It is not uncommon for corporates to relate Transfer Pricing as the 'cost plus' question – how much margin is appropriate given the nature of transaction? Would a cost plus margin in the range of 10 – 15 percent be sufficient or is a higher mark-up warranted? While finalizing these decisions what must not be overlooked is the functional profile of the taxpayer. Before the margin question, a fundamental question needs answering – what is the taxpayer's characterization and risk profiling?
The 'cost plus' model can only be used if the service provider does not own significant intangibles and undertakes routine functions/ activity calling for a low/ reasonable return on the cost. The 'plus' or 'mark-up' on cost is benchmarked with reference to comparables providing similar services.
In this regard, the Her Majesty's Revenue and Customs (HMRC) provides instructive guidance ('HMRC Guideline INTM463050'). "Cost-plus is a relatively low risk form of reward – it provides the supplier of the goods or services with a guaranteed return on the relevant cost base. Consequently it is important, in deciding whether cost-plus is an appropriate methodology to apply in testing the pricing of a particular transaction, to consider the risk allocation between the parties:"
OECD Guidelines [(Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017 – Paragraph 1.81] also second that It is the determination of how the parties actually manage and control risks, as set out in the remaining steps of the process of analyzing risk, which will determine the assumption of risks by the parties, and consequently dictate the selection of the most appropriate transfer pricing method.
The cost plus model and the hourly rate model are two commonly used models for captive service providers in IT industry. Provided below is a snapshot comparison of the two models. The factors mentioned below are just one example of the considerations that must be kept in mind while adopting the cost plus model.
Comparative View – Cost Plus Model vs Hourly Rate
|Particulars||Hourly Rate||Cost Plus|
|Transfer Pricing Policy||Fixed hourly rate paid to service provider (hourly rate should be in line with rates agreed between third parties).||Fixed cost plus margin paid to Indian entity|
|Implications on functional characterization of service provider||Not a risk insulated entity – may make a profit or loss – the entity's operational decisions determine local profitability.||Risk insulated entity – shall always earn a positive profit margin.|
|Data Requirements||Reliable data on Comparable Uncontrolled Prices i.e. similar transactions undertaken at lower or same rates.||Benchmarking required based on external/ internal comparables to support cost plus mark-up.|
|Factual or commercial substance requirement||Hourly rate model must be reflected in substance
e.g. bench cost to be borne by Indian entity.
|No critical or strategic decision making undertaken by a cost plus service provider.|
|Nexus with Group Profitability||Hourly rates are benchmarked with reference to third party rates and have limited nexus with group profitability as such.||Cost Plus Margin is determined by what third party comparables are earning and hence, the plus margin should be maintained irrespective of supernormal group profit and loss.|
Each model has its merits and demerits. The application of each model is dependent upon a number of factors such as;
- Nature of business operations
- Ease of administering the cost plus model
- Availability of data
- Group policy objective etc
Therefore, Transfer Pricing modelling is more than just a mark-up question. Other critical questions that inhere in the decision making process are the choice of tested party itself (whether taxpayer is indeed the correct transactional entity for profitability testing) and the selection of the right charge out model. Corporates are required to holistically examine the supply chain and seek expert advice before pegging mark-ups. Depending upon the facts and circumstances some operations
may be so market driven that their profitability cannot be tested. Cost plus methodology is never the right choice in such circumstances. Based on expert advice, taxpayers must explore other alternatives such as overseas testing, applying hourly rate model or some other transactional method based on the specific facts of each case.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.