INTM421060 - Transfer pricing: Methodologies: OECD Guidelines: Cost plus
Introduction
The cost plus method is described by the OECD Transfer Pricing Guidelines as one of the traditional transaction methods, and is discussed at paragraphs 2.39 - 2.55.
The Guidelines say at paragraph 2.39 that the cost plus method is most useful where semi-finished goods are transferred between related parties (e.g. a manufacturing company selling to a distribution affiliate), where joint facility agreements have been concluded, or where the controlled transaction is the provision of services.
The starting point should be with the costs incurred by the supplier of the goods or services. A ‘plus’ percentage should be added to this to give the supplier a profit appropriate to the functions carried out and the market conditions. The profit element should be calculated by reference to the profit the supplier earns in comparable uncontrolled transactions (an “internal comparable”). Failing this possibility (because the supplier does not enter into comparable uncontrolled transactions), the mark up that would have been earned in comparable transactions by an independent enterprise (an “external comparable”) can serve as a guide.
The Guidelines stress that whilst the level of the profit margin is critical, it would be wrong not to give careful consideration to the level and type of costs to which the margin should be applied. This is particularly important when looking for comparable enterprises, which may classify costs in different ways in their accounts - some at operating expense level, some at gross margin level. Thus, although in principle the cost plus methodology should compare margins at the gross profit level, the guidelines recognise that there may be practical difficulties in so doing - see paragraphs 2.46 - 2.52 of the Guidelines. Further, different types of costs may mean that different functions are being carried out: this of course would mean that the enterprises were not comparable.
Transfer of semi-finished goods
The term “semi-finished goods” has a very wide meaning, ranging from the buyer having to assemble the goods before selling them on to a third party, to the buyer merely breaking down the containers in which the goods arrive to enable him to sell them in individual units. A functional analysis should leave no doubt as to which party performs each activity. This case mirrors the situation where an independent manufacturer supplies goods to a distributor. Case teams should consider the ways in which independent parties would arrive at their prices in this instance. It is perhaps most likely that a manufacturer needs a margin on their gross costs (the direct and indirect costs of manufacture - raw materials, labour, machinery depreciation, etc) which will leave them with a profit out of which the more limited operating costs (administration, legal, office, etc.) can be covered - those which are not so directly related to the chief function.
Using cost plus where there are transfers of goods from a supplier to a related party is uncontroversial and is recommended by the OECD Guidelines. In many ways this reflects the fact that a manufacturer, when setting prices, will have a cost base in mind which they know must be covered and in addition they will obviously want a profit to compensate for the functions carried out and the risk borne. The amount of that profit will depend on what market conditions exist at the time the price is struck. The buyer will have his own agenda (for a start, they must be able to sell on at a higher price to compensate for their own risks and activities.) What the buyer will be unwilling to do is to agree to cover the costs of the supplier irrespective of what those costs are or what they may become, since on a cost plus basis any expense marked up will earn a ‘plus’. The size of the plus and the cost base should give the connected supplier the same profit they would enjoy in similar transactions with independents. This margin is arrived at by either (in the best case scenario) discovering what the connected enterprise makes from dealing with independents, or what independents themselves make in similar circumstances from similar transactions. None of these independents are likely to have negotiated a cost plus agreement with their customers, but the methodology can be used to calculate the margin the connected supplier would have made at arm’s length.
