Under a cost-plus arrangement the Indian company's service fee equals its operating costs of providing the service plus an agreed markup. For Indian transfer pricing the cost base is all operating expenses — employee cost including share-based payment charges, premises, depreciation, software, travel and allocated overheads — and excludes interest, income-tax, foreign-exchange differences and genuine pass-through costs on which the Indian company performs no function and bears no risk. The markup is applied to the base, not to pass-throughs; the 15.5% safe harbour in Rules 86 to 102 of the Income-tax Rules, 2026 is defined on exactly this basis (operating profit over operating expenses), so an agreement drafted on these lines is safe-harbour-ready.
Key facts
| Provision | Old reference (to 31 Mar 2026) | New reference (from 1 Apr 2026) | Rate / threshold | Timing | Form |
|---|---|---|---|---|---|
| Operating expense / operating revenue definitions | Rule 10TA | Rules 86–102 (definitions) | Excludes interest, tax, provisions for bad debts, extraordinary items, pass-throughs | — | — |
| Safe harbour IT services margin | 17%–24% | 15.5% on operating expenses | ≤ ₹2,000 crore | Five-year block | Form 49 |
| TNMM profit level indicator for service providers | Rule 10B(1)(e) | Rule 79 | Operating profit / operating cost | — | — |
| GST — pure agent reimbursements excluded from value | Rule 33 CGST Rules | Unchanged | Conditions: acts as pure agent, no title, no markup, separately indicated | Each invoice | — |
| GST — credit notes for downward true-up | s. 34 CGST Act | Unchanged | — | By 30 November following FY or annual return, whichever earlier | GSTR-1 |
Building the cost base
The base should be defined by reference to the Indian company's books, not to a management view of "project cost". A workable definition:
| Category | In the base? | Notes |
|---|---|---|
| Salaries, wages, bonus, gratuity and leave provisions, employer PF/ESI, insurance | Yes | Include year-end bonus accruals — a common cause of margin drift. |
| Share-based payment charge for parent-company options granted to Indian employees | Yes, if the cost is recharged by the parent or booked in India | If the parent bears it and does not recharge, state so expressly; the department may still question it. |
| Rent, utilities, facility management, security | Yes | — |
| Depreciation and amortisation | Yes | On the Indian company's own assets. Excluding it understates the base. |
| Software licences, cloud used by the Indian team | Yes | Distinguish from cloud consumed by the parent's products (see pass-through). |
| Travel, recruitment, training, communication | Yes | — |
| Professional fees (audit, tax, legal, payroll) | Yes | — |
| Allocated head-office or shared costs borne by the Indian company | Yes | With a documented allocation key. |
| Interest, bank charges on borrowings | No | Non-operating. |
| Income-tax, deferred tax | No | — |
| Foreign-exchange gain or loss | No (for the markup base) | Treated as non-operating in safe harbour definitions; benchmarking studies generally align. |
| Provision for doubtful debts, loss on sale of assets, extraordinary items | No | — |
| Pass-through costs | No — recharged at cost | See below. |
What qualifies as pass-through
A cost is pass-through only where the Indian company (a) incurs it on the Principal's instruction, (b) for the Principal's direct benefit, (c) performs no significant function in relation to it beyond paying and recharging, and (d) bears no risk — it is reimbursed whether or not the underlying item is useful. Examples: third-party cloud capacity consumed by the parent's production systems but billed to the Indian entity for procurement convenience; a software licence specified by the parent for the parent's product; a contractor engaged on the parent's instruction and managed by the parent. Counter-examples: the Indian team's own laptops and tools, recruitment fees for Indian hires, the Indian office's internet — these are the Indian company's own costs of doing its job and belong in the base.
For GST, the same items should meet the pure agent conditions of Rule 33 of the CGST Rules if they are to be excluded from the value of the export supply: the Indian company acts as a pure agent, does not hold title, does not use the goods or services for its own interest, recovers only the actual amount and shows it separately on the invoice. Where the pure-agent conditions are not met, the reimbursement forms part of the value of the service — which for an export under LUT is still zero-rated, but the treatment should be consistent across the transfer pricing file, the GST returns and the FEMA purpose code.
Applying the markup
Service fee for the period = (Operating costs for the period) × (1 + markup). Pass-through costs are added below the line at cost. The markup percentage is set annually: by reference to a benchmarking study, or at not less than 15.5% if the company is in the IT services safe harbour. Where monthly invoices are raised on budget, the true-up at year end recomputes the fee on actual costs and raises the difference.
Keeping the margin where the agreement says it is
The booked margin in the statutory accounts is what the TPO tests. Three controls keep it on target: (1) monthly management accounts that compute OP/OC on the agreed definition; (2) a quarterly review that adjusts the budget invoice if the margin is drifting; (3) a hard true-up before the books close, with the credit note or supplementary invoice issued inside the GST window. If the parent's accounting calendar makes an April invoice difficult, agree a provisional true-up in March and a final adjustment in the first quarter of the following year.
Worked example
Indian subsidiary, tax year 2026-27, agreed markup 15.5% (safe harbour elected).
| Line | ₹ lakh |
|---|---|
| Employee cost incl. bonus accrual and PF | 1,840 |
| Share-based payment charge (recharged by parent) | 95 |
| Rent, utilities, facilities | 210 |
| Depreciation | 88 |
| Software, communication, travel, recruitment, professional fees | 167 |
| Operating cost base | 2,400 |
| Markup at 15.5% | 372 |
| Service fee | 2,772 |
| Pass-through: production cloud capacity contracted at parent's direction (at cost, separately itemised, pure-agent conditions met) | 140 |
| Total invoiced | 2,912 |
| Excluded from base: forex loss 12; interest 3; income-tax 94 | — |
Operating profit ÷ operating expenses = 372 ÷ 2,400 = 15.5%, matching the Form 49 declaration. Had the ₹140 lakh of cloud cost been left in the base, the fee would have risen by ₹21.7 lakh and the parent would have paid a markup on its own infrastructure; had the ₹95 lakh ESOP charge been left out, the booked margin would have fallen to about 14.9% and the safe harbour condition would have failed.
Common mistakes we see
- Marking up pass-through costs 'for simplicity', which inflates Indian income and invites questions from the parent's tax authority.
- Excluding ESOP charges or depreciation from the base, producing a booked margin below the agreed percentage.
- Computing the markup on budget and never truing-up to actual, so the agreement says 15.5% and the accounts show 11%.
- Treating ordinary Indian operating costs (laptops, local software, recruitment) as pass-through because the parent 'approved' them.
- Netting foreign-exchange gains into operating revenue to lift the margin — the safe harbour definitions treat forex as non-operating.
- Issuing the year-end credit note after the GST section 34 cut-off, so the GST return and the books disagree.
Frequently asked questions
Should the markup apply to pass-through costs?
No. Pass-throughs are recharged at cost. Applying a markup converts them into operating revenue and overstates the service fee.
Are ESOP costs part of the cost base?
If the cost is booked in the Indian company or recharged to it by the parent, yes — it is an employee cost of providing the service. If the parent bears it without recharge, document that position expressly.
Is depreciation included?
Yes. The safe harbour definition of operating expenses includes depreciation and amortisation, and benchmarking studies compute comparables' margins after depreciation.
What about foreign-exchange gains and losses?
Excluded from both operating cost and operating revenue for the markup computation under the safe harbour definitions; most benchmarking studies follow the same approach.
How often should the fee be trued-up?
At least annually before the books close, with the credit note or supplementary invoice issued within the GST window. Quarterly reviews reduce the size of the year-end adjustment.
Can the cost base be defined as 'total expenses per the audited accounts'?
It is a reasonable starting point but should be refined to exclude interest, tax, forex and pass-throughs, and to add any cost borne by the parent that should be in the base.
Sources
Primary sources only. Statutory text is read from the official publication; where a provision has been renumbered, the pre-2026 reference is given alongside so older material can be reconciled.
- Income-tax Act, 2025 and Income-tax Rules, 2026 — Income Tax Department, Tax Laws & Rules
- CGST Act, IGST Act, CGST Rules and GST circulars — CBIC
- e-Gazette of India — Finance Act, 2026; Income-tax Rules, 2026; FEMA notifications
Last reviewed on 1 November 2026 by Vidushi Jhunjhunwala, FCA, VMS Jhunjhunwala & Co. Law stated as at that date; the Income-tax Act, 2025 and Income-tax Rules, 2026 apply from 1 April 2026.
