Cost-Plus Transfer Pricing for Shared Services: A Startup Guide to Defensible Markups

Understanding Cost-Plus Transfer Pricing for Shared Services

Your startup is growing. You have just opened a new entity in the US or UK to access a new market, and now you face a practical problem: how do you pay for the shared work? Your UK-based finance person handles the US books. Your US-based marketing lead runs global campaigns. These cross-border activities create intercompany service charges, a common challenge for expanding SaaS, Biotech, and E-commerce companies.

Getting your related party transactions wrong can lead to serious headaches during an audit or investor due diligence, especially with tax authorities like the IRS watching closely. The key is to establish a clear, defensible system from the start. This process, known as transfer pricing, does not require a massive budget or a Big Four firm, just a logical approach. While our hub on transfer pricing documentation covers when you need detailed records, this guide provides a step-by-step framework for one of the most critical markup calculation methods: Cost-Plus.

Here, we will explain how to calculate markup for intercompany shared services, ensuring you achieve transfer pricing compliance and build a solid foundation for future growth.

Foundational Understanding: Transfer Pricing in Plain English

At its core, transfer pricing is about setting a price for services or goods exchanged between two related entities within the same corporate group. Think of a UK parent company providing HR and IT support to its US subsidiary. It must charge the US entity for those services. The fundamental rule governing this process is the arm's length principle.

Arm's Length Principle: The goal of transfer pricing is to price intercompany transactions as if they were between two independent companies. The price charged should be what would have been charged to an independent, third-party company.

For routine support services, the most common and accepted method is the 'Cost-Plus' method. It is simple: you calculate the total cost of providing the service (the 'cost base') and add a reasonable profit margin (the 'plus' or 'markup'). This demonstrates to relevant tax authorities, including the IRS in the US and HMRC in the UK, that you are not artificially shifting profits to a lower-tax jurisdiction. For a startup, this is not about complex tax avoidance schemes. It is about maintaining clean, accurate financial records for each legal entity, ensuring robust transfer pricing compliance, and building a solid foundation for future scrutiny.

Step 1: How to Calculate Your Shared Services Cost Base

The first step in how to calculate markup for intercompany shared services is defining your cost base. This is the total pool of expenses the parent company incurs to provide support that benefits its subsidiary. Accurately capturing this is often the biggest challenge for founders who manage finances in QuickBooks or Xero using spreadsheets. Costs must be categorized correctly to create a defensible shared services allocation.

Distinguishing Direct vs. Indirect Costs

First, you must distinguish between direct and indirect costs. A direct cost is an expense incurred entirely for the benefit of one entity and should be charged directly to that entity without a markup. An indirect cost is a shared expense that benefits multiple entities and belongs in the shared cost pool.

• Direct Cost Example: A software license for a sales CRM used exclusively by the US sales team. This cost should be billed directly to the US subsidiary.
• Indirect Cost Example: The salary of a finance manager who splits their time between the UK parent and the US subsidiary. A portion of this salary belongs in the shared cost pool.

Separating Operational vs. Shareholder Costs

Next, you must separate allowable operational costs from unallowable shareholder costs. Shareholder costs, also known as stewardship costs, are expenses related to managing investments and complying with corporate governance as the parent company. These activities benefit the parent as an owner, not the subsidiary as an operational entity. Therefore, they cannot be included in the cost base allocated to a subsidiary.

Common shareholder costs to exclude from your cost base include:

• Expenses related to raising capital (investor relations, fundraising legal fees).
• Parent company board of directors meeting costs.
• Group-level financial consolidation and reporting expenses.
• Costs associated with an IPO or other strategic parent-level activities.

Choosing the Right Allocation Key

Once you have your pool of allowable indirect costs, you need a fair 'allocation key' to divide it. This is a metric that reasonably reflects how the services are consumed by each entity. While several keys exist, simplicity and defensibility are paramount for an early-stage company.

• Headcount (Recommended): For most startups, headcount is the simplest and most defensible option. It serves as an excellent proxy for the consumption of general and administrative services like HR, IT, and finance support.
• Revenue: This can be a valid key but is often less stable in fast-growing startups and may not accurately reflect the consumption of support services, especially if one entity is in a pre-revenue R&D phase.
• Time Tracking: While highly accurate, implementing comprehensive time tracking for administrative staff is often impractical and overly burdensome for a small team.

Mini-Case Study: Headcount Allocation

Consider a UK-based Deeptech startup with a parent company and a new US research entity.

• Shared Cost Pool: £150,000. This includes a portion of salaries for the operations manager and IT support staff, plus subscriptions for shared project management and communication software. Shareholder costs have been excluded.
• Total Company Headcount: 25 employees (20 in the UK, 5 in the US).
• Allocation Key: Headcount.
• US Entity's Share: 5 employees / 25 total employees = 20%.
• Allocated Cost: 20% of £150,000 = £30,000. This £30,000 is the cost base for the intercompany service charge to the US entity.

Step 2: How to Calculate a Defensible Markup for Intercompany Shared Services

After calculating the cost base, the next step is determining the 'plus' in your cost-plus calculation. This markup represents the small profit the service-providing entity earns, just as an independent professional services firm would. Selecting an appropriate markup is a critical element for satisfying both HMRC and IRS examiners examining your cross-border service fees.

Low-Value-Adding vs. High-Value Services

It is essential to distinguish between different types of services. The cost-plus method with a low markup is specifically intended for routine, low-value-adding support services. These are administrative functions that support day-to-day operations but do not create core intellectual property (IP) or contribute directly to the company's primary value proposition.

• Examples of Low-Value-Adding Services: HR administration, payroll processing, basic IT helpdesk support, accounts payable and receivable management, and general bookkeeping.
• Examples of High-Value Services: Core research and development, patent development, licensing of key technology or brand IP, strategic management decisions, and specialized engineering support.

High-value services require far more complex transfer pricing methods and are outside the scope of this simple cost-plus approach. Applying a low markup to the transfer of valuable IP would be a major red flag for tax authorities.

Finding the "Safe Harbor" Markup

For the administrative shared services most startups deal with, there is a well-established benchmark. International consensus, guided by principles from organizations like the OECD, has created a reliable standard. For routine, low-value-adding support services, a markup in the 5% to 10% range is widely considered a safe and defensible starting point. This range is recognized by numerous OECD country guidelines which inform local tax authority practices.

A scenario we repeatedly see is founders overthinking this. They believe a complex economic analysis is needed at this stage. For these types of services, it is generally not. Selecting a markup within this safe harbor range and applying it consistently demonstrates a good-faith effort to comply with the arm's length principle.

Applying the Markup: Case Study Continued

Continuing our Deeptech startup example:

• Allocated Cost Base: £30,000
• Selected Markup: 5% (a conservative, defensible choice within the safe harbor range)
• Markup Amount: 5% of £30,000 = £1,500
• Total Intercompany Charge: £30,000 + £1,500 = £31,500

The UK parent would invoice its US subsidiary for £31,500 for the services provided. This represents the arm's length price for the support functions.

Step 3: Create Your "Audit-Ready" Documentation

Proving your calculation is as important as the calculation itself. The reality for most startups at this stage is more pragmatic than commissioning a massive report. You need simple, logical, and contemporaneous transfer pricing documentation. It’s about having a logical paper trail that explains what you did and why you did it. This can be broken down into three core components that meet the primary transfer pricing documentation requirements.

1. Intercompany Services Agreement (ICSA)

This is a simple contract between the parent and subsidiary that formalizes the arrangement. It does not need to be overly complex, but it should be signed and dated. You can use our transfer pricing policy template as a starting point for a simple ICSA.

A basic agreement should include:

• Parties: Clearly name the two legal entities (e.g., 'UK Parent Ltd.' and 'US Sub Inc.').
• Services: List the specific services being provided (e.g., 'Accounting and bookkeeping, HR administration, IT helpdesk support').
• Pricing: State the pricing method clearly (e.g., 'Services will be charged at Cost-Plus 5%. The cost base will be determined from the shared cost pool and allocated based on relative headcount, reviewed annually.').
• Term: Define the start date, duration, and payment terms.

