Transactional Net Margin Method (TNMM): A case study for a distribution company

Introduction

The Transfer Pricing (TP) rules were introduced to regulate the transactions executed between related companies. The effective TP framework is of main interest in cases where the related parties are established in different states or jurisdictions. In such cases, the various corporate tax rates and regimes, in general, may motivate multinational groups for profit shifting resulting in erosion of tax base. The arm’s length principle (the main concept behind TP regulations) is consistently reviewed using at least one method as suggested by OECD TP Guidelines (Comparable Uncontrolled Price – CUP method, Resale Price Method – RPM, Cost Plus Method – CPM, Transactional Net Margin Method – TNMM and Profit Split Method – PSM).

The scope of this article is to elaborate on the selection procedure and concludes that this process resulted in the selection of TNMM. Therefore, a case study is developed to provide details on the application of this method, under actual conditions.

 

Short description of TNMM

Under the TNMM, the level of operating profit generated from a controlled transaction is compared to the operating profit generated by independent companies which enter into comparable transactions. Most of the times, operating profit is not as closely dependent on price as happens with gross profit on cost or sales. Therefore, the calculation of arm’s length price using the TNMM is relatively indirect compared with the traditional transaction methods (CUP, RPM and CPM). In more detail, the level of operating profit may be affected by any difference in functions performed by the parties of transactions. However, it is generally assumed that this difference is, in some extent, reflected to operating costs (sales expenses, administrative expenses etc.). So, regardless there exists a substantial difference in the level of gross profit on sales, the operating profit level balances and an ‘accurate’ profit adjustment may be unnecessary.

It is noted that some qualitative factors, such as the management efficiency of management, may affect more intensively the level of operating margin than the gross margin on cost or sales. These factors shall be taken into account when examining the application of the TNMM. To sum up, the TNMM results are robust and do not fluctuate substantively, in cases that there are small differences in functions performed by associated and independent companies. On the other hand, traditional transaction methods provide unreliable results when such function divergences exist.

 

Case study

Assumptions

Consider that company A manufactures product x, using original technology developed by its R&D department. Company A is also responsible for defining marketing strategies including original advertising and sales promotion activities concerning the manufactured product x. Company A established a 100% subsidiary (company B) in Country U, which is in charge of distributing x in that country. More specifically, company B purchases product x from its parent company (A) maintaining a sufficient stock and sells it to several third-party agents in country U in line with the group’s sales plan.  

Functional analysis – determination of tested party

The rational for the determination of the tested party shall be developed. In more detail, company B engages only in the sales of products and obviously performs simpler and previously defined functions. Company A undertakes manufacturing, R&D and marketing activities directly or appointing third-party providers. Therefore, the adoption of company B as the tested party is considered more appropriate.

Method selection process

The selection of the appropriate method requires initially an analysis of the functions performed and the risks assumed by the related parties. Then, specific factors are taken under consideration as listed below:

  • Pros and cons of each arm’s length price calculation method,
  • Adequateness of each method to the nature of controlled transaction in line with the business activities undertaken by the associated enterprises
  • Availability of the necessary data/information for the application of each method of calculation,
  • Similarity/comparability between controlled transactions and transactions carried out between independent firms.

Examining the transactions executed by both related companies and taking under consideration that company B is the sole distributor of product x in country U, it is impossible to find internal comparable transactions. In addition, x is unique, created using internal R&D technology. So, there are not external comparable prices from available and reliable sources enabling the application of the CUP method.

Company B is not in charge of conducting original advertisement and marketing activities for the promotion of product x. As a result, company B does not offer unique and valuable contribution upon the determination of the product price. The measurement of sales cost and gross profit usually depends on the accounting practices and principles adopted by each company. Moreover, such potential external comparable data cannot be retrieved from accessible databases in country U. Therefore, an accurate adjustment of gross profit cannot be obtained in order to use external comparable gross margins for the application of RPM or CPM.

As for the TNMM, external comparable information on operating profits can be found from open accessible or subscription databases. The comparability analysis revealed that the value of functions performed by company B is highly connected to the sales level, instead of the operating costs. So, an operating profit ratio can be used as a reliable indicator for reviewing the arm’s length principle.

The PSM is rejected because it is often used in cases of cross-border controlled transactions, highly integrated, related to global trading or joint ventures. The activities of the tested party (company B) do not match this type of business.

Application of TNMM

The existence of small differences in functions performed by related and independent companies does not affect the operating profit ratios and the reliability of TNMM. However, in the case where the principle function under evaluation differs significantly, the calculation of the profit indicator is normally affected. The profit level indicators used in the case of application of the TNMM include:

  • The operating margin on sales (operating profit / sales). This indicator is deemed as appropriate if the value of functions undertaken by the associated buyer of inventories is recognized to be correlated with the sales level.
  • The operating margin on total costs (operating profit / sales). This indicator examines the controlled transactions from the selling side and it presumes that the functions performed by the buyer are not reflected on the operating costs.
  • The gross margin on operating expenses. This method is suitable for cases where the intra-group transaction is related with the operating costs but not substantially affected by the sold product’s value.

The selection of the profit indicator bases on the results of comparability analysis in combination with the assets used and risks assumed by the tested party. In more detail, the selected indicator shall exactly represent the value of the function performed.  In this context, the first ratio (operating margin on sales) is usually selected by reselling companies, the second indicator is used by manufacturing or sales companies and the third ratio corresponds to functions performed by intermediary agents or service providers.

Regarding the tested party of our case (company B), the operating margin on sales ratio provides consistent results and contributes to the review of the arm’s length principle. The same ratio is calculated for the final set of comparable transactions[1] or companies. It is noted that interests earned, interest paid, corporate tax and extraordinary profits/losses are generally excluded when determining the corporate operating profits.

If the comparable data form a wide range of ratio’s values, then, statistical tools (such as quartile function) are applied in order to exclude outliers. If the operating margin on sales of company B approximates the corresponding profit margin of comparable independent companies, the pricing policy adopted and the controlled transactions are considered as consistent with the arm’s length principle. Otherwise, an adjustment of taxable profits and a re-design of the pricing policy are indispensible.

 

Conclusion

The TNMM is usually selected by multinational enterprises (MNEs) because:

  • It is not significantly affected by accounting standards adopted by comparable companies.
  • It is a one-side method, so the ratio is examined for only one related party entering into the controlled transactions.
  • It is flexible given that several indicators can be used on the basis of the functions performed by the tested party.
  • The calculations are simple and in line with well-known ratios developed at the financial analysis field.
  • It may provide robust results despite minor differences in functions performed and risks assumed by associated and independent companies.

However, under the OECD Guidelines, the TNMM is relatively indirect compared with traditional transaction methods. Therefore, the rejection process of CUP, RPM and CPM shall be justified accordingly.

 

 

[1] The final set of comparables is defined after the implementation of bulk and special rejection filters to the set of potential comparable transactions.