Joint facility arrangements/long term buy and supply arrangements
This is the second broad area where the OECD Guidelines recommend trying to use a cost plus methodology. Case teams may encounter references to “contract manufacturer”, an entity typically said to be carrying low risk and carrying out low-level functions (see INTM441090). The problem with terms like ‘contract manufacturer’ is that they have no defined or universally understood meaning. It may also be suggested that a low margin would be earned at arm’s length - which may or may not be the case. Case teams should not accept without question claims that a company is low risk and carries out low-level functions. What the company actually does is more important than terms that are applied to it. What risks are being borne? If a company sells to a parent that has guaranteed to buy all of its output whatever the quantity, then this might indicate that the manufacturer does not carry much risk. Case teams would need to find a comparable independent company (in the absence of similar transactions between the tested enterprise and independents) to see what the arm’s length reward would be. That reward is likely to be different (either higher or lower) from that enjoyed by a manufacturing company which also has to distribute its goods and is not guaranteed to sell them. Once again uncontrolled transactions which are sufficiently comparable to the tested party’s transactions need to be considered before any valid conclusions can be drawn about the arm’s length reward.
Cost plus for intra-group services
In transfer pricing, the term ‘service’ is often suggestive of a low-level reward for the activities carried out. But independents go into trade to maximise a profit, not just to cover their costs. A sufficiently valuable service will always attract a high reward, which may have little direct connection to the level of costs incurred in providing the service.
A business may claim that that the functions carried by the enterprise amount to a service and that cost plus is therefore appropriate. The level of the plus then depends on the nature and complexity of the service. This is sometimes an appropriate approach where the activities performed are of relatively low importance to the multinational enterprise as a whole. (Always look at the other end of the transaction - how does the receiver of the service benefit from what is done?) Some services at arm’s length are rewarded by reference to the cost of the supplier with a margin on top but the reward is rarely calculated directly in this fashion.
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 (although this does not necessarily equate to a guaranteed profit depending upon what costs incurred by the provider are excluded from the 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.
This should begin with the contractual risk allocation and whether the actual conduct of the parties conforms to the contractual terms and obligations; see paragraph 1.48 of the Guidelines.
It should then be considered whether the actual risk allocation (either under the contractual arrangements or that indicated by the actual conduct of the parties where the latter differs) is one that would have occurred between comparable independent parties at arm’s length. This will include a search for comparables demonstrating similar risk allocations in comparable circumstances. The absence of such comparables does not, of itself, establish that the contractual risk allocation is not equivalent to an arm’s length arrangement. Other factors that should then be taken into account include a consideration of which party has greater control over the risks and of the financial capacity of the party to which the risk has been contractually assigned to actually bear that risk. Paragraph 1.49 of the Guidelines provides further guidance on this issue.
Should it be concluded that the arrangements made in relation to the tested transaction differ from those which would have been agreed between comparable independent parties, every effort should be made to adjust the price to reflect the actual risk allocation. However, in the exceptional circumstances where it is not possible to arrive at a reasonable price by recognising the actual risk allocation, the transfer price should be computed on the basis of an allocation of risk reflecting that which would have occurred at arm’s length - in a business restructuring context, see paragraphs 9.34 - 9.38 of the Guidelines.
Cost plus for R & D services
Paragraph 2.55 of the OECD Guidelines, which provides an example of the application of the cost plus method to contract research agreements, does not mean that the cost plus nature of arrangements between connected parties in respect of research contracts are automatically at arm’s length. For example, let’s say a UK subsidiary carries out research and development services for a parent company. There is an agreement between the connected parties that the reward for this will be a mark up of 10% on the costs incurred by the R & D company. It may be suggested that the size of the plus reflects the nature of the R & D. The parent company will own all rights and intangibles that are created. The group argues that this means that the parent company is taking all of the risk, the UK company takes no risk and that therefore a low-level reward is appropriate. The realities of how any group operates means that costs will be controlled or supervised by the parent who will at the very least have budgetary overview.
The group may provide a transfer pricing report giving details of apparently comparable R & D companies whose operating profits are not too far out of line with the size of the plus margin of the tested company. The guarantee of having costs paid would be consistent with low risk for the company and since one of the factors affecting reward in the market place is risk, this would tend to support an argument in favour of a low reward at arm’s length.