2. Cost Calculation Spreadsheet

This is the proof behind your numbers. Your spreadsheet should clearly show how you got from the total expense pool in your profit and loss statement to the final charge. This transparency is crucial for any future review.

A well-organized spreadsheet might include:

• Column A: Expense Category: (e.g., 'Salaries - Operations', 'Software - Slack', 'Office Rent').
• Column B: Total Expense (£): The total P&L expense for that line item.
• Column C: Allocation Logic: A note explaining the allocation method (e.g., 'Headcount', 'Square Footage', 'Direct to UK', 'Exclude - Shareholder Cost').
• Column D: Allocated Amount to Sub (£): The calculated portion of the expense attributable to the subsidiary.
• Summary Section: Clear totals for the Allocated Cost, Markup Percentage, and the Final Intercompany Charge.

3. Transfer Pricing Policy Memo

This is a brief narrative, often just one page, that connects the dots. It explains the company's policy in simple terms for an auditor, investor, or new finance team member. It summarizes the what, why, and how of your approach.

An effective memo outline includes:

• Purpose: To document the transfer pricing methodology for intercompany services between the listed entities.
• Entities Involved: List the parent and subsidiary.
• Methodology: State the use of the Cost-Plus method as appropriate for low-value support services.
• Cost Base: Briefly explain what costs are included (shared G&A) and excluded (direct costs, shareholder costs).
• Allocation Key: Justify the choice of headcount as a reasonable proxy for service consumption.
• Markup: State the chosen markup (e.g., 5%) and justify it as being within the standard arm's length range for these services.

Implementation and Annual Review

Implementing a cost-plus transfer pricing policy for your cross-border service fees is a manageable process for an early-stage company. It is less about complex tax law and more about sound financial housekeeping. The goal is not perfection, but a reasonable, documented approach.

Start by creating the three simple documents: the one-page agreement, the calculation spreadsheet, and the policy memo. In your accounting software, this is straightforward to implement. For US companies using QuickBooks, you can set up a recurring invoice to your subsidiary. For UK companies on Xero, the process is similar. In the parent company's books, you will record this as 'Intercompany Revenue.' In the subsidiary's books, it will be an 'Intercompany Management Fee' or a similar expense account.

This process is not a one-time setup. You should revisit your cost base and allocation key annually, or if there is a significant change in your business, such as a large hiring round in one location or the opening of a new entity. Our UK guide details specific documentation triggers. This regular review ensures the allocation remains fair and reflects the current reality of your operations.

By establishing this process early, you avoid the common pain of a messy and expensive clean-up during a future funding round or audit. It demonstrates financial discipline to investors and provides a clear, defensible position to tax authorities like the IRS and HMRC, allowing you to focus on growing your business across borders. For implementation support and templates, visit the transfer pricing documentation hub.

Frequently Asked Questions

Q: What if we're behind on our intercompany service charges?
A: It is best to address this proactively. You can perform a retroactive calculation for past periods and document the methodology, then book catch-up entries in your accounting system. Correcting this before an audit or due diligence process is far less costly than having an external party discover the oversight.

Q: Do we need an expensive benchmarking study for our markup?
A: For routine, low-value-adding services, a formal benchmark study is often unnecessary at the early stage. The 5% to 10% range is a widely accepted safe harbor. A study becomes necessary for high-value transactions, like IP licensing, or as your intercompany transaction volume becomes very significant.

Q: Can our intercompany markup be zero?
A: No, a zero markup is generally not defensible. The arm's length principle requires the service provider to earn a small profit, as an independent company would. Charging at cost (0% markup) implies the service has no profit motive, which tax authorities can challenge as a way to artificially shift profits.

Q: How does VAT or sales tax apply to these charges?
A: VAT and sales tax are separate considerations from transfer pricing. Depending on the jurisdictions and the nature of the services, these cross-border service fees may be subject to VAT. You should consult with a local tax advisor to determine the correct VAT treatment for your specific situation.