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Cost Plus Method Of Transfer Pricing

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Cost Plus Method Of Transfer Pricing

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The cost plus method begins with the costs incurred by a supplier of a product or service provided to an non-arms length enterprise, and a comparable gross mark-up is then added to those costs. This comparable gross mark-up is determined in two ways, by reference to:

--the cost plus mark-up earned by a member of the group in (internal)comparable uncontrolled transactions; or
--the cost plus mark-up earned by an arm's length enterprise in (external) comparable uncontrolled transactions.

In either case, the returns used to determine an arms length mark-up must be those earned by persons performing similar functions and preferably selling similar goods to arm's length parties. The more comparable the functions, risks and assets, the more likely it is that the cost plus method will produce an appropriate estimate of an arms length result.

Where the transactions are not comparable and the differences have a material effect on price, taxpayers must make adjustments to eliminate the effect of those differences. For example, if the gross markup among unrelated parties ranges from 40-45%, the parent would need a markup of that range with related party for arms length principle to apply, else adjustments may apply. Other such differences include:

--the relative efficiency of the supplier;
--intanglibles and contracts;
--any advantage the activity creates for the group.

In general, for purposes of applying a cost-based method, costs are divided into three categories:

--direct costs such as raw materials;
--indirect costs such as repair and maintenance which may be allocated among several products; and
--operating expenses such as selling, general, and administrative expenses.

The cost plus method uses margins calculated after direct and indirect costs of production. In comparison, net margin methods such as the transactional net margin method (TNMM) use margins calculated after direct, indirect, and operating expenses. For purposes of calculating the cost base for the methods, operating expenses usually exclude interest expense and taxes. Properly determining cost under the cost plus method is important. Cost is usually calculated in accordance with accounting principles that are generally accepted for that particular industry in the country where the goods are produced.

However, it is most important that the cost base of the transaction of the tested party to which a mark-up is to be applied be calculated in the same manner and reflects similar functions, risks, and assets as the cost base of the comparable transactions. Where cost is not accurately determined in the same manner, both the mark-up and the transfer price will be misstated. For example, if the comparable party includes a an item as an operating expense, while the tested party includes the item in its cost of goods sold, the cost base of the comparable must be adjusted to include the item.

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Return to Transfer Pricing.

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