Introduction
The transfer pricing rules are meant to prevent tax leakage and market distortion that may result from the prices set for transactions among related parties. While cost-plus is one of the most commonly used methods to assign an appropriate price for a product or service, it’s not the best method to follow in all cases. Let’s explore why the cost-plus method isn’t always a good idea when assigning a price tag to your transfer pricing transactions and why another method might be more suitable.
Assessing transfer price using the Cost-Plus Method
The cost-plus method is a commonly used method to determine transfer pricing for inter-company transactions. With the cost-plus method, the first step is to determine the total cost incurred in production or service delivery for the product or service in question. The cost is then apportioned to assign a cost to each unit produced or service delivered. The price is then set by adding a mark-up percentage to the cost to arrive at the transfer price, where the mark-up is generally set to reflect the company’s desired profit margin. The cost-plus method can be applied in several other ways depending on the circumstances, for instance, the cost-plus method may be used to set a transfer price by first calculating the cost of resources used in production and then using a formula to set the transfer price by adding a mark-up percentage to the cost. While the cost-plus method is a commonly used method to assess transfer price, it is not the best method to use in all cases. Let’s explore why the cost-plus method isn’t always a good idea when assigning a price tag to your transfer pricing transactions and why another method might be more suitable.
How to determine Profit Markup under Cost Plus Method
For determining Arm’s Length Price under Transfer Pricing, 2 components are considered namely Cost of production and Profit Markup. Computation of Cost of production is quite simple as entire data is available with assessee. However, figuring out Profit Markup is complicated. As per Rule 10B(1)(c) of Income Tax Rules, amount of normal gross profit markup is added to the cost to determine Arm/s Length Price.
Under Cost Plus Methods, components to be considered for determining cost of production are not defined under Income Tax Act and it shall be determined as per transaction entered. However, following category of costs are generally considered:
Direct costs- Cost of Raw Material, Freight Charges, Labour Expenses etc.
Indirect costs- Cost of repair and maintenance, rent, administration charges, Finance Charges etc
E.g., X Limited has transferred goods to its wholly owned subsidiary Y Limited for INR 1,00,000. X Limited has incurred following cost of production for such goods:
Cost of Raw Material: INR 60,000
Labour Cost: INR 15,000
Apportioned Indirect Cost: INR 20,000
Total Cost of production: INR 95,000
Profit Mark up: 20%
In this example, Arm’s Length Price for a transaction entered into with a wholly-owned subsidiary is INR 1,14,000 (INR 95,000 plus Profit Markup of 20%). Therefore, for the purpose of Income Tax, such transaction shall be deemed to be entered at INR 1,14,000.
Limitations of the Cost-Plus Method
There are a few limitations of the cost-plus method that need to be considered when assessing transfer pricing using this method.
Determining the cost is subjective:
The first limitation of the cost-plus method is that the cost is largely subjective. When determining the cost of a product or service, there are often several different ways to go about it, which means the final cost determined will vary from one person to the next, making it difficult to arrive at a common cost that can be applied to all transactions. – Transfer price becomes difficult to track
Another limitation of the cost-plus method is that it can make it difficult to track the actual transfer price for specific transactions.:
When a company uses the cost-plus method to assign a transfer price, it is generally required to keep records of the total cost incurred, the quantity produced or delivered, and the mark-up percentage applied to determine the transfer price. This means an audit or tax authority may not be able to easily track the actual transfer price that was used to assign a specific transaction.
Mark-up percentage may not be accurate:
A third limitation of the cost-plus method is that the mark-up percentage applied to the cost to determine the transfer price may not always be accurate. Depending on the circumstances, it may be difficult to determine the appropriate mark-up percentage to apply to the cost to arrive at the transfer price. Additionally, even if a company is able to determine an appropriate mark-up percentage, it may not be able to accurately predict its future cost, which can change from one year to the next.
When to use Cost Plus Method?
Section 92C of Income Tax Act, provides for following 5 methods for computation of Arm’s Length Price:
1. comparable uncontrolled price method;
2. resale price method;
3. cost plus method;
4. profit split method;
5. transactional net margin method;
6. such other methods as may be prescribed by the Board.
Though, Section 92C does not specify which method is to be used under which circumstance. Rather, as per Section 92C, the most appropriate method must be selected based on facts and circumstance of the case.
Following factors must be considered for selection of method:
- Nature of transaction
- Class of transaction
- Class of associate persons
- Functions performed
- Other relevant factors
The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand.
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