Transfer Pricing for Loss-Making Entities: Cost-Plus Pricing, Documentation and Funding Steps

The Core Conflict: Startup Reality vs. Tax Authority Expectations

When you expand your startup from the US to the UK or vice versa, one of the first financial complexities you face is intercompany transactions. Your new subsidiary needs funding and provides services, like R&D or sales support, back to the parent company. But what happens when the entire group is pre-revenue or burning cash to grow? How do you price these internal services when there's no profit to be had? This situation creates an immediate tension between the commercial reality of a loss-making startup and the compliance demands of tax authorities like HMRC and the IRS, who are skeptical of losses. Getting this wrong can lead to serious tax compliance issues for unprofitable subsidiaries and introduce multinational startup tax risks you cannot afford.

Transfer pricing is governed by a single, core idea: the 'arm's length principle' requires intercompany pricing to be the same as it would be between two unrelated companies. Tax authorities in both jurisdictions, including the UK’s HMRC and the USA’s IRS, use this principle as their foundation. For a profitable company, applying this is relatively straightforward. For a loss-making startup, it represents a direct conflict. Your operational reality is about survival and growth, not generating taxable profit in every entity.

Tax authorities, however, are trained to see persistent losses in one jurisdiction as a potential red flag for artificially shifting profits to avoid tax. Their default assumption is that a business is meant to make a profit. This skepticism is the root of the compliance challenge in documenting losses in group companies.

The practical consequence tends to be the risk of double taxation. Imagine your US parent pays its UK R&D subsidiary for software development. If the IRS decides the payment was too high and disallows a portion of the expense, the US parent pays more tax on that adjusted amount. Meanwhile, HMRC has already treated the full payment as taxable revenue for the UK subsidiary. Your group has now paid tax twice on the same money. Scrutiny typically begins when intercompany transactions become material, for example, consistent six-figure flows, so it’s a problem that grows with you.

Proving Commercial Rationale: Why Your Subsidiary Is Losing Money

Tax authorities scrutinize losses because they need to distinguish between genuine business struggles and artificial accounting maneuvers designed to reduce tax. Your primary task is to provide a compelling narrative, supported by evidence, that your subsidiary’s losses are a deliberate and commercially sound part of your growth strategy. This is where the concept of “commercial rationale” comes in.

It is essential to distinguish between justifying the arm's length price of a specific service and justifying the overall commercial loss of the business entity. You must be prepared to do both, as they address two different questions an auditor might ask.

1. Justifying the Entity's Overall Loss: The "Why"
2. This justification is about the strategic purpose of the subsidiary. Why does this entity exist, and why is it expected to lose money right now? For a Biotech or Deeptech startup, the answer is often obvious: you are in a multi-year R&D phase with no commercial product and therefore no revenue. For a SaaS company, it might be a market-entry strategy, such as hiring a sales team in a new region that is not expected to generate a significant pipeline for 12 to 18 months. This justification shouldn’t live in your head; it needs to be contemporaneously documented in business plans, financial forecasts, strategy documents, and, most importantly, board minutes that show a deliberate decision to invest for future growth. For more on this, see our guide on documenting R&D cost sharing.
3. Justifying the Price of Intercompany Services: The "How Much"
4. This is about the pricing of specific transactions. Even if the subsidiary is losing money overall, the price it charges the parent company for its services must still be at arm’s length. You cannot simply have the parent cover all the subsidiary’s losses and call that a service fee. This is the most common mistake and a direct path to challenges during transfer pricing audits for startups. Proving the price is appropriate requires a clear intercompany agreement defining the services rendered and the pricing methodology used.

In practice, we see that for an early-stage group, a simple, one-page agreement and board minutes referencing the market entry or R&D strategy are often enough to satisfy initial inquiries from tax authorities.

How to Handle Transfer Pricing for Unprofitable Subsidiaries: The Cost-Plus Method

This is a major source of confusion for founders. The goal is not to find a loss-making comparable company. The goal is to find a defensible price for the *service* your subsidiary is providing, independent of its overall profitability. An independent company would not agree to provide services at a perpetual loss. It would, at a minimum, want to cover its costs and make a reasonable profit margin. This is the logic you must follow to satisfy the arm's length principle for loss entities.

While tax regulations outline several transfer pricing methods, including the Transactional Net Margin Method (TNMM) and the Profit/Loss Split Method, the most pragmatic and defensible for most early-stage startups is almost always the Cost-Plus Method. This approach is favored for routine, low-risk services like R&D, sales support, or administration, which is precisely what most startup subsidiaries provide. It involves identifying the costs incurred in providing a service and adding a small markup.

The Cost-Plus Method typically involves adding a markup of 5-10% to the total cost of the services. This approach is simple to implement using data you already have in your accounting software like Xero or QuickBooks. You calculate the total cost base associated with providing the service and add a small, reasonable markup. This creates a charge that is fair to both jurisdictions.

Consider a synthetic example: A US-based SaaS parent company has a UK subsidiary performing R&D. The UK team consists of two software developers.

