Transactions between related parties or associate enterprises are always doubted for being entered at unfair prices. Sometimes such transactions result in lower tax liabilities. Therefore, under tax laws and accounting principles, valuation provisions are always provided for determining Arm’s length price (“ALP”) of transactions entered into between related parties. Provisions provided for determining ALP are known as Transfer Pricing provisions.
Under Income Tax Act, various methods are laid down for determining Arm’s length Price of domestic or international transactions entered into between related parties. One of the methods is the Cost Plus Method.
This article will briefly explain what is the Cost Plus Method, when to use it, how to use it, and what are its advantages and disadvantages.
1. What is the Cost Plus Method
- As the name itself suggests, under the Cost Plus Method, Arm Length Price is determined by adding profit markup to the direct and indirect cost of production incurred with respect to goods transferred or service provided. Manner of computation of ALP under Cost Plus Method is given under Rule 10B(c) of Income Tax Rules.
- 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%
In this example, Arm’s 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.
2. How to determine Profit Markup under Cost Plus Method
- For determining Arm’s 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.
- Following are the steps for computation of Gross Profit Mark-up:
- Gross Profit Mark-up is taken from other transactions entered for the same or similar product or service by either the same enterprise or by unrelated enterprise.
- Adjustment to Gross Profit Mark-up for functional and other differences.
2.1 Computation of Gross Profit Mark-up from other transactions
- For computation of gross profit mark-up, either of the following transactions must be entered:
- Internal Transactions
- External Transactions
2.1.1 Internal transactions
- Gross Profit Mark-up is computed through internal transactions when the same enterprise is engaged in the trading of same or similar goods or provision of same or services.
- However, internal transactions should be comparable and also must be uncontrolled.
- E.g. Company X supplies services to both, the related party, which is Company Y, and the unrelated party, Company A. Therefore, for computation of Arm’s Length Price of transaction entered into with Company Y, Gross Profit Mark-up of services provided to Company A can be considered.
2.1.2 External Transactions
- When an entity is itself not engaged in sale or provision of same or similar products in uncontrolled transactions then reference must be given to any similar transaction entered into by an unrelated party.
- To understand this better, that following example can be taken into consideration:
- Company X is supplying goods to a related party, Company A. Company X is not supplying such goods to any customer other than Company A. Whereas, Company P, an unrelated entity, is supplying the same goods to Company Q, an independent party.
- Therefore, for computing Arm’s Length price of goods supplied to Company A, gross profit mark-up can be taken from transactions entered into by Company P and Company Q.
2.2 Adjustment of Gross Profit for Functional and Other difference
- Once gross profit mark-up is taken from an uncontrolled comparable transaction, necessary adjustment must be made on account of differences in transactions for which Arm’s Length Price is to be computed and uncontrolled comparable transaction.
- E.g.
- Company X has supplied 50,000 units of Black colour phone to Company Y, which is a related party.
- Similarly, Company X supplies 10,000 units of white colour phone to Company Z, which is an unrelated party.
- Gross Profit Markup of goods sold to Company Z is 20%.
- However, in white colour Phones, profit market is 2% higher as compared to black colour phones and also for supply of 20,000 or more units, the company provides a discount of 1% on sales price.
- Therefore, adjusted gross profit Mark-up for black phone sold to Company Y will be:
- Gross Profit Markup of Uncontrolled transaction: 20%
- Adjustment of difference in profit mark-up based on colour: -2%
- Adjustment on account of bluk discount: -1%
- Gross Profit Markup for computation of ALP: 17%
3. When is the Cost Plus Method used
- Section 92C of Income Tax Act, provides for following 5 methods for computation of Arm’s Length Price:
- comparable uncontrolled price method;
- resale price method;
- cost plus method;
- profit split method;
- transactional net margin method;
- such other methods as may be prescribed by the Board.
- La Sección 92C no especifica qué método debe utilizarse en cada circunstancia. Por el contrario, según la Sección 92C, el método más apropiado debe seleccionarse en función de los hechos y las circunstancias del caso.
- Para la selección del método deben considerarse los siguientes factores:
- Naturaleza de la transacción
- Clase de transacción
- Clase de personas asociadas
- Funciones desempeñadas
- Otros factores relevantes
- El método de costo adicionado (cost plus) es muy útil para evaluar los precios de transferencia en actividades rutinarias y de bajo riesgo, como la fabricación de bienes tangibles. Para muchas organizaciones, este método es fácil tanto de implementar como de comprender.
4. Aspectos clave de la aplicabilidad del método de costo adicionado
- Debe existir coherencia en la base de costos entre las transacciones controladas y las no controladas, especialmente en circunstancias en las que los costos influyen en el margen de beneficio.
- Deben eliminarse las inconsistencias contables entre las transacciones controladas y las no controladas.
- El perfil de riesgo debe ser similar entre las transacciones controladas y las no controladas. Los comparables internos son más fiables.
- En este caso, podrían ser necesarios ajustes adecuados, como los niveles de inventario y tasas de rotación, programas de ventas, marketing y asesoramiento, prácticas contables, nivel de mercado, términos contractuales y activos tangibles e intangibles, para eliminar cualquier diferencia material.
5. Ventajas y desventajas del método de costo adicionado
Como todo en esta vida, el método de costo adicionado en materia de precios de transferencia también tiene sus ventajas y desventajas.
5.1 Ventajas
- El método de costo adicionado es relativamente fácil de entender.
- La mayor parte de la información necesaria para calcular el precio de plena competencia (ALP) mediante este método está disponible en las entidades, como los costos directos e indirectos incurridos en el suministro de bienes o servicios.
- Este método es preferible en el caso de transacciones rutinarias de bajo riesgo sin muchas variables, como el ensamblaje y la venta de bienes tangibles.
- Asimismo, el cálculo del margen de beneficio bruto es sencillo si se dispone de transacciones comparables no controladas internas.
5.2 Desventajas
- Si una entidad no ha realizado una transacción similar, no es fácil obtener el margen de beneficio bruto de otra entidad, ya que ninguna empresa comparte los detalles de su beneficio bruto con sus competidores.
- Además, el ajuste por diferencias transaccionales no es sencillo. Es fundamental realizar una comparación precisa; incluso pequeñas diferencias en la forma en que dos empresas operan y gestionan su contabilidad de costos pueden distorsionar por completo los resultados de este método.
- Por lo tanto, en circunstancias en las que no se dispone de datos fiables, se recomienda utilizar un método diferente para determinar los precios de transferencia correctos.
