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Cost plus method

Cost Plus Method

As per OECD guidelines, entities required to compute Arm’s Length Price (ALP) should compute it using the most appropriate method. Since UAE Corporate Tax public consultation document refers to the guidelines provided by the OECD, hence cost-plus method can be considered as a useful method and can be applied for UAE Corporate Tax.

 

As per the guidance document by OECD “The cost-plus method begins with the costs incurred by the supplier of property or services in a controlled transaction for property transferred or services provided to an associated enterprise. An appropriate mark-up, determined by reference to the mark-up earned by suppliers in comparable uncontrolled transactions, is then added to these costs, to make an appropriate profit in light of the functions performed and the market conditions. Such arm’s length mark-up may be determined by reference to the mark-up that the same supplier earns in comparable uncontrolled transactions (an “internal comparable”), or by reference to the mark up that would have been earned in comparable transactions by an independent enterprise (“external comparable”). In general, the mark-up in a cost-plus method will be computed after direct and indirect costs of production or supply, but before the operating expenses of the enterprise (e.g. overhead expenses).”

 

Thus, in a cost-plus method, the mark-up on costs that the manufacturer or service provider earns from the controlled transaction is compared with the mark-up on costs from comparable uncontrolled transactions.

 

This Cost-plus method probably is most useful where:

  • goods are sold by a manufacturer that does not contribute valuable unique intangible assets or assume unusual risks in the controlled transaction, such as may be the case under a contract or toll manufacturing arrangement; or
  • the controlled transaction is the provision of services for which the provider does not contribute any valuable unique intangible assets or assume unusual risks.

 

ALP under this method can be computed in the following manner:

 

  1. All the direct & indirect cost of production incurred by enterprise for goods & services provided to related party should be determined.
  2. The normal GP percentage should be added to such costs.
  3. This GP percentage can be adjusted after taking into account any functional differences.

 

Following example provides the situation and how to calculate the Arm’s Length Price (ALP) under Cost Plus Method:

POR LLC & XYZ LLC are related parties PQR LLC develops software & provides consultancy to customers. PQR LLC billed XYZ LLC for 75 hours at the rate of AED 250 per man hour, Total cost being AED 15000. It also billed to another customer, K LLC at the rate of AED 400 per man hour for similar level of manpower & earned GP of 50% of cost.

 

Following are the differences in transaction of two entities:

  1. PQR LLC gets technical support from XYZ LLC while no technical support is received from K LLC. Value of this support can be taken at 15% of normal GP.
  2. PQR LLC gets large volume business form XYZ LLC he does not get so from K LLC. Quantity discounts are therefore given to XYZ LLC at 10% of normal gross profits.

 

Calculation of ALP for the transaction:

Particulars

Amount / %

GP % markup in case of K LLC (unrelated party)

50%

Less: Adjustment for functional differences

(Value of technological support from XYZ LLC) (50 x 15%)

(7.5%)

Quantity discounts (50 x 10%)

(5%)

ALP markup

37.5%

Cost incurred by PQR LLC in executing XYZ LLC’s work

15,000

Add: Adjusted GP (15000 x 37.5%)

5,625

ALP billed value

20,625

Actual billed value

18,750

In the above given example, the Arm’s Length Pricing is arrived based on adjusted mark-up.

 

ALP Compliance

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AUTHOR

Pratiksha S

Senior Audit Executive

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