Professional Services Transfer Pricing: A Practical Cost-Plus Subcontracting and Documentation Guide

Why Internal Subcontracting Demands a Transfer Pricing Strategy

Your UK-based professional services firm just landed its first major US client through your new American entity. The project requires a specialist developer who happens to sit in London. The US team needs to “borrow” them for 60 hours next month. This common scenario of agency group resource billing instantly creates a tax compliance challenge. How do you set transfer prices for subcontracted work between agencies in a way that satisfies both HMRC in the UK and the IRS in the US?

Ignoring this can lead to inaccurate financial reporting, distorted performance metrics, and significant exposure to costly audit adjustments. This isn't about complex tax theory; it's about having a practical, defensible system for charging for time between related companies. This article provides a simple, three-part framework for transfer pricing compliance for consultancies that you can implement using the tools you already have.

What Is Internal Subcontracting in Transfer Pricing?

When one part of your company provides a service to another part across a border, the price it charges is called a “transfer price.” For a growing professional services firm, it’s easiest to think of this as internal subcontracting. In our example, your UK entity is acting as a subcontractor for your US entity, providing a skilled resource for a fee. This is a classic example of managing related party transactions.

The guiding tax principle here is the “Arm's-Length Principle.” The Arm's-Length Principle states that the price between your related entities should be the same as if they were two unrelated companies negotiating in the open market. The challenge for internal services is that no clear market benchmark exists. This is where a specific methodology becomes essential. Tax authorities like HMRC and the IRS generally view the Cost-Plus method as a low-risk approach for routine intercompany support services. This method involves calculating your cost to provide the service and adding a reasonable markup. It’s one of the most straightforward internal chargeback methods and creates a compliant and fair system for consistent, material cross-border work.

Part 1: How to Set Transfer Prices for Subcontracted Work Between Agencies

Determining a defensible arm’s-length rate is the first major hurdle in cross-border service pricing. The Cost-Plus method breaks this down into two simple parts: establishing the true cost of the service and adding a fair profit margin. Let’s walk through a mini-case study to see how it works in practice.

Imagine DevCo UK is your UK-based development agency and SalesCo US is your new US sales and service entity. Sarah, a senior developer at DevCo UK, is being subcontracted to work on a SalesCo US client project.

Step 1: Calculate the Fully-Loaded Cost Base

Your first instinct might be to use Sarah’s salary, but this is a critical mistake. A defensible cost base must be 'fully-loaded'. This includes all direct employee costs (gross salary, employer taxes like National Insurance or FICA, pension contributions, health benefits) and a proportional share of indirect overhead costs (rent, utilities, software licenses, management overhead). Calculating this precisely can be difficult for a startup without a full-time finance team.

A scenario we repeatedly see is founders getting stuck trying to perfectly allocate every last penny of overhead. The reality for most startups is more pragmatic. A common and acceptable estimation for a fully-loaded cost is to multiply an employee's gross salary by a factor of 1.25 to 1.4. This multiplier accounts for those extra costs like employer taxes, benefits, and office space.

• Sarah’s Gross Salary: £70,000
• Multiplier: 1.3 (a safe middle ground)
• Fully-Loaded Annual Cost: £70,000 x 1.3 = £91,000
• Hourly Cost: Assuming 1,800 working hours per year, the hourly cost is £91,000 / 1,800 = £50.56

This £50.56 is your defensible cost base per hour for Sarah’s time.

Step 2: Add a Defensible Markup (the “Plus”)

The markup represents the profit margin DevCo UK should earn for providing this service. For low-complexity internal support services like subcontracting staff, a markup between 5% and 15% is a widely accepted and low-risk range. For most startups, a starting markup of 10% is a solid, defensible position. It demonstrates to tax authorities that you are not trying to aggressively shift profits between countries but are operating in a commercially reasonable way.

• Cost-Base per Hour: £50.56
• Markup: 10%
• Intercompany Hourly Rate: £50.56 x 1.10 = £55.62

Under this policy, DevCo UK will charge SalesCo US £55.62 for every hour of Sarah's time dedicated to the US project.

Part 2: Creating Compliant Intercompany Agreements for Agencies

One of the biggest compliance exposures for startups is the lack of transfer pricing documentation. You don’t need a 100-page formal study at this stage, but you absolutely need a simple, “good enough” intercompany agreement. This document is your first and most important piece of evidence.

The most important rule is that intercompany agreements require 'contemporaneous documentation'. This means the agreement must be put in place as the work is performed, not backdated months or years later during an audit. A contemporaneous agreement shows tax authorities your intent to comply from the beginning and establishes the legal basis for the charges.

What founders find actually works is a straightforward, one-page document that covers the essentials. Your minimum viable agreement should include the following components:

1. The Parties: Clearly name the legal entities involved (e.g., “DevCo UK Limited” and “SalesCo US, Inc.”).
2. The Date: State the date the agreement goes into effect.
3. Scope of Services: Provide a brief but clear description of the work. For example, “DevCo UK will provide software development and related support services to SalesCo US on an as-needed basis for its client projects.”
4. Pricing Mechanism: State the transfer pricing method clearly. For example, “Services will be billed based on the Cost-Plus method. The price will be calculated as the fully-loaded cost of the employee providing the service plus a markup of 10%.”
5. Payment Terms: Specify the billing frequency and settlement process (e.g., “Invoiced quarterly based on approved timesheets, with the balance to be settled via intercompany loan account reconciliation”).

