Transactional Profit Methods
Introduction
This section delves into transactional profit methods, which serve to analyze the profits derived from specific controlled transactions to ascertain if the transfer price aligns with arm’s length principles. Within this category, two primary methods are discussed: the Transactional Net Margin Method (TNMM) and the Profit Split Method (PSM).
Categories of Methods
Transactional profit methods differ from traditional methods in that the analysis doesn’t necessarily rely on comparable uncontrolled transactions with identical or broadly comparable products. Instead, the analysis often centers on the net return (EBIT – earnings before interest and tax, and extraordinary items) realized by companies engaged in a specific line of business. This approach, suitable for aggregation, may be particularly relevant when associated enterprises contribute valuable intangible assets (e.g., technology) in transactions with other associated enterprises, necessitating the determination of an appropriate return for the use of such intangible assets.
Utilization and Reliability
While it’s uncommon for enterprises to directly determine prices using transactional profit methods, the resulting profit from a controlled transaction can signal whether the transaction was influenced by conditions differing from those of independent enterprises in comparable circumstances. These methods come into play when complexities make traditional transaction methods unreliable, