and risk involved, then an adjustment should be made. If more expenses are due to additional functions that bring efficiency, then compensation should be given. If due to the inefficiencies, there are higher expenses like supervisory, general, administrative expenses etc., then no adjustment should be made to the margin.

While calculating the cost, we should not ignore the accounting consistency. If the accounting treatment in a controlled transaction is different from the accounting treatment in an uncontrolled transaction, appropriate adjustments should be made to the data used to ensure that the same type of costs is used in each case to ensure consistency.

The cost-plus method is a very traditional method and easy to understand. Generally, this method is applicable where it involves the transfer of semi-finished products to the related party, where joint facility agreements have been concluded, or where the controlled transaction is the provision of services.

The biggest challenge in this method is to get the mark up from the other party, which is not easily available. Moreover, keeping in view the functions performed and the risk involved, the adjustment on account of transactional differences would not be an easy job.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax and OECD transfer pricing guidelines. For any queries/clarifications, please write to him at compliance@kresscooper.com.