If your multinational group has a subsidiary providing services to a related entity, the arm’s length price for that service is almost certainly benchmarked using net cost plus markup. Software engineering, contract R&D, administrative support, sales and marketing, procurement: the tested party’s total costs are the base, and the markup on top is what gets benchmarked.
The concept is simple. A US subsidiary incurs $10 million in total costs providing software engineering services to its German parent. It charges $10.7 million. The markup is 7%. Whether that 7% is arm’s length depends on what comparable independent companies earn for similar services.
Where things go wrong is rarely the markup percentage itself. It is how the cost base gets defined, whether gross and net are confused, and whether a company applies one markup to ten different services that have ten different risk profiles.
How It Works
Net cost plus markup equals operating profit divided by total costs. Total costs means everything: cost of services, selling expenses, general and administrative expenses. This is the “net” in net cost plus, and it is what distinguishes it from gross markup, which uses only direct costs as the denominator.
Why this indicator and not operating margin? Because intercompany service providers are compensated for what they spend plus a return. They do not set market prices. They do not bear significant commercial risk. Their profitability is a function of their cost base. Net cost plus markup captures that relationship directly. Operating margin (operating profit divided by revenue) is the right indicator for distributors, where revenue from third-party sales is the reference point. For a broader comparison, see our article on TNMM vs CPM.
The Cost Base Problem
The cost base is the denominator. Every error in defining it flows straight into the markup calculation. Three issues account for most of the problems we see.
Gross vs. net confusion. A company calculates its markup on direct service costs only (salaries, contractor fees, software licenses) and arrives at 15%. Its benchmarking study uses comparable companies measured on a net cost plus basis (total costs including SG&A) showing a range of 3% to 11%. The company concludes it is above the range and adjusts downward. But the comparison is meaningless, because the two numbers use different denominators. This sounds like a basic mistake. It shows up in professional studies more often than it should.
Cost allocations from the parent. Intercompany service providers often receive allocations for shared infrastructure: group IT, HR systems, facilities, legal. Whether these allocated costs sit inside or outside the cost base changes the markup materially. Consider a service entity with $8 million in direct operating costs and $2 million in parent allocations. If allocations are included, total costs are $10 million and a $700,000 profit equals 7% markup. If excluded, total costs are $8 million and the same profit equals 8.75%. The treatment must be consistent between the tested party and the comparables.
Stock-based compensation. Should SBC be part of the cost base? The question has real consequences. A technology services subsidiary with $10 million in cash operating costs and $3 million in SBC has a cost base of either $10 million or $13 million, depending on the treatment. At $700,000 operating profit, that is either 7.0% or 5.4% markup.
The IRS position, reinforced by Altera in the Ninth Circuit, is clear for cost-sharing arrangements: SBC is in. For TNMM/CPM services pricing, practice is less settled. What matters is consistency. If the tested party excludes SBC from its cost base while the comparables include it, the benchmarking comparison is distorted. Document the choice and apply it uniformly.
What the Ranges Actually Look Like
A question we hear often: “What is the right markup for intercompany services?” The answer is that there is no single right markup. Different services produce different ranges because they involve different levels of complexity, specialization, and risk.
From the studies in the CompPress library, which covers ten intercompany service profiles using FY 2022-2024 financials from SEC EDGAR and Financial Modeling Prep:
The North American Software Engineering Services study, covering custom application development, systems integration, cloud platform engineering, QA, and related functions (SIC code 7370 and others), produces a ballpark interquartile range of roughly 3% to 11% net cost plus markup.
Simpler, lower-risk functions like administrative support and basic business process services tend to cluster at the lower end. More complex, higher-value services tend to produce wider ranges that extend higher.
These figures illustrate why applying a blanket 5% markup to all intercompany services is a position that cannot be supported by a single benchmarking study. A group that charges 5% for both payroll processing and custom software development is undercharging on one and potentially overcharging on the other.
The One-Markup-Fits-All Problem
This deserves its own section because it is the most common structural error in intercompany service pricing.
A multinational group has a US subsidiary providing software engineering, IT infrastructure management, and administrative support to three affiliates. The group applies a 5% markup across the board, based on an advisor’s recommendation from years ago or a general understanding that “cost plus 5% is standard.”
There are three problems. First, the 5% is not based on a current benchmarking study, so it is an assertion, not a documented arm’s length price. Penalty protection in the US requires contemporaneous documentation. Second, each service has a different functional profile and produces a different arm’s length range. Software engineering is not the same as payroll processing. Third, when a tax authority benchmarks one of these services independently and finds the arm’s length range is 3% to 11%, a flat 5% for a complex service looks low, and the burden shifts to the taxpayer to justify it.
The fix is straightforward: benchmark each service category separately, or at minimum group services by functional similarity and benchmark each group. The CompPress library is structured around this: separate studies for each of the ten service profiles, so practitioners can match the benchmark to the function.
A Closing Note
Net cost plus markup is intuitive, widely accepted, and well-supported by available comparable data. It is the right PLI for the vast majority of intercompany services. The problems are never in the concept. They are in the denominator.
Frequently Asked Questions
What is the difference between gross markup and net cost plus markup?
Gross markup is calculated on direct costs (cost of goods sold or cost of services), while net cost plus markup is calculated on total costs, including operating expenses like SG&A. In transfer pricing, net cost plus markup is the standard measure under TNMM/CPM because it captures the full cost of providing the service. Using gross markup in a TNMM/CPM study is a common error that produces misleading results.
When should I use net cost plus markup instead of operating margin?
Net cost plus markup is the natural choice when the tested party is compensated for its costs plus a return: most intercompany service providers, contract manufacturers, and contract R&D entities. Operating margin is better suited for distributors and resellers where revenue is the primary reference point. The choice should follow from the functional analysis.
What is a typical arm's length markup for intercompany services?
It depends on the service type and risk profile. Simple administrative or back-office support functions typically fall at the lower end. More complex services like software engineering or contract R&D produce higher ranges. The range should be established through a proper benchmarking study, not assumed.
Should stock-based compensation be included in the cost base?
This is a contested area. The IRS position, reinforced by the Altera decision in the Ninth Circuit, is that stock-based compensation should be included in the cost base for cost-sharing arrangements. For services pricing under TNMM/CPM, the inclusion of SBC in the cost base increases total costs and therefore reduces the effective markup percentage. Practice varies, and the treatment should be documented.