Benchmarking transfer pricing after Series A: a pragmatic, defensible cost-plus guide

Benchmarking Studies for Transfer Pricing

Your startup is growing. You have just closed a Series A, or you are expanding internationally by setting up a new subsidiary in the US or UK. Suddenly, the way you account for services between your entities is under a microscope. This process, known as transfer pricing, becomes a critical compliance priority post-Series A or when annual intercompany transactions are projected to exceed approximately $1M. This is not just about moving numbers between two versions of your company in QuickBooks or Xero; it is a significant legal and financial requirement. For a founder or operations lead without a dedicated finance team, conducting a formal benchmarking study can seem daunting, especially when proprietary data sources cost tens of thousands of dollars. The core challenge is clear: how do you justify your intercompany pricing to tax authorities without a massive budget? You can find a complete list of required materials in the transfer pricing documentation hub.

Understanding the Arm's Length Principle

At the heart of all transfer pricing regulation is a single concept. The governing principle is the 'arm's length principle,' which requires that transactions between related entities are priced as if they were between independent companies. In simple terms, if your UK parent company provides engineering services to your US subsidiary, you must charge a price that an independent US company would willingly pay an independent UK firm for the same services.

For most early-stage startups in sectors like SaaS, Biotech, or Deeptech, intercompany transactions often involve services like R&D, management, or sales support. The most direct way to comply is by using a cost-plus model. This approach falls under a methodology called the Transactional Net Margin Method (TNMM), where the service provider charges the recipient its total costs plus an appropriate markup.

The Transactional Net Margin Method (TNMM), applied via a cost-plus model, is the most common and defensible approach for inter-entity services in early-stage startups. It is favored for its simplicity and reliance on the internal cost data of the service provider, which is usually well-documented. Your primary task is to prove that your chosen markup is at arm's length by comparing it to the markups earned by independent companies performing similar functions.

Step 1: Frame the Analysis and Select the Tested Party

Before you can find comparables, you must clearly define the transaction you are pricing. This involves identifying the services rendered, the parties involved, and, most importantly, the “tested party.” The tested party is the entity in the transaction for which financial data is most reliably tested against comparables. In a typical startup structure, this is usually the entity with the simpler functional profile, which is often the service provider.

Consider a UK-based SaaS company that has just raised a Series B and established a US subsidiary to handle North American sales. The UK parent provides all the R&D, engineering, and administrative support. The US subsidiary is purely a sales and marketing operation. In this scenario, the UK parent is the service provider. Since its functions are more straightforward to benchmark (providing services on a cost basis) than the new, potentially loss-making sales entity, the UK parent would be selected as the tested party. Note that R&D activities often need bespoke documentation; see our guidance on transfer pricing for R&D cost sharing.

A simple way to visualize this is a UK parent company, acting as the tested party, providing management and R&D services to its US subsidiary in exchange for payment on a cost-plus-markup basis. Choosing a cost-plus approach under TNMM is logical here. The UK entity's costs are tracked in its accounting software, and determining an appropriate markup based on comparable companies is a clear, defensible path to compliance.

Step 2: How to Find Comparables for Transfer Pricing on a Startup Budget

This is where most startups get stuck. How do you find comparables for transfer pricing without paying for expensive subscriptions to databases like Orbis or Capital IQ? The answer lies in publicly available data. The SEC's EDGAR database is a free, comprehensive source for US company filings, primarily their 10-K (annual) and 10-Q (quarterly) reports. This is your starting point for finding US-based comparable company analysis data.

While UK public data is less centralized, US data is often accepted by authorities like HMRC for benchmarking UK entities, provided you document your reasoning. For more information, see our notes on transfer pricing for UK startups for practical considerations when using US comparables.

Your search begins with identifying companies that perform similar functions to your tested party. To do this systematically, you will use industry classification codes. The most common systems are:

• NAICS (North American Industry Classification System): Used by federal statistical agencies in the US to classify business establishments.
• SIC (Standard Industrial Classification): An older system still widely used in business databases.

For example, if your parent company provides software development services, you might search for companies under NAICS code 541511 (Custom Computer Programming Services). If it provides management support, you could use NAICS code 541611 (Administrative Management and General Management Consulting Services). These searches will likely return hundreds of potential companies.

The next step is qualitative screening. You must carefully narrow this large list to a small set of companies that are genuinely comparable to your tested party. This means applying clear rejection criteria to filter out unsuitable companies. You should exclude:

• Industry Giants: Companies like Microsoft or Oracle have immense scale, brand value, and diversified operations that make them incomparable to a startup.
• Companies with Complex Business Models: Filter out companies with significant non-service revenues (e.g., hardware sales, manufacturing) or those that operate in multiple, unrelated industries.
• Entities Owning Significant Intangible Property: If your tested party is a simple service provider that does not own valuable intellectual property (IP), you must reject companies whose profitability is driven by unique patents, brands, or technology.
• Companies with Different Geographic Focus: If possible, exclude companies whose operations are concentrated in vastly different economic markets.

Your goal is to build a final set of 5 to 10 companies that truly reflect the functions performed, assets used, and risks assumed by your tested party. This screening process must be thoroughly documented in your report.

Step 3: Analyze Financial Data and Calculate the Arm's Length Range

Once you have your final set of comparable companies, the next step is to analyze their financial data to determine a defensible markup. For each company, you will need to pull key figures from their 10-K reports for the last three years: Revenue, Cost of Goods Sold (COGS), and Selling, General & Administrative (SG&A) Expenses, often referred to as Operating Expenses.

These figures are used to calculate a Profit Level Indicator (PLI), which is a financial ratio that measures profitability. Since we are using a cost-plus model, the appropriate PLI is the Return on Total Costs (ROTC), sometimes called a net cost plus markup. It is calculated as Operating Profit / Total Costs. The components are calculated as follows:

• Operating Profit: Revenue - (COGS + Operating Expenses)
• Total Costs: COGS + Operating Expenses

You will calculate the ROTC for each of your comparable companies over a multi-year period (typically three years) to smooth out any annual fluctuations. This will give you a set of markups that independent companies in the open market have earned for performing similar services. However, this data set will almost certainly have outliers, such as unusually high or low markups that could skew your results.

To address this, tax authorities like the IRS and HMRC expect the use of the interquartile range. This statistical measure identifies the range between the 25th and 75th percentile of your data set, effectively removing the bottom and top quarters to establish a reliable 'arm's length range'. In practice, we see that this is the most critical calculation in the entire study.

You can calculate this range easily using standard spreadsheet software. In Excel or Google Sheets, the 25th percentile is calculated with QUARTILE.INC(range, 1) and the 75th percentile with QUARTILE.INC(range, 3).

For example, imagine you have calculated the following ROTC markups for seven comparable companies: 3.5%, 5.1%, 6.8%, 7.2%, 8.5%, 9.1%, and 15.2%.

• Using QUARTILE.INC(range, 1), you would find the 25th percentile is 5.95%.
• Using QUARTILE.INC(range, 3), you would find the 75th percentile is 8.8%.

Your arm's length range is therefore 5.95% to 8.8%. Any markup your company chooses within this range would be considered defensible from a tax perspective.

Step 4: Document Your Process in a Defensible Transfer Pricing Report

The final step is to document your entire process in a transfer pricing report. This document is your primary defense in the event of an audit. It does not need to be overly complex, but it must be logical, clear, and comprehensive, allowing a tax auditor to replicate your work. The reality for most Series A startups is more pragmatic: a well-reasoned report showing your work is far better than a perfect but undocumented policy.

