Cost-Plus Method The cost-plus method is most appropriate when there are no comparable uncontrolled sales and the related buyer does more than simply distribute the goods it purchases. Whereas the resale price method subtracts an appropriate gross profit from the resale price to establish the transfer price, the cost-plus method adds an appropriate gross profit to the cost of producing a product to establish an arms-length price. This method is normally used in cases involving manufacturing, assembly, or other production of goods that are sold to related parties. Once again, the appropriate gross profit markup is determined by reference to comparable uncontrolled transactions. Physical similarity between the products transferred is not as important in determining comparability under this method as it is under the comparable uncontrolled price method. Factors to be included in determining whether an uncontrolled transaction is comparable include similarity of functions performed, risks borne, and contractual terms. Factors that may be particularly relevant in determining comparability under this method include the following:

Complexity of the manufacturing or assembly process.

Manufacturing, production, and process engineering.

Procurement, purchasing, and inventory control activities.

Testing functions.

To illustrate use of the cost-plus method, assume that Pruitt Company has a subsidiary in Taiwan that acquires materials locally to produce an electronic component. The component, which costs $4 per unit to produce, is sold only to Pruitt Company. Because the Taiwanese subsidiary does not sell this component to other, unrelated parties, the comparable uncontrolled price method is not applicable. Pruitt Company combines the electronic component imported from Taiwan with other parts to assemble electronic switches that are sold in the United States. Because Pruitt does not simply resell the electronic components in the United States, the resale price method also is not applicable. Therefore, Pruitt must look for a comparable transaction between unrelated parties in Taiwan to determine whether the cost-plus method can be used. Assume that an otherwise comparable company in Taiwan manufactures similar electronic components from its inventory of materials and page 382sells them to unrelated buyers at an average gross profit markup on cost of 25 percent. In this case, application of the cost-plus method results in a transfer price of $5 ($4 + [$4 25%]) for the electronic component that Pruitt purchases from its Taiwanese subsidiary.

Now assume that Pruitts Taiwanese subsidiary manufactures electronic components using materials provided by Pruitt on a consignment basis. To apply the cost-plus method, Pruitt would have to make a downward adjustment to the otherwise comparable gross profit markup of 25 percent, because the inventory risk assumed by the manufacturer in the comparable transaction justifies a higher gross profit markup than is appropriate for Pruitts foreign subsidiary. If Pruitt cannot reasonably ascertain the effect of inventory procurement and handling on gross profit, the cost-plus method might not result in a reliable transfer price.

THE HOMEWORK QUESTION

International Lamp Company (ILC), a U.S. taxpayer, manufactures crystal chandeliers at its wholly-owed subsidiary in Poland (Polampa) at a production cost of $185 per chandelier. Polampa chandeliers are sold to two customers in the United StatesLighting Supermart (an ILC wholly-owned subsidiary) and Home Store (an unaffiliated customer). Polampa and Lighting Supermart are related parties and transactions between them fall under Section 482 of the U.S. Internal Revenue Code.

The cost to transport the chandeliers to the United States is $15 per unit and is paid by Polampa. Other Polish manufacturers of crystal chandeliers sell to customers in the United States at a markup on total cost (production plus transportation cost) of 40 percent. Polampa sells chandeliers to Home Store at a landed price of $320 per unit (Polampa pays transportation costs). Home Store pays applicable U.S. import duties of 2 percent on its purchases of chandeliers. Lighting Supermart also pays import duties on its purchases from Polampa. Consistent with industry practice, Home Store places a 50 percent markup on the total cost of a chandelier and sells them at a retail price of $389.60 per unit. Lighting Supermart sells Polampa chandeliers at a retail price of $359.00 per unit.

HOW WOULD I FIND THE COST PLUS METHOD TRANSFER PRICE?

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