Every effort should be made to price the transaction as structured, as stated in paragraph 1.64 of the OECD Guidelines. This should include, as with any transfer pricing case, a full consideration of the comparability factors (see INTM485070 onwards) and any reasonably accurate adjustments that might be necessary - see INTM485120 and paragraphs 1.33 and 3.47 of the Guidelines onwards. In the context of research contracts, particular consideration should be given to the control of the project in question and hence of the risk as indicated in paragraph 1.49 and expanded upon in paragraph 9.26 of the Guidelines in a business restructuring context.
Paragraph 1.34 of the Guidelines points out the need to consider realistically available options or alternative structures in pricing the transaction as actually structured. What this means is that, at arm’s length, there may have been a potentially more advantageous option available to the party undertaking the research than a contract R & D arrangement earning it only a routine cost-plus reward. For example, the facts may suggest that it would have been of potentially greater benefit to the research entity if it had retained
- some form of economic interest in the results of the research (e.g. via licensing for a sales-based royalty,) or
- full ownership and rights to exploit the results
where it had (or would have been able to obtain) the resources necessary to do so, including the financial capacity to assume any additional risks involved.
Consequently, although it is generally not appropriate to disregard the cost plus structure of an arrangement adopted by a business this does not mean that a cost plus methodology necessarily has to be applied in testing the pricing of the transaction. See the example at INTM441120.
Equally, it is generally not appropriate to assume an allocation of risk between the transacting parties that differs from that assigned under the actual contracts or agreements between them.
However, in the exceptional circumstances described at paragraph 1.65 of the OECD Guidelines (see INTM440150), and reiterated at paragraph 9.38, it may be appropriate to disregard the actual structuring of the activities of the R & D company as a contract for a guaranteed fee (but with no retained interest in the sales potentially generated by its discoveries) and re-characterise it as, for example, a licensing arrangement, and re-allocate the risk assumed accordingly
It is therefore sometimes important to consider not just who contractually takes the entrepreneurial risk of the research (which under inter-company arrangements might be the person paying the cost plus) but who would take the entrepreneurial risk were the parties independent.
Further guidance on the issue of risk allocation may be found at paragraphs 1.47 to 1.50 of the Guidelines, and in a business restructuring context at 9.34 to 9.46.
Chapter 7 of the Guidelines, on ‘Special considerations for Intra-group services,’ also provides relevant commentary, particularly at paragraph 7.41.
The cost base
If cost plus is the appropriate transfer pricing method to arrive at the arm’s length price, it is most important to ensure that all the relevant costs are included in the cost base in determining the price charged. For example if a UK service provider had salary costs of £10m and (say) stock options of £0.5m and applied a plus of 5% then the arm’s length price should be £11.025m ({£10m plus £0.5m} @ 105%). Ensuring that the full costs of employing any UK staff are properly reflected in the cost base is potentially more important than the rate of uplift to be applied. This will include the costs of share options where these are made available to the UK staff (see the guidance on share options at INTM440210).
The basic principle is to determine what price would be charged if the parties were unconnected. An independent would need to ensure that all costs are covered and that a profit is earned. The usual starting point in determining the cost base would be the accounts prepared under IFRS or UK GAAP. In the example above the charge in the accounts (under FRS20) would be the fair value of the stock options/awards and that would be the most appropriate figure, reflecting the arm’s length charge for providing the share options. The multi-national enterprise (MNE) may use another method for determining the share option costs for the purpose of computing the arm’s length charge and it would be necessary to consider if in those circumstances there would be a significant risk that the overall result would deflate the taxable profits of the UK entity. The calculation of the FRS20 figure may not be available until after the accounting year end and the MNE may price internally using the option spread at the time of vesting. If the entity consistently used the option spread at the time the shares vested then this is unlikely to present a significant risk to the UK, being in effect, and taking one year with another, a proxy for the cost in providing options at arm’s length. What is important however is that the method is used consistently so that over the full length of the arrangement including the various vesting periods, a result is achieved equating to what would be expected in an arm’s length situation.