Transactional Net Margin Method

The transactional net margin method (TNMM) is a transfer pricing technique in which the net profit margin is examined in relation to a proper base or derivative, such as assets, sales, or costs obtained from a bounded transaction by a taxpayer. It ensures that inter-business transactions are conducted at market rate.

It has applications in every transaction type as the net margins have been highly tolerant to functional discrepancies in contrast with gross margins. It allows evaluation of arm's length characteristics of controlled transactions amongst comparable firms. It comes in handy when the direct contrast of complex transactions becomes challenging.

The transactional net margin method refers to a profit-reliant method mostly used to apply the principle of arm's length applied by or to any concerned party. OECD transactional net margin method of accounting has been one of the 5 commonly used transfer pricing techniques as per Organization for Economic Cooperation and Development (OECD) guidelines. It basically comprises a contrasting net profit margin obtained from testing parties commonly subsidiaries with that of comparable autonomous companies. 

Then, the comparison between the participant companies takes place based on profit level indicators or PLIs like operating profit to sales ratio. Actually, the TNMM approach determines whether the cost-plus fulfills the criteria of arm's length using profit indicators. Therefore, if one has to conduct the TNMM, then the detailed method shown below must be used:

• First, identify and select a few potentially comparable firms.
• Next, rank these firms in ascending order.
• Then, remove the outlier companies from the top and bottom of the list.
• After that, the remaining companies in the middle become in the arm's length range.
• After the examination, if the profit margin of the tested party falls inside the arm's length range 
• Finally, it indicates the correctness of the method.

TNMM's flexibility and accessibility to financial data make it widely used for benchmarking. It has been one of the trusted methods used in different inter-company transactions in the absence of finding any direct comparable. Minor transactional discrepancies affect TNMM to a lesser extent and depend mostly on external financial records, allowing its execution much more easily than other techniques.

It helps companies comply with the principle of arm's length, leading to risk mitigation from penalties and tax adjustments. It also facilitates the alignment of transfer pricing policies with global standards for multinational companies. As a result, it promotes transparency and fairness in cross-border trade transactions globally. 

It has two main elements, net cost-plus margin and net resale minus margin, which are useful in comparable uncontrolled transactions with controlled transactions of the profit margin. It becomes vital in the absence of finding any direct comparable using the below components:

#1 - Net Cost-Plus Margin

In practice, it is commonly used for companies involved in service provision or manufacturing activities. It operates as shown below:

• The percentage of costs is used to calculate the net profit.
• It is mostly employed when the tester party turns out to be a service provider or manufacturer.
• It has the formula = operating profit / total cost.

Operating cost is Earnings before interest and taxes (EBIT), and total cost means indirect and direct operational costs excluding extraordinary items. 

Internal Revenue Service (IRS) states that the term remains widely used in TNMM in 84% of cases of intangible and tangible property transfers.

#2 - Net Resale Minus Margin

Most of the businesses engaged in distribution activities use this approach as per the below method of application:

• The percentage of sales forms the basis of net profit calculation.
• Applied in case the tester party is a distributor or engaged in sales activities.
• Its formula = EBIT / Turnover is used to measure a company's return on sales.

It eliminates discrepancies coming out of sales categorization within sales revenue or miscellaneous revenue during comparison.

Both methods should be cautiously used when selecting comparable firms, and proper adjustments should be made to ascertain the reliability of each method.

Let us use a few examples to understand the topic.

Example #1

An online article published on 10 Jun 2024 discusses the wrong decision taken by the Irish Tax Appeals Commission concerning employee stock options transfer pricing treatment. Here, case no. 59TACD2024 entailed conflict between unknown domestic subsidiaries of an international software development multinational company and Irish revenue commissioners. Further, both parties involved in the dispute agreed to use TNMM as the sole method related to transfer pricing. 

Nevertheless, the issue pertaining to the structure or services cost-base remained. Moreover, the revenue commissioners stressfully argued in favor of charging stock options to the parent firm with an extra 10% markup. In contrast, the taxpayer insisted that the economic cost attached to the parent firm must be removed from the cost base.

Example #2

Let us assume that Sun Traders Inc. of Old York purchases and supplies mobile phones to its subsidiary, Lukas Phones, in Canada. Both decided to assess if the transfer price translates into fair market value or arm's length. Hence, for this purpose, the accounts team comes together and compares the net profit margin of syn traders upon mobile sales to similar companies. 

Further, Sun Traders' net profit margin is 14%, which is calculated as net profit /sales. After thorough research, the team found that the three phone distributors in areas A, B, and C have net profit margins of 10%, 13%, and 15%, respectively, on comparable mobile sales. Hence, the team concluded that Sun Traders' net profit margin of 14% fell within the acceptable market range of 10-15%, making the TNMM likely at arm's length.

Let us use the listicle below to understand TNMM's advantages:

• It is not affected by differences in transactions as much as it is by the price utilized in the CUP method.
• It can be easily implemented as it depends on external financial records by using numerous sources of public data. 
• It becomes highly effective in covering transactions comprising the inter-business sales of items or the offering of inert-business services.
• It has been less sensitive about discrepancies amongst comparable transactions.