Cost-Plus Method - A Better Way to Assess Transfer Price

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Cost-Plus Method A Better Way To Assess
Transfer Price?
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• 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, its
  not the best method to follow in all cases. Lets
  explore why the cost-plus method isnt always a
  good idea when assigning a price tag to your
  transfer pricing transactions and why another
  method might be more suitable.

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• 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 companys 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. Lets
  explore why the cost-plus method isnt always a
  good idea when assigning a price tag to your
  transfer pricing transactions and why another
  method might be more suitable.

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• How to determine Profit Markup under Cost Plus
  Method
• For determining Arms 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

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• In this example, Arms 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.

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• 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 Arms
  Length Price 1. comparable uncontrolled price
  method2. 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

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• 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. The author can be
  reached at advashishparashar_at_gmail.com Tags
  Transfer PricingRead more at https//taxguru.in
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