CA Ram Bajaj
What is TNMM Method – TNMM mean Transactional Net Margin Method. It simply state that net profit realized by enterprise from the international transaction with AE should not be less than comparable party having similar transaction. For Example Company a in India having subsidiary at Dubai Company B. now if company A is selling something to Company B, then price charged by A should be similar to other company having same business. In TNMM, we approach Net Margin, that is to say Net Profit of Company A in Transaction with its Subsidiary company B should not be less than other company in similar business and similar conditions. Income Tax Rules
10B(1)(e) transactional net margin method, by which,—
(i) the net profit margin realized by the enterprise from an international transaction 55c[or a specified domestic transaction] entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction [or the specified domestic transaction] and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);
(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction [or the specified domestic transaction]
Matter with Example – Normally while taking PLI i.e. Price Level Indicator for the purpose of TNMM, TPO use a approach that they use combined data for the purpose of calculation of PLI and make addition to assessee in TP Adjustment. for example A Ltd. Is subsidiary of B Ltd. Of USA and providing service to B Ltd. As well as other own client in India which is unrelated and maintain separate account for transaction with AE as well as transaction with other Indian client. Its operating profit / operating cost Ratio is say 25% in case of AE case and 15% in other clients. In TP audit, auditor find out that compare company is having operating profit / operating cost Ratio is 23%, hence it is at arm’s length, hence need not any adjustment.
At the time of assessment procedure at TPO, TPO has departmental approach. He simply take PLI of other clients also in his TP calculation, mean now company PLI will be 25+15/2=20, mean less than comparable i.e. 23% and make TP adjustment for 2%.
Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by OECD
“3.42 An analysis under the transactional net margin method should consider only the profits of the associated enterprise that are attributable to particular controlled transactions. Therefore, it would be inappropriate to apply the transactional net margin method on a company-wide basis if the company engages in a variety of different controlled transactions that cannot be appropriately compared on an aggregate basis with those of an independent enterprise. Similarly, when analyzing the transactions between the independent enterprises to the extent they are needed, profits attributable to transactions that are not similar to the controlled transactions under examination should be excluded from the comparison. Finally, when profit margins of an independent enterprise are used, the profits attributable to the transactions of the independent enterprise must not be distorted by controlled transactions of that enterprise
Analysis of OECD Guidelines – these are in favour of assessee but since these guidelines are just for guide, so usually department skip these guidelines on that fact that these are not applicable in Indian income tax act as there is nothing mentioned in Income Tax Act 1961 about these guidelines. These are just for the guide.
Judicial Decision –
1. In our understanding, the international transaction or an aggregate of similar international transactions, have to be evaluated, on a standalone basis and then compared with similar analysis undertaken on independent transactions. Comparison of the operating profits of the assessee-company as a whole, with the overall operating profits of certain other companies, without any adjustments, in our considered opinion, would not satisfy the requirements of evaluating an international transaction under TNMM, for the purpose of arriving at the arm’s length price.” UCB India (P.) Ltd. Asstt. CIT  121 ITD 131
2. The TNMM requires establishing comparability at a broad functional level. It requires comparison between net margins derived from the operation of the uncontrolled parties and net margin derived by an associated enterprise on similar operations. Aztec Software & Technology Services Ltd.
3. A plain reading of the above shows that TNMM requires comparison of net profit margins realized by an enterprise from an international transaction or an aggregate of international transactions and not comparisons of operating margins of enterprises. For arriving at this conclusion, we drew strength from the decision of Mumbai ‘L’ Bench of the Tribunal in the case of UCB India (P.) Ltd. v. Asstt. CIT  121 ITD 131 (Mum.) where it is held that section 92C read with Rule 10B(1)(e) deals with Transactions Net Margin Method (TNMM) and it refers to only net profit margin realised by an enterprise from an international transaction or a class of such transaction, but not operational margins of enterprises as a whole.
Respectfully following the same, we set aside the issue to the file of the Assessing Officer for the reasons that the Assessing Officer has not followed properly and correctly any of the method prescribed for the purpose of determining the ALP under the Act. Even the transaction at net margin method has not been properly and correctly applied in this case. We, therefore, set aside the issue to the file of the Assessing Officer to decide the issue afresh. Wockhardt Ltd
4. A plain reading of the above shows that TNMM requires comparison of net profit margins realized by an enterprise from an international transaction or an aggregate of international transactions and not comparisons of operating margins of enterprises. For arriving at this conclusion, we drew strength from the decision of Mumbai ‘L’ Bench of the Tribunal in the case of UCB India (P.) Ltd. Asstt. CIT  121 ITD 131 where it is held that section 92C read with rule 10B(1)(e) deals with Transactions Net Margin Method (TNMM) and it refers to only net profit margin realised by an enterprise from an international transaction or a class of such transaction, but not operational margins of enterprises as a whole. Tej Diam
5. From the above it is clear that under Chapter X of the Income-tax Act, the determination of ALP of an international transaction has to be only at the transaction level or at the level of a class of transactions. Law does not permit determination of ALP of international transactions, by comparing operating margins at entity levels, or by taking overall industry level averages. Thus the exercise done by the TPO as modified by the CIT(A) is against the provisions of the Act and Rules and has to be struck down as illegal. Ankit Diamonds
6. The transfer pricing adjustments should be restricted to transactions with the AE only and also that operating cost of the software segment referable to AE transactions only should be taken into consideration
Conclusion – from the above mentioned case as well as OECD Guidelines, it is clear that approach of department at TPO level is not correct and Tribunal also given a lot decision in favor of assesee. Even if the assessee in two different segment of business and having maintained difference account, and having AE Transfer Pricing in one segment only, then also TPO cannot take PLI of combined business. He has to take only that specific segment data for the purpose of TP Analysis. So CA as well as tax advocate can argue before TPO or DRP or Appeal on this inclusion on above mentioned case.