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Transfer Pricing Methods: Cost Plus Method

Publishing Date : 19 November, 2019

TUMELO RANNAU

The Cost Plus Method (CPM) is one of the traditional transaction methods recommended by the Organization of Economic Cooperation and Development (OECD) and United Nations (UN) to both tax administrations and taxpayers for determining transfer price between related parties.


The method is usually recommended for use by companies that provide routine manufacturing of goods or simple administrative services.  The manufacturing entity or service provider is used as the tested party and compared to third party companies that are in the same business to establish the arm’s length price. Just as its name implies, the method focuses on costs incurred by the tested party in production/sales or providing services. The sales or transfer price is then established by adding a mark-up to those costs.


The cost of production/sales is made up of costs directly incurred in production or provision of services. Example of those are direct labour costs, direct material costs and factory overheads associated with production, these overheads can range from electricity and water. The appropriate mark-up to be added to these costs should consider functions performed, risks assumed and assets used by the 2 entities being compared.


Additionally the general market conditions of the industry the company operates in should be considered when determining the appropriate mark-up. Where functions or assets used by the entities being compared are different adjustments in those differences may be made if they are not material. Such differences may be on who does marketing, sales or raw materials procurement and other functions necessary for production.


When it comes to assets, 2 manufacturing companies may use same type of machinery or the other company may use highly specialized machinery compared to the other one. Where there are differences in the assets used the companies may not be comparable and a different company should be selected that has similar assets used by the tested party. Furthermore, differences in costs related to assets may be because one of the companies owns the assets while the other one has leased the assets.


The one who owns the assets ideally has more risks compared to the entity that is leasing the assets. Therefore this is an important factor and should be considered when choosing an entity that is to be compared with the group’s tested party and where possible minimal adjustments should be made to reflect level of risk assumed by each company. Entities tend to use different accounting methods for their inventory and other costs.


What one company treats as cost of sales/production may not necessarily be treated as such in another company. Therefore in making comparisons between the 2 companies any differences in treating of costs must be adjusted to ensure one is comparing like with like. Inconsistencies in treatment of costs and other aspects of comparability analysis may result in unnecessary disputes between the taxpayer and tax authority especially where there are tax adjustments resulting in a tax liability. Though theoretically the simplest and easiest method to apply when determining arm’s length price practically the method is said to be the least used by both taxpayers and tax administrators because of the growing complexity of transactions across various industries.

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