Method involves the computation of the real costs associated with the controlled transaction
By Mahar Afzal/Compliance Corner
The transfer price under the cost-plus method, as implied by its name, consists of the cost plus a relevant mark-up reflecting the functions performed, risks involved, and assets utilised. This definition is outlined as given below in the transfer pricing guidelines provided by the Organisation for Economic Cooperation and Development (OECD); and defined in the transfer pricing guide (CTGTP1) issued by the Federal Tax Authority (FTA).
“A transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus mark-up 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”.
This method involves the computation of the real costs associated with the controlled transaction. These costs encompass both direct and indirect expenses tied to the transaction. Direct costs are those specifically incurred in the production of a product or the provision of a service, such as raw material expenses, which can be directly linked to the relevant product or service. Indirect costs, on the other hand, can be shared costs, such as the expenses of a maintenance department that supports equipment used in the production of multiple products.
The calculated cost is augmented with a suitable mark-up that reflects the functions undertaken, associated risks, and prevailing market conditions. A comparable mark-up should be applied to the comparable cost basis. For instance, if one supplier conducts business using leased assets, its cost basis would differ from that of a supplier utilising owned assets, and this distinction should be considered when applying the mark-up .
The cost-plus mark-up applied by the supplier in the controlled transaction should be contrasted with the cost-plus mark-up utilised by the same supplier in uncontrolled transactions (internal comparable). This comparison involves evaluating the cost-plus mark-up earned by the supplier from the related party against that earned from any unrelated party. If disparities exist, adjustments should be made.
Furthermore, the cost-plus mark-up that an independent enterprise has earned in comparable transactions can provide a reference point (external comparable). External comparable represent the cost-plus mark-up that has been or would have been earned by an external supplier engaged in a similar business, akin to an internal supplier, and selling identical goods and services under equivalent terms and conditions to any third party.
If the cost-plus mark-up in the uncontrolled transaction is found to be identical, then the current cost-plus mark-up should be deemed an arm’s length price. However, if significant disparities are discovered, a fair adjustment should be applied to mitigate the substantial impact of these differences.
We must consider both the magnitude and nature of expenses, including operating and non-operating expenses. If higher expenses are attributed to increased assets and risk, an adjustment should be made. If the additional expenses stem from added functions that enhance efficiency, appropriate compensation should be provided. Conversely, if higher expenses result from inefficiencies, such as supervisory, general, and administrative expenses, no margin adjustment should be applied.
When computing costs, it’s important to consider accounting consistency. If the accounting methods in a controlled transaction differ from those in an uncontrolled transaction, suitable adjustments should be applied to the data to guarantee the uniform use of cost types in both instances, thus ensuring consistency.
The cost-plus method is a conventional and easily comprehensible approach. Typically, it is utilised in scenarios involving the transfer of semi-finished products to related parties, when joint facility agreements have been established, or in controlled transactions relating to the provision of services.
The primary difficulty with this method lies in obtaining the mark-up from the other party, which is often not readily accessible. Furthermore, considering the functions undertaken and the associated risks, making adjustments for transactional disparities is no simple task.
Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official opinion of Khaleej Times but an opinion of the writer. For any queries/clarifications, please write to him at [email protected].