The first foreign subsidiary of a small US company: cost-plus transfer pricing, the markup tax offices accept and the yearly paperwork

A US software company hires its first developers in India, Poland or the Philippines, and at some point an accountant says the team should sit in a local subsidiary. Setting the company up is the easy part. The part that arrives every year afterwards is a question the two tax offices will both ask: what does the subsidiary charge the parent for the work, and can you show the price is one a stranger would have paid?

This piece starts after the subsidiary exists. (Our article on hiring a developer in another country covers the earlier choice between a contractor, an employer of record and your own entity.) It explains why a service subsidiary bills the parent its costs plus a markup, what the three countries publish about that markup, the US form that carries a $10,000 penalty, and a full year for a five-person subsidiary with the numbers.

A note on how sure the figures are. Tax rules in these three countries changed in 2025 and 2026, and some of what we found is still draft or described only by advisers. Where that is so, the text says it. This is a guide to the questions, not tax advice for your case.

Why the subsidiary bills cost plus

A subsidiary whose five employees build the parent's product has no customers of its own, owns no code (the parent does), and carries no market risk: if the product fails, the parent loses money and the subsidiary still has a contract. Tax offices call that a routine service provider, and the accepted way to pay a routine service provider is its total costs plus a modest profit. The markup is the subsidiary's entire profit, so it is also the amount the foreign country taxes.

Two offices pull in opposite directions. The country where the subsidiary sits wants the profit high enough to tax. The US wants the parent's deduction for what it pays to be no larger than what an unrelated company would pay. The US rule is section 482 of the Internal Revenue Code: prices between related companies must be at arm's length, and the regulations (Treas. Reg. 1.482-1) test a price against a range of results from comparable companies. If your result sits inside the range, no adjustment; if it sits outside, the IRS can move it to the median.

One shortcut does not apply to you. The US services cost method lets a parent charge a subsidiary cost with no markup, but only for services listed in an IRS revenue procedure or whose comparable median markup is 7% or less, and the regulation's list of excluded activities includes research, development or experimentation and engineering (2012 edition of Treas. Reg. 1.482-9; check the current text). A subsidiary writing software for the parent's own product is a poor fit for no-markup billing.

So the work is: pick a markup the local office accepts, put it in a written intercompany agreement, bill on it, true it up at year end, and keep the file that supports it.

What the three countries publish about the markup

India is the only one of the three with a published number for development work, and it is an operating margin on operating expenses, which is what most small subsidiaries mean by cost plus. The 15.5% figure comes from the Union Budget 2026 and the CBDT's draft Income-tax Rules, 2026 (KPMG reported the draft in February 2026: the four IT sub-categories merged, the 17% to 24% range replaced by 15.5%, the eligibility ceiling raised from INR 300 crore to INR 2,000 crore, and a five-year validity). Advisers' summaries since then describe it as in force from tax year 2026-27, but we did not find the notified rule text, so check it before you rely on it. For FY 2025-26, the old rules still apply.

Poland is the trap. The 5% safe harbour is real, but it is for ordinary support services (accounting, audit, finance, HR, IT, legal, tax) that a Polish company receives from a related party, as Garrigues described the rules when they were introduced in 2019; the list is closed. A Polish subsidiary that builds your product is providing core services to its parent, not receiving low value-adding ones, so do not assume 5% covers it. Poland also makes the paperwork depend on size, below.

The Philippines offers no shortcut, and the tax office has a second question beside the price: where foreign-parent staff work in the country for long periods, the BIR can argue the parent has a permanent establishment there. Keep managers, contracts and decisions with the parent's own people in the parent's own country, and keep the Philippine staff under the subsidiary's direction.

For the markup itself, where no safe harbour exists, practitioners build a benchmark: a set of independent companies that do similar work, with the median and interquartile range of their profit on total costs. We found no published table of those ranges for small software service providers, and no published price for a benchmarking study, so a figure you may hear quoted (10% to 20% on total costs) is a rule of thumb, not a source. Ask whoever prepares the study for the range and the database it came from, and write the markup in the agreement as a fixed percentage inside that range.

The US form: 5471 and the $10,000

A US company, or a US person, that owns more than half of a foreign corporation is a category 4 filer of IRS Form 5471; a US shareholder with at least 10% of a controlled foreign corporation is a category 5 filer. A US parent with a 100% owned subsidiary files in both. The form goes in with the parent's own income tax return, by that return's due date including extensions (Instructions for Form 5471, revised December 2025).

The form asks for the subsidiary's balance sheet and income statement, its shareholders, and (Schedule M, for category 4 filers) the transactions between the corporation and its US owner, which is where the service fees you charged show up. That is why the transfer-pricing work and the form are really one job: the invoices in your books must match the amounts on Schedule M and the amounts in the subsidiary's local accounts.