• Step 1: Calculate the Total Cost BaseThe cost base should include all direct and indirect costs associated with the service. This means more than just salaries.
  • Developer Salaries: £160,000
  • Employer National Insurance & Pensions: £25,000
  • Allocated Office Rent & Utilities: £10,000
  • Software Licenses & Equipment Depreciation: £5,000
  • Total Annual Cost Base: £200,000
• Step 2: Apply the Arm's Length MarkupThe markup compensates the subsidiary for its function and risks, ensuring it earns a profit consistent with what a third-party provider would require. A 7.5% markup is a common and defensible starting point for low-risk services.
  • Cost Base: £200,000
  • Markup (e.g., 7.5%): £15,000
• Step 3: Determine the Intercompany ChargeThe final charge is the sum of the cost base and the markup. This is the amount the US parent will pay the UK subsidiary.
  • Total Intercompany Service Fee: £215,000

This calculation is logged via a journal entry in QuickBooks or Xero. The US parent now has a defensible £215,000 expense, and the UK subsidiary has £215,000 in revenue. This creates a small, defensible profit of £15,000 in the UK, satisfying local tax requirements, even while the group as a whole is unprofitable. This is how to handle transfer pricing for unprofitable subsidiaries in a compliant and systematic way.

Managing Cash Flow and Tax Planning

The Cost-Plus model creates a paper transaction, but startups operate on cash. A common point of failure is confusing the funding of a subsidiary with payment for its services. Sending cash to your UK team to make payroll is not a service payment; it is a funding event, and the two must be accounted for separately to maintain compliance.

Funding vs. Service Payments

To manage this correctly, you must distinguish between service fees and capital contributions or intercompany loans. Your intercompany service fee (£215,000 in our example) creates a receivable for the UK subsidiary and a payable for the US parent. This is a formal transaction that should be supported by a periodic invoice.

However, for day-to-day cash management, the US parent should provide funds to the UK subsidiary as either a documented intercompany loan or a capital contribution (equity). These funding flows are tracked separately on the balance sheet as liabilities or equity and do not generate taxable revenue for the subsidiary. This separation is critical for a clean audit trail.

To remain compliant, intercompany balances should be settled periodically, at least annually, to avoid them being re-characterized by tax authorities as a loan or a dividend. A simple wire transfer at year-end to clear the payable/receivable balance is typically sufficient.

Strengthening R&D Tax Relief Claims

This separation also has significant benefits for tax planning. Many startups in the SaaS, Biotech, and Deeptech sectors rely on R&D tax relief to extend their runway. The UK offers a specific R&D tax relief scheme, and the relevant US tax code for R&D is Section 174. Having a clear, cost-plus arrangement for R&D services provided by a subsidiary helps substantiate the costs incurred in that location, strengthening your claim for these valuable credits. It creates a clean audit trail that demonstrates substance and commercial purpose, which tax authorities appreciate.

A Practical Implementation Checklist for Founders

For an early-stage founder without a large finance team, navigating transfer pricing for intercompany transactions with losses feels complex. However, the initial steps are pragmatic and can be managed within your existing tools like QuickBooks and Xero.

1. Draft a Simple Intercompany Agreement. It does not need to be a 50-page legal document. A single page defining the relationship, the services provided (e.g., “software development services”), the pricing method (“cost plus 7.5%”), and payment terms is a huge step forward and serves as your foundational evidence.
2. Document Commercial Rationale in Board Minutes. When you decide to open the new entity, ensure your board minutes reflect the strategic reason. For example: “to access the UK engineering talent pool for developing Project X” or “to establish a sales presence in the European market with an expected 24-month path to profitability.”
3. Default to a Cost-Plus Model. For most support services, this is the most defensible method. Calculate the fully-loaded cost of the employees providing the service, including salaries, benefits, and a share of overheads. Add a markup between 5-10% to arrive at the intercompany charge.
4. Fund with Loans or Equity, Not Service Fees. Keep cash injections for operational runway separate from your transfer pricing invoices. Track these funding events clearly on the balance sheet as intercompany loans or capital contributions to avoid mischaracterization.
5. Settle Your Balances Annually. At the end of your financial year, ensure the intercompany payable and receivable created by your service charges are formally settled with a cash transfer. This satisfies auditors and tax authorities that the transactions are commercially real.

By following these steps, you build a compliant foundation that aligns with accounting standards like FRS 102 in the UK and US GAAP in the US. This proactive approach significantly reduces future tax risks and prepares you for scrutiny as you scale. For a deeper dive, explore our transfer pricing documentation hub.

Frequently Asked Questions

Q: Can our subsidiary just charge the parent company its exact costs with no markup?
A: This is generally not advisable. Charging at cost implies a zero-profit margin, which an independent third-party service provider would never accept. Tax authorities can challenge this arrangement as it fails the arm's length principle, potentially leading to an upward adjustment of the subsidiary's income and penalties.

Q: What happens if we ignore transfer pricing until we are profitable?
A: Delaying transfer pricing compliance is a significant risk. Tax authorities can conduct audits covering previous years. If they find non-compliant intercompany transactions with losses, they can impose adjustments, penalties, and interest, creating a large, unexpected liability just as your company is becoming successful.

Q: How often do we need to review our transfer pricing policy?
A: For an early-stage startup, an annual review is a good practice. You should revisit your policy whenever there is a significant change in your business, such as the subsidiary taking on new functions, a dramatic change in headcount, or a shift in your group's overall business model.

Q: Is an intercompany agreement legally binding in the same way as a third-party contract?
A: While it is a contract between related parties, an intercompany agreement is a critical piece of evidence for tax authorities. It documents the intent and terms of your internal transactions. Tax authorities expect to see it, and its absence can weaken your defense during an audit.