Application of the Transactional Net Margin Method in transfer pricing analysis

One of the main difficulties in the application of the transfer pricing methods to evaluate compliance with the arm’s length principle is the availability of comparable transactions.  In the absence of internal comparable transactions, usually the method used is the Transactional Net Margin Method (TNMM), which was initially considered a last resort method, although in practice, it was the method used in 90% of the cases.

The TNMM is defined in the Glossary of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), as a method that examines the net profit margin relative to an appropriate base (e.g. costs, sales or assets) that a taxpayer realizes from a controlled transaction.

The OECD Guidelines indicate that the TNMM should be applied in a manner similar  to the application of the Resale Price Method (RPM) or the Cost Plus Method (CP). Specifically, this implies that the indicator of the net benefit which the taxpayer obtains from the relatedtransactions, should ideally be established by reference to the net profit indicator that the sametaxpayer earns in comparable uncontrolled transactions carried out in the free market. In other words, using “internal comparables” as reference. Where this is not possible, the net margin that would have been earned by an independent enterprise in a comparable transaction. That is, an “external comparable.”  However, it must be mentioned that in spite of that stated in the guidelines, for practical purposes, in the presence of internal comparables one usually applies the RPM or CPM, practically limiting the application of the TNMM to external comparables.

It is possible to identify these external comparables, thanks to international financial markets which allow for obtaining financial information of enterprises that is made available for use by investors, by those enterprises that place securities in these markets. In addition, some specialized enterprises have undertaken the task of compiling this information for creating data bases which include automated tools that facilitate the debugging and management of the information, as well as brief descriptions of the enterprises. To align the information, the functionalities available in the data bases and the transaction to be tested, it is necessary to define a search strategy that may optimize the quantitative and qualitative criteria to be considered for identifying evaluating, accepting or rejecting a potentially comparable company. Some of the most common quantitative criteria are:

  • average or recurrent losses (to avoid selecting companies with particular situations that affect their performance),

  • research and development or advertising expenditures above specific sales levels (to avoid selecting enterprises that develop non-routine intangibles),

  • sufficient financial information.

On the other hand, some of the most common qualitative criteria are:

  • controlled enterprise,

  • bankrupt, being restructured or winding up,

  • in the start-up stage,

  • carrying out different functions.

On the other hand, the guidelines suggest that the TNMM would not be a reliable method if each party involved in the transaction makes unique and valuable contributions.  They also state that the tested party should be the most simple entity on which there is reliable information.

A key element for the application of the TNMM is the selection of a net profit indicator. These indicators may consider as denominator such items as:

  • sales,

  • costs and expenses or

  • Assets (example,Operational Assets, Fixed Assets, Capital Used among others).

In this regard, the OECD Guidelines note that the denominator should be focused on the relevant indicator or indicators of the value of the functions performed by the party whose operation is being tested, taking into account the assets used and the risks assumed.  In general, sales or distribution expenses, included in the operational ones, may constitute an adequate base for the distribution activities. On the other hand, total costs or operational costs may be appropriate for the rendering of services or manufacturing activity, while the operating assets may be an adequate base for the activities requiring much capital, such as certain manufacturing activities or specific infrastructural services.

In spite of that previously mentioned by the OECD Guidelines, the operating assets might not be the best denominator in cases wherein such aspects as duration or effect of the value of the currency (inflation or depreciation) could affect such values , rendering difficult the comparability  when using comparable companies from jurisdictions other than that of the tested party. The foregoing situation is the main reason why in Latin American countries the use of profitability indicators based on assets is not very common, while the indicators used are generally based on costs or sales.

Another important aspect for the application of this method is the availability of segmented financial information that may allow for effectively identifying revenues, costs and operational expenses, as well as some accounts of the balance sheet for certain indicators, associated to the transaction or transactions to be tested. In this sense, the OECD Guidelines state that the costs or revenues that are not related to the controlled transaction under review (tested transaction) should be excluded where they materially affect comparability with uncontrolled transactions. It is necessary to count on an appropriate level of segmentation of the taxpayer´s financial datawhen determining or testing the profitability of a controlled transaction.  Likewise, the guidelines indicate that it would be inappropriate to apply the TNMM in an aggregated manner (company-wide basis), if the company is involved in a variety of different controlled transactions that cannot be appropriately compared on an aggregated basis with those carried out by an independent enterprise.

The exercise for preparing the segmented financial information becomes even more complex, to the extent the quantity of transactions to be tested increase, the level of aggregation of thecompany’s financial information is high and neither the accounts or costs centers have been determined for identifying the items necessary for calculating the selected profit indicator.  In these cases, one must determine and apply allocation keys for assigning the financial information that is not disaggregated.

There may be circumstances requiring the application of comparability adjustments, which may be applied to the tested party or the comparable companies, depending on the information available, as well as its quality and reliability. Some of the most common adjustments are the Working Capital adjustments (Accounts Receivable, Accounts Payable and Inventory),  idle capacity, supplementary expenses, pre-operational phase expenses, among others.  The most important challenges are their identification and correct quantification.

In spite of the evolutionary process experienced by the transfer pricing regulations in the region and at the global level  in general, the TNMM continues to be one of the most important methods mostly used by the Tax Administrations and Taxpayers, although one must be careful in assuring that in fact, it is the best method for the particular case and that no other method can be applied.

 

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