A late form is the usual way to get the penalty, and a first-year company that did not know it had to file is the usual case. Treat the cost of preparing the form as part of the price of having a subsidiary. Our worked year below assumes $2,500 for a preparer, an estimate, against $10,000 for a missed form.

A worked year: five people in India

Our example is a subsidiary with one team lead and four developers in India, working only for the US parent. The salary and office figures are our assumptions for a mid-sized Indian city, chosen to make the arithmetic readable, not benchmarks. The markup is India's 15.5% safe harbour. Tax is India's base 22% corporate rate with 10% surcharge and 4% cess, 25.17% (our arithmetic from the statutory rates).

Now the year-end true-up. Suppose the team replaced two laptops early and the actual costs came to $198,000, not the budgeted $190,760. The agreement says the markup applies to actual costs, so the year should have been billed at $198,000 x 1.155 = $228,690. Twelve monthly invoices of $18,361 added up to $220,328, so the subsidiary sends one more invoice for $8,362 before the books close. Without it, the subsidiary earns less than 15.5% on its costs, which is exactly what an Indian assessing officer looks for.

And what each wrong turn costs on the original budget:

There is also a small cost to the group in billing at the higher markup. The parent deducts the $29,568 at the US federal rate of 21%, a saving of $6,209, while India taxes it at 25.17%, $7,442. The group pays about $1,233 more in tax a year for each such markup, before the US tax on the subsidiary's income to its owner (which we have not worked out here). That is a reason to stay at the low end of an accepted range, not to drop to zero.

Where the rules differ: do you even need the report?

The paperwork follows size. In Poland and the Philippines a five-person subsidiary may sit under the documentation thresholds; in India it does not.

The conversions are ours, at 3.7 zloty and 58 pesos to the dollar; use the rate of the day. Two cautions on the thresholds. The Polish test is per kind of transaction and is measured on both cost and revenue sides, so a subsidiary that buys services from the parent as well as selling them can cross it sooner. And the Philippine thresholds are from RR 34-2020 and RMC 54-2021 as summarised by Grant Thornton for the 2025 tax year; if the subsidiary was documented the year before, the next year is documented too.

Below the threshold you still need to be able to defend the price. Keep the intercompany agreement, the monthly invoices and a one-page note saying why the markup is what it is. The point of that page is that it exists before anyone asks.

The year's calendar for the first subsidiary

Most of the cost is not in the filings, it is in doing the monthly invoice and the true-up on time. A subsidiary billed at a rounded monthly number for two years, with no true-up, is where adjustments come from.

What to decide before the first hire

1. The markup rule. In India, opt in to the safe harbour if the final rules confirm 15.5%. In Poland and the Philippines, ask for a benchmark and write the percentage into the agreement.

2. Who owns the code. The employees assign their work to the parent through the subsidiary; the agreement says so. A subsidiary that owns the code is no longer a routine service provider and its profit should be larger.

3. The form. Put Form 5471 on the calendar with the parent's own return and decide who prepares it before the subsidiary's first year ends.

4. The size check. Each year, compare the subsidiary's billing with the local thresholds; the day it crosses one, the paperwork changes.

5. Permanent establishment. Keep decisions and managers with the parent's staff in the parent's country.

If you are also deciding where the company itself should sit, our guide to a US LLC for a founder abroad covers the yearly filings on the US side of a foreign-owned company, the mirror image of this one.

Sources

IRS: Instructions for Form 5471 (revised December 2025: categories 4 and 5, due date, section 6038 penalties, foreign tax credit reduction, Schedule M); IRS: International information reporting penalties ($10,000, $10,000 per 30 days after 90, $50,000 maximum); 26 CFR 1.482-9 on Cornell LII and the 2012 CFR edition (services cost method, 7% low margin test, excluded activities); KPMG: India draft rules amending the transfer pricing safe harbor regime (February 2026: 15.5%, INR 2,000 crore, five years, draft); Taxguru: Budget 2026 transfer pricing (20 February 2026: proposed margin, graded fee); ClearTax: Section 92E and MBG: transfer pricing timelines and penalties (Form 3CEB, 31 October, Rs 1 lakh under 271BA); getsix: transfer pricing in Poland, thresholds, limits and documentation 2025 (PLN 2,000,000 and 500,000, deadlines, 720 daily rates); Garrigues: changes to Polish transfer pricing regulations 2019 (5% on low value-adding services, listed services); Grant Thornton Philippines: transfer pricing compliance guide (Form 1709, P15 million, P150 million and P90 million, 15 April, P1,000); KPMG Philippines: transfer pricing requirements (local comparables, no materiality limit on the form); Triple i Consulting: transfer pricing in the Philippines (permanent establishment risk). Read 8 November 2026. The salary and office figures, the $2,500 preparer fee, the exchange rates and the 25.17% Indian rate are our own assumptions and arithmetic, and are labelled so in the text. This article is general information, not tax advice.