All you need to know about the transactional net margin method

The transfer pricing methods can be categorised into traditional transaction methods (traditional methods – preferred methods) and transactional profit methods (profit methods – alternative methods).

Under the traditional methods, we can ascertain the transfer price by applying three different methods (CUP, RPM and cost-plus), which we have discussed in detail in our previous articles. There are two ways to establish the transfer price under the transactional profits methods, and the transactional net margin method (TNMM) is one of them, which has been covered in this article.

The TNMM examines the net profit relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction. The net profit indicators [ratio of net profit to an appropriate base (e.g., costs, sales, assets)] of the controlled transaction should be compared with the net profit indicators (NPIs) of the uncontrolled transaction.

Ideally, the NPIs of the controlled transaction should be the same as the NPIs of the uncontrolled transaction. Where the NPIs of the controlled transaction are different from the NPIs of the uncontrolled transaction, then an adjustment should be made in the controlled transaction price to arrive at the arm’s length price.

By following the general principle of comparability, the NPIs of the controlled transaction should be compared with the NPIs of transactions by the same supplier to any third party (internal comparables). Where this is impossible, the net margin that would have been earned in comparable transactions by an independent enterprise (external comparables) may serve as a guide.

The TNMM can be applied by applying the followings steps:

• Calculate the net profit (sales price less direct and indirect cost)

• Identify the NPIs of the controlled transaction [net profit/(costs, or sales, or assets)]

• Identify the NPIs of the comparable uncontrolled transaction or group of comparable uncontrolled transactions. While calculating the NPIs, the same base should be used, which has been used to calculate the NPI of the controlled transaction.

• Adjust the differences that could affect the net profit and NPIs in the open market

• Use the adjusted net profit to establish the arm’s length price

Let us discuss this scenario which will provide you with a comprehensive understanding of the TNMM. Skitters Ltd (a UAE-based company) has sold 50,000 bags of sugar to its German subsidiary (Placers Ltd) for Dh600,000 and Skitters Ltd sold 110,000 bags of sugar to its French client for Dh1.1million. The cost of production for each bag is material Dh5, labour Dh2, and overheads Dh2. It is the internal policy of the company that if the quantity of the order is more than 100,000 units, Skitters Ltd offers a discount of 1.5 per cent.

From the above example, we can calculate the net profit per bag for the controlled transaction (sales to Placers Ltd) is Dh3 (12-5-2-2), and NPI is 25 per cent (3/12*100), while NPI for the uncontrolled transaction (sales to French client) is 10 per cent (1/10*100). Since Placers Ltd placed an order of more than 100,000, so Placers Ltd had availed discount of 1.5 per cent. This needs adjustment, and the pre-discount adjusted NPI is 11.5 per cent (10 per cent+1.5 per cent).

Based on the adjusted NPI, the sales value of 50,000 bags to Placers Ltd would have been Dh508,474.58 instead of Dh600,000 at which goods are actually sold, and this will result in a profit of Dh58,474.58. The sales price of Dh508,474.58 has been calculated by grossing up the cost, which is 88.5 per cent (1-11.5 per cent).

The above transaction clearly shows that the group has sifted profits from high tax jurisdiction to low or no tax jurisdiction. Inflated sales prices by skitters Ltd have increased the purchase price of Pacers Ltd, which will reduce the taxable profits in Germany and increase the taxable profits in the UAE. Since the price is not at arm’s length, so this transaction will be adjusted by the tax authorities to tax the profits in the respective jurisdictions.

The TNMM can be applied to any type of transaction, and net margins are more tolerant to functional differences as compared to gross margins. Moreover, NPIs are less affected by transactional differences than is the case with price, as used in the CUP method.

Another practical strength of the TNMM is that, as with any one-sided method, it is necessary to examine a financial indicator for only one of the associated enterprises instead of all participants, as applicable in the profit split method.

There are also several weaknesses to the TNMM. The NPI of a taxpayer can be influenced by some factors that would either not have an effect or have a less substantial or direct effect on the price or gross margins between independent parties. The application of any arm’s length method requires information on uncontrolled transactions that may not be available at the time of the controlled transactions. There may also be difficulties in determining an appropriate corresponding adjustment when applying the transactional net margin method, particularly where it is impossible to work back to a transfer price.

While using the TNMM, businesses should be very careful, and they need to make sure the same basis has been used to calculate the NPI of the controlled transaction and uncontrolled transaction. Moreover, businesses should prefer the traditional methods, and if, due to some limitations, traditional methods can not be applied, then TNMM should be used.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax and OECD transfer pricing guidelines. For any queries/clarifications, please write to him at compliance@kresscooper.com