Your report should include the following sections:

1. Company and Transaction Overview: Describe your business, the group structure, and the specific intercompany transaction being priced. Explain the business rationale for the transaction.
2. Industry Analysis: Provide a brief overview of your industry (e.g., SaaS, Biotech), noting key trends and competitive dynamics that might influence profitability.
3. Functional Analysis: This is a critical section. Detail the functions performed, assets used, and risks assumed (the "FAR analysis") by each entity in the transaction. This justifies your choice of the tested party.
4. Methodology Selection: Explain why you chose the TNMM and a cost-plus model. Justify why other methods, like the Comparable Uncontrolled Price (CUP) method, were not suitable.
5. Comparable Search Process: Summarize your search strategy, including the databases used (e.g., SEC EDGAR), keywords, NAICS/SIC codes applied, and the full list of qualitative screening criteria you used to accept or reject companies.
6. Benchmarking Analysis: Present the final list of comparable companies. You should include a summary table with columns for Company Name, Revenue, COGS, Operating Expenses, Total Costs, Operating Profit, and the calculated ROTC for each company over the analysis period.
7. Conclusion: State the final calculation of the interquartile range and your company's transfer pricing policy. For example: “The company will apply a cost-plus markup of 7% on all management services, as it falls within the arm’s length range of 5.95% to 8.8%.”

The final step is to document your entire process in a formal transfer pricing report. Use clear tables to present financial data, cite your sources, and keep the supporting extracts from public filings. Use a simple file structure so you can produce the report quickly in an audit. Our transfer pricing documentation checklist can help you stay organised.

Common Pitfalls to Avoid

• Using Global Data Indiscriminately: Using US-based comparable data for a transaction between two European entities requires strong justification. Tax authorities prefer local comparables because different markets have different economic conditions and profit expectations. If you must use data from another region, clearly explain why local data was unavailable or unreliable.
• Forgetting to Update: A benchmarking study is not a one-time event. It should be reviewed annually to ensure the underlying data remains valid and formally updated every three years, or whenever your business model changes significantly. A major pivot, acquisition, or change in functional responsibilities would trigger the need for a new study.
• Poor Record-Keeping: Your report is only as good as your underlying data. Ensure the cost base used for the markup in your accounting system like QuickBooks or Xero is accurate, complete, and consistently defined. Inconsistent cost allocation can invalidate your entire analysis.

A Pragmatic Approach to Compliance

For founders and operators managing finance at a growing startup, transfer pricing compliance can feel like one more complex task on an already full plate. However, breaking it down into a logical, step-by-step process makes it entirely manageable. Your goal is to demonstrate a reasonable, good-faith effort to comply with the arm's length principle, not to create an unassailable academic document.

Start by identifying the trigger: you have raised a Series A, your international presence is growing, or your intercompany transaction volume is approaching $1M. Frame the analysis by defining the transaction and tested party. Use free public resources like the SEC EDGAR database and NAICS codes to conduct a comparable search. Analyze the financial data using the Return on Total Costs and calculate the interquartile range to set your price. Finally, document every step of your process clearly and logically.

This pragmatic approach provides a defensible position that satisfies tax authorities like the IRS and HMRC, de-risks your company for future financing rounds or an exit, and lets you get back to building your business. Refer to the transfer pricing documentation hub for templates and next steps.

Frequently Asked Questions

Q: What is the difference between the cost-plus method and TNMM?

A: The cost-plus method is a specific application of the broader Transactional Net Margin Method (TNMM). TNMM looks at the net profit margin relative to a specific base (like costs, sales, or assets). When the base is total costs, it is effectively a cost-plus approach, often called a net cost plus analysis.

Q: How many comparable companies do I really need for my analysis?

A: There is no magic number, but a final set of 5 to 10 highly comparable companies is a widely accepted standard. The quality and comparability of the companies are far more important than the quantity. A small set of well-justified comparables is more defensible than a large set of weakly related companies.

Q: Can I use loss-making companies as comparables?

A: Generally, yes, if they are genuinely comparable in function and risk. Persistent, long-term losses might indicate a company is not a reliable comparable, but short-term losses, especially in a volatile industry, can be normal. You should document your reasoning for including or excluding any loss-making companies from your final set.

Q: What happens if my chosen markup falls outside the arm's length range?

A: If your markup is outside the range determined by your benchmarking study, tax authorities can adjust your taxable income to a point within the range (often the median). This can result in additional taxes, interest, and potential penalties. It is best practice to set your policy to target a point within the calculated range.