Cost base in transfer pricing – increasing risk in tax audits

In transfer pricing practice, taxpayers tend to focus primarily on demonstrating that the applied profit margin is consistent with market conditions. To support this, transfer pricing analyses are prepared to confirm that the achieved level of profitability falls within an arm’s length range.

However, experience from tax audits and recent administrative court rulings shows that tax authorities are increasingly examining the structure of the cost base itself, which underpins the calculation of remuneration in transactions between related parties.

In practice, this means that even if the applied mark-up falls within the market range, the authorities may still challenge the taxpayer’s position if they consider that the costs included in the remuneration calculation have been incorrectly identified, allocated or documented.

The cost base as the foundation for remuneration calculation

In many intra-group models, remuneration is determined based on operating costs incurred, plus a specified profit margin. In such cases, the correct determination of the cost base is essential to ensure compliance with the arm’s length principle.

The cost base should reflect the actual functions performed, assets used and risks assumed by the entity, in line with the functional analysis. This is particularly relevant for routine service providers within capital groups, such as shared service centres or entities providing IT, technical, administrative or operational support.

Typically, such entities perform limited functions and bear limited risks. Consequently, their remuneration should correspond to this functional profile, and the cost base should include only those costs that are directly related to their operational activities.

What costs should be included in the cost base

A key element of any remuneration model is the proper determination of the scope of operating costs included in the cost base.

As a general rule, the cost base should include all costs that are economically linked to the functions performed and necessary for the provision of services within controlled transactions.

These typically include:

• employee remuneration, including social security contributions and other benefits,
• costs of external services supporting operations (e.g. IT, accounting, legal),
• administrative and office costs (e.g. rent, utilities, IT infrastructure, office equipment),
• business travel expenses related to service provision,
• other routine operating costs necessary for business activities.

At the same time, the cost base should exclude costs of a financial, incidental or non-operational nature.

Costs that often raise doubts

In practice, tax authorities frequently challenge certain categories of costs that require careful individual assessment. These include in particular:

• shareholder costs related to ownership functions performed by the parent company,
• recharged (pass-through) costs, which in many cases should not be subject to a mark-up,
• administrative or general overheads requiring appropriate allocation keys,
• one-off or extraordinary costs (e.g. restructuring or litigation expenses).

Increasing attention is also being paid to employee incentive schemes based on equity instruments. In such cases, it is crucial to determine whether the economic burden is borne by the local entity or at the group level.

This assessment determines whether such costs should be included in the cost base and whether they should impact the calculation of remuneration.

The importance of correct cost allocation

Another critical element is the method used to allocate costs to specific transactions and entities within the group.

In practice, allocation keys may be based on:

• the number of employees,
• revenue levels of individual entities,
• the degree of employee involvement in service delivery,
• other metrics reflecting the actual use of services.

Allocation keys should be economically justified, aligned with the nature of the services, and based on reliable data. An inappropriate allocation method may distort the level of costs assigned to a transaction and, as a result, call into question the arm’s length nature of the arrangements.

Transfer pricing adjustments

An important component of the settlement model is the mechanism for making transfer pricing adjustments when actual profitability deviates from the level assumed at the beginning of the year.

Polish regulations permit such adjustments, provided that certain conditions are met particularly demonstrating the arm’s length nature of the transaction and ensuring that appropriate documentation is in place, including confirmation that the adjustment has been recognised by the counterparty.

In practice, there is a growing trend towards ongoing monitoring of profitability throughout the year, which helps to reduce the need for significant year-end adjustments.

Our support

We can assist you in mitigating tax risk by performing a comprehensive review of the cost base applied in transactions with related parties. As part of our services, we prepare an expert opinion on the correctness of the cost base structure, covering, among other things:

• analysis of the costs included in the cost base and their alignment with the entity’s functional profile,
• assessment of which operating costs should form the basis for calculating remuneration,
• verification of cost allocation keys applied between group entities,
• analysis of the impact of specific cost components (e.g. employee incentive schemes) on remuneration,
• assessment of the treatment of recharged (pass-through) costs and costs excluded from the cost base,
• review of transfer pricing adjustment mechanisms,
• identification of potential tax risks along with recommendations on aligning the accounting model with current tax authority practice and case law.

If you would like to verify whether the cost base applied in your transfer pricing model is properly structured, please feel free to contact us.
 

Contact us – will support your company in preparing for the evolving tax landscape.