You can treat this basic intercompany agreement as your first transfer pricing policy. This simple agreement, signed by directors from both companies and filed away, provides powerful evidence that you’ve considered your transfer pricing obligations. Keep contemporaneous copies; they matter. For a helpful list of required items, see our transfer pricing documentation checklist.

Part 3: Implementing Subcontractor Cost Allocation Without an ERP

Inaccurate subcontractor cost allocation distorts your financial reality, making it impossible to see which parts of your business are truly profitable. Fortunately, you can manage tracking and billing for cross-border services perfectly well with the tools common in early-stage consultancies, like Xero, QuickBooks, and a time tracker such as Harvest or Toggl.

Step 1: Track the Time Accurately

The process is identical to tracking time for an external client. In your time-tracking software, create a new project or client named something clear and distinct, like “Internal: SalesCo US Support.” When Sarah works on the US project, she logs her hours there. This discipline keeps the data clean and separate from other billable and non-billable work, making reporting simple and accurate.

Step 2: Calculate the Intercompany Charge

At the end of each month or quarter, run a time report for the internal project. Let’s say Sarah logged 80 hours against the “Internal: SalesCo US Support” project.

• Total Charge: 80 hours x £55.62/hour = £4,449.60

Step 3: Record the Transaction with Journal Entries

Instead of creating a PDF invoice and wiring cash, which can create unnecessary administrative work and runway headaches, you handle this with a journal entry in your accounting software. This creates a clean, auditable paper trail and ensures each entity’s profit and loss statement is accurate.

• In DevCo UK’s books (Xero): You will record revenue from the US entity and create a receivable, showing that the US company owes you money.
  • Debit: Intercompany Receivable - SalesCo US (£4,449.60)
  • Credit: Intercompany Services Revenue (£4,449.60)
• In SalesCo US’s books (QuickBooks): You will record an expense for the UK services and a payable, showing you owe the UK company money.
  • Debit: Intercompany Subcontractor Expense ($5,562, assuming a 1.25 USD/GBP exchange rate)
  • Credit: Intercompany Payable - DevCo UK ($5,562)

This intercompany balance can be left to accumulate and settled periodically, often once a year, to minimize bank fees and FX risk. Your external accountant can help you post the first entry correctly. If you want a short primer on differences in documentation and safe harbors, compare with our UK vs US transfer pricing guide.

Beyond Compliance: The Strategic Value of Accurate Transfer Pricing

Viewing transfer pricing as purely a tax task is a missed opportunity. Proper internal subcontracting provides a clearer picture of entity-level profitability and is a powerful business intelligence tool. It helps you answer a critical question: is your new US entity truly profitable, or is its performance being artificially inflated by free or underpriced resources from the UK?

This entire process can be boiled down to a simple, repeatable framework:

1. Set the Rate: Use the Cost-Plus method. Calculate a fully-loaded cost for your employee (a 1.3x salary multiplier is a great start) and add a defensible 10% markup.
2. Sign the Agreement: Draft a simple, one-page intercompany agreement outlining the services and pricing mechanism. Make sure it’s signed and dated contemporaneously.
3. Track and Record: Use your existing time-tracking software for agency group resource billing. At the end of each period, calculate the total charge and record it in your accounting systems (like Xero in the UK and QuickBooks in the US) using a journal entry.

This practical approach solves the three biggest pain points for professional services firms: it provides a defensible arm's-length rate, creates compliant documentation, and ensures accurate subcontractor cost allocation.

Your Next Steps for Compliance

Transfer pricing compliance for consultancies doesn't need to be an intimidating, expensive project. You can build a robust and defensible foundation today with a few pragmatic steps. The key is to start now, before the volume of intercompany work becomes a significant administrative and financial problem.

1. Calculate Your Costs: For any team members who work across your UK and US entities, calculate their estimated fully-loaded hourly cost using the 1.25x to 1.4x salary multiplier. Document this calculation.
2. Draft the Agreement: Use the key points in this article to write a simple, one-page intercompany services agreement. Get it signed by directors of both entities this week.
3. Update Your Tools: Create a new project in your time-tracking software dedicated to this internal work. Brief your team on when and how to use it to ensure accurate data capture from day one.

Visit the transfer pricing documentation hub for templates and examples. This simple system will serve you well through your early growth stages, ensuring your financials are accurate and you are prepared for any questions from tax authorities.

Frequently Asked Questions

Q: What happens if we ignore transfer pricing for small amounts of work?
A: While small, infrequent transactions may not trigger an audit, failing to establish a policy early on creates risk. As your business grows, these "small amounts" can become material. Tax authorities can impose penalties and back taxes for multiple years, making it much more costly to fix later than to implement correctly from the start.

Q: How often should we review our transfer pricing markup and cost base?
A: It is good practice to review your transfer pricing policy annually. You should update your fully-loaded cost calculations to reflect salary changes and shifts in overhead. The markup percentage is generally more stable but should be reassessed every few years or if the nature of the intercompany services changes significantly.

Q: Can we just charge for the work at cost, with a 0% markup?
A: Charging at cost is a common mistake and is not compliant with the Arm's-Length Principle. An unrelated third-party subcontractor would not provide services without a profit margin. A 0% markup suggests you might be artificially shifting profits to the entity receiving the service, which is a red flag for tax authorities.

Q: Do we need to actually move cash between the UK and US entities for each invoice?
A: No, you do not need to settle each transaction with a cash transfer. Using an intercompany loan account, as shown in the journal entry example, is a standard and efficient practice. This allows you to track the debt between entities and settle the net balance periodically, perhaps annually, which is better for cash flow management.