Navigating Transfer Pricing Methods – Part 3


Transactional Profit Methods

The Transactional Net Margin Method (TNMM): Net Margin data derived from uncontrolled transactions. TNMM examines the net profit relative to an appropriate base like costs (Net Profit return to Costs), sales (Net Profit return to Sales), or assets (Net Profit Return to Assets).

It operates like a cost plus or resale minus, except that a return to the tested party is established or tested by net profit margin indicator (“NPI”) for the controlled transaction with the same NPI for comparable uncontrolled transactions.

The NPI should be established by reference to external comparable where internal ones are not available and a functional analysis is required for comparability and necessary adjustments. While TNMM is not reliable if each party makes valuable, unique, contributions, a total lack of such contributions does not automatically make it the most appropriate method.

In comparison to methods that uses gross profit data, net profit data is less likely to be subject to distortion arising from differences in accounting practices. It is also because of there is more availability of reliable net profit data compared to than gross profit data, especially where commercial databases are used.

Something to note is that NPIs can be directly influenced by the threat of new competitors or products, management efficiency, cost of capital and business experience.

A closer look at each NPIs should form as a guidance in applying the TNMM. They include but not limited to;

  • Net Profit Return to sales: Net profit over sales is often used when deciding the prices of products being purchased from a related party. The sales used should only be those of the related party products being purchased, unless the unrelated party purchases are insignificant. Additionally, any sales rebates and discounts should be taken into account when calculating the sales revenue.
  • Net Profit Return to Costs: Under this indicator, costs should only be considered when they reflect the value of the functions, assets, and risks associated with a transaction. Specifically, only the costs incurred in the actual transaction should be considered, such as direct costs, indirect costs, and overhead that has been allocated to the transaction. Therefore, when determining the costs of a project, it should be done in the same way that an independent third party would do it. The costs should be based on actual costs, standard costs, or budgets, but there should be safeguards in place if the budget varies from actual numbers. Comparability should also be considered so that it is known what the comparable cost is.
  • Net Profit Return to Assets: When a company has assets (such as land, inventory, trade receivables, etc.) that have added value, such as in manufacturing or other asset-intensive activities, those assets can be used to measure the company’s worth. However, only the operating assets (tangible and intangible assets) should be used in the calculation.
  • Barry Ratios (BRs): BRs are gross profits over operating expenses. Interest is generally excluded and depreciation included in operating expenses, depending on the circumstances (OECD Para. 2.106). BRs are appropriate where the value of functions is proportional to operating expenses and not to sales, and where the taxpayer does not perform other significant functions.

They can still prove useful if taxpayers both buy from and sell to related parties: cost plus does not work here, as the provider is a related party and resale minus does not work, as the buyer is related: operating expenses are typically unaffected by related party transactions, unless they contain material related party charges (e.g., management fees).

Therefore, when applying the cost-plus method, the following steps should form as a guide;

  • Have we excluded the applicability of traditional transfer pricing methods?
    • If yes, then you should document your reason just as before.
    • If no or unsure, then note that TNMM is not different from the traditional transfer pricing methods and utilizing it with other methods is appropriate.
  • Are we able to identify the tested party performing routine functions?
    • If yes, then establish the most vital precondition for applying the TNMM as the most appropriate method.
    • If no, then you will need to consider applying the two methods as well devoting additional effort to document the arm’s length consideration made by both parties.
  • Can we identify sufficiently reliable data for the comparability analysis?
    • If yes, you will need to provide a detailed documentation on the search process.
    • If no or maybe, then you need to cope with the situation as best as possible. Confirm that you are 100% sure of your functional analysis. OECD para.3.39 “even in cases where comparable data are scarce and imperfect, the selection of the most appropriate transfer pricing method should be consistent with the functional analysis of the parties”.

In conclusion, the bottom line for the TNMM section is simple: You need to actively monitor the net margins of the routine entities within your group if you want to minimize transfer pricing-related tax risks.

Author: Eddie Opiyo