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Is “Cost Plus” the Right Transfer Pricing Model for Your Company?

Industries: International Business

Services: International Business

By: Michael Arena

When multinational groups have an entity performing a service that benefits another entity, it has become increasingly common for the service-providing entity to be remunerated for its costs plus a profit markup. This arrangement is often referred to as a “cost plus” model. In fact, these arrangements have become so popular that the rate of misuse has increased to a level that has now drawn the attention of tax authorities around the world.

First, there is a technical point of confusion to address. It’s easy to see why the abbreviated term “cost plus” has been adopted to describe situations in which an entity is reimbursed for its costs, plus a profit markup. The adoption of this term, however, has led to mix-ups during examinations. The confusion arises because the term “cost plus”, as it is used in U.S. transfer pricing rules, refers to two different concepts. The first use is in reference to a specific transfer pricing method called the “cost plus method”, which does not apply to intercompany service transactions, but rather to intercompany transactions involving the manufacture or assembly of goods [see 1.482-3(d)]. The second use of the term “cost plus” refers to one of the specified “profit level indicators” to be employed as part of the application of the comparable profits method. “Cost plus” models or arrangements are actually the application of the comparable profits method for services using the net cost plus profit level indicator.

Now let’s return to how companies run the risk of misusing the popular “cost plus” model. Below are common pitfalls that companies run into related to cost plus models.

 Pitfall #1: The intercompany service does not provide a benefit to the recipient. Under the U.S. rules, an activity is considered to provide a benefit if it directly results in a reasonable identifiable increment of economic or commercial value. Situations that do not confer a benefit upon the recipient include the following:

If a benefit is not conferred upon the recipient, then the recipient should not pay for the service. If a cost plus model is implemented for a service that does not provide a benefit to the recipient, the full amount of the remuneration and deduction, not just the profit markup, would be disallowed.

Pitfall #2: Complications that arise when there are charges going both ways. In multinational groups, it is common to have entities that do not have a full management function. In these cases, those entities are often receiving managerial assistance from other members of the group. Let’s take an example. A subsidiary is set up to perform sales and marketing activities in its local market. Sales and marketing activities are the subsidiary’s only activity. The management for the group sits at the parent. The parent provides strategic guidance and various headquarter services its subsidiary. The parent also performs a variety of other activities unrelated to the subsidiary. The company sets up service charges going both ways: one in which the parent compensates the subsidiary for the sales and marketing services at cost plus; and one in which the subsidiary compensates the parent for management and administrative services at cost plus. With charges going in both directions, careful analysis must be undertaken to determine whether the cost plus should be calculated inclusive or exclusive of the incoming service charge. The determination depends on the functions performed and risks borne by the entities, and how those compare to arm’s length situations.

Pitfall #3: Determining the appropriate cost base. Entities that provide a service to related parties may also perform other unrelated functions. In such cases, isolating the correct cost base for the intercompany service charge is critical. Costs that are not related to the intercompany service activity cannot be included in the cost base of the service fee.

Pitfall #4: The service qualifies for the services cost method. The services cost method allows certain services to be charged without a markup. Eligibility for this method is subject to multiple requirements. In certain cases, it can be beneficial for a company to not include a profit markup for intercompany services. If there is a tax or operational efficiency that can be achieved through the absence of a profit markup, careful consideration should be given to whether the intercompany service qualifies for the services cost method.

Pitfall #5: The cost plus model, which relies on the comparable profits method, is not the best method as required by the U.S. rules. Often, companies will default to using a cost plus model for their intercompany services, but if the cost plus model under the comparable profits method is not the “best method” as required by the US transfer pricing rules, then the arrangement will be subject to adjustment by the IRS. Specific transfer pricing methods are described in Section 482 of the Treasury Regulations. Which method a company selects is not subject to its discretion. Rather, the rules require that taxpayers apply the method that, under the specific facts and circumstances, provides the most reliable measure of an arm’s length result. If the taxpayer chooses to apply a cost plus model under the comparable profits method, the IRS may determine that another method produces a more reliable measure of an arm’s length result and make an adjustment.

 To determine the most appropriate transfer pricing method and model, it is best to consult with a transfer pricing specialist.