The TNMM assesses the net profit in relation to a suitable base
By Mahar Afzal/Compliance Corner
Under the transactional profit methods, there are two approaches to establish the arm’s length price, with the transactional net margin method (TNMM) being one of them. The TNMM has been explained in detail in the guidelines issued by the Organisation for Economic Cooperation and Development (OECD) and given in the transfer pricing guideline (CTGTP1) issued by the Federal Tax Authority (FTA).
The TNMM assesses the net profit in relation to a suitable base such as costs, sales, or assets that a taxpayer gains from a controlled transaction. The net profit indicators (NPIs), which are the ratios of net profit to an appropriate base, of the controlled transaction need to be compared with those of the uncontrolled transaction. Ideally, the NPIs of the controlled transaction should align with those of the uncontrolled transaction. If there are disparities between the NPIs of the controlled and uncontrolled transactions, an adjustment to the controlled transaction price is necessary to establish an arm’s length price.
Adhering to the overarching principle of comparability, the NPIs of the controlled transaction should be determined with the NPIs of transactions conducted by the same supplier or one of the related persons or connected persons with third parties (internal comparable). If this proves unfeasible, the net margin that an independent enterprise has achieved in comparable transactions (external comparable) can be used to determine the net profit margin.
The TNMM can be applied by computing the net profit (sales price minus direct and indirect costs), determining the NPIs of the controlled transaction (net profit divided by costs, sales, or assets) and comparable uncontrolled transaction. When computing the NPIs, it’s important to use the same base that was employed for calculating the NPI of the controlled transaction. Any variances that might impact the net profit and NPIs in the open market should be adjusted, and the adjusted net profit should be used to establish the arm’s length price.
It is highly recommended that the TNMM should be applied at the transactional level, but there is harm in applying at the company level where in each product lines similar functions are being performed.
Functional analysis is very important to ascertain the net profit margin. Operative expenses are based on the functions performed. More functions mean higher operative expenses and less functions means lower operative expenses. Moreover, while applying the TNMM, the selection of denominator is based on the functions performed, risk taken, and assets utilised. For example, sales may be an appropriate base for distribution activities, full costs or operating expenses may be an appropriate base for a service or manufacturing activity, and operating assets may be an appropriate base for capital-intensive activities such as certain manufacturing activities.
The TNMM is suitable for application to various transaction types. Net margins can accommodate functional differences to a greater extent when compared to gross margins. NPIs are less influenced by transactional disparities than the price aspect in the CUP method. Additionally, a practical advantage of the TNMM is that, like other one-sided methods, it requires the examination of a financial indicator for only one of the involved enterprises, rather than all participants, as is the case with the profit split method.
The TNMM also has several shortcomings. The NPI of a taxpayer can be impacted by certain factors that might not affect the price or gross margins between independent parties or could have a less significant or direct impact. Utilising any arm’s length method necessitates data on uncontrolled transactions, which may not be accessible at the time of the controlled transactions. Additionally, challenges may arise in establishing a suitable corresponding adjustment when employing the transactional net margin method, particularly in situations where deriving a transfer price is unfeasible.
When employing the TNMM, businesses must exercise caution and ensure that the same basis is employed when calculating the NPI for both the controlled and uncontrolled transactions. Furthermore, businesses should prioritise the traditional methods, resorting to the TNMM only if traditional methods cannot be applied due to certain limitations.
Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official opinion of Khaleej Times but an opinion of the writer. For any queries/clarifications, please contact him at [email protected].