INTM463050 - Transfer Pricing: OECD and methodologies
Cost plus
Transfer of semi-finished goods
Joint facility arrangements/long term buy and supply
arrangements
Cost plus for inter-group services
Cost plus for R & D services
Cost plus is probably the most misunderstood and misused OECD
method applied in pursuing the arm's length principle. The cost
plus method is described by the OECD Transfer Pricing Guidelines as
one of the traditional transactional methods. The Guidelines
discuss this method from Para 2.32 - 2.48.
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 he has carried out and the market conditions. The profit
element should be calculated by reference to the profit the
supplier earns in comparable uncontrolled transactions. 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
can serve as a guide. Note the emphasis on the need to look at
comparable transactions. An enterprise which is superficially
similar to the tested party may be carrying out comparable
transactions but equally it may not.
The OECD Transfer Pricing 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. 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.
The OECD Transfer Pricing Guidelines say at Paragraph 2.32
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.
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. Your functional analysis should leave you in no doubt as to
which party performs each activity. This case mirrors the situation
where an independent manufacturer supplies goods to a distributor.
You have to 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 his gross costs (the direct
and indirect costs of manufacture – raw materials, labour,
machinery depreciation, etc) which will leave him with a profit (he
hopes) out of which his more limited operating costs
(administration, legal, office, etc.) can be covered - those which
are not so directly related to his 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 Transfer Pricing Guidelines. In many ways this reflects
the fact that a manufacturer, when setting his prices, will have a
cost base in mind which he knows must be covered and in addition he
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 (or are assumed to exist) at
the time the price is struck. The buyer will have his own agenda
(for a start, he must be able to sell on at a higher price to
compensate for his 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'. Thus
the cost plus pricing method is often misunderstood. The size of
the plus and the cost base should give the connected supplier the
same profit he would enjoy in similar transactions with
independents. You arrive at this margin 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 will have negotiated a cost plus agreement with their
customers, but you can use the methodology to calculate the margin
your 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 Transfer Pricing Guidelines recommend trying to use a cost plus methodology. You should familiarise yourself with the concept of a "contract manufacturer", typically said to be carrying low risk and carrying out low-level functions (see INTM465060).It may also be suggested that a low margin would be earned at arm's length. This may or not be the case. The problem with terms like 'contract manufacturer' is that they can mean all things to all people. You 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 what it is called . 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. You 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 – risk can go either way – but different) from that enjoyed by a manufacturing company which also has to distribute its goods and is not guaranteed to sell them. Once again you need to consider uncontrolled transactions which are sufficiently comparable to the tested parties transactions before you can draw any valid conclusions about the arm's length reward.
Cost plus for inter-group services
In transfer pricing, the term 'service' is often suggestive of a
low-level reward for the activities carried out. Always remember
that one man’s service is someone else’s trade and
independents always go into trade to maximise a profit not just
cover their costs. A sufficiently valuable service will always
attract a high reward and one that may have little direct
connection to the level of costs incurred in providing the service.
In a transfer pricing report (
INTM466000), you will often see claims
that the functions carried by the enterprise amount to a service
and that therefore the cost plus basis 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 never calculated directly in this fashion.
The supplier hopes he knows what his costs are going to be and
negotiates a price based on this plus a profit fee. This profit
element might be a flat amount or be fixed (but would perhaps be
open to re-negotiation if providing the service at this price
becomes untenable for the supplier.) The person paying for the
service looks around to see what he would have to pay elsewhere or
whether he should carry out the activities in-house (this may not
always depend solely on costs.)
You should be able to see from all of this that where the
functions carried out amount to a service that would possibly be
contracted out to an independent, then an intra-group cost plus
agreement may give the arm's length reward for this service. This
is despite the fact nobody agrees a cost plus at arm's length but
they might agree a contract that gives a reward similar to that
given by a cost plus arrangement.
It is however completely inappropriate to use a cost plus
method consisting of a mark up on total costs, where the functions
carried out are not the type of functions that would be contracted
out at arm's length, being functions vital to the overall trade of
the group. Payroll functions or legal work might be contracted out
to an independent but more critical functions would not. What
constitutes a critical function will depend on the nature of the
trade. A cost plus agreement means the person proving the functions
loses any benefit linked to the contribution those functions make
to the profitability of the trade, since the provider gets the same
flat rate irrespective of success. If those functions are critical
to the overall success of the trade, then why would the person
carrying out those functions accept a small return on his
costs?
Paragraph 2.48 of the OECD Transfer Pricing Guidelines, which
deals with cost plus agreements, is frequently misunderstood. It
does not mean state that cost plus arrangements between connected
parties 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 at 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.
On the face of it this seems all well and good. The group
will almost certainly 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.
However the most important consideration - how would the
activities of the R & D company actually be rewarded in an
arm's length situation - has not yet been addressed. An independent
R & D company would be more than happy to have a guarantee that
its costs were paid but perhaps not at the price of losing all of
the value of what it may discover from carrying out that R & D.
Independent R & D companies try and retain some interest in
what they create. (The shareholders of the company might hope that
the company will get taken over if a larger company wants to
acquire a discovery – but it is difficult to reflect such
hope value in a transfer pricing enquiry) If the R & D company
is without the resources to exploit a discovery itself, it might
license the discovery to an enterprise that has the ability to do
so: the terms of the arrangements between the parties will reflect
what each brings to the table and the relative power of each.
Typically, the cost negotiated might include a small royalty based
on the final sales of the product containing the results of the R
& D. At arm's length, research companies struggle hard to
maintain an interest in what they develop. A large R & D
company, or a company that performs a variety of functions, might
have the resources to finance R & D and maintain complete
ownership of any resulting intangible property. It will always be a
matter of fact or degree but you will always need to consider the
way any R & D activities would actually be rewarded at arm's
length. Few commercial organisations would be willing to accept a
small cost plus in return for a complete surrender of rights in
resulting intangible property, if they have a choice.
It therefore sometimes important to consider not just who
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.
Also consider Chapter 7 of the OECD Transfer Pricing
Guidelines, on 'Special considerations for Intra-group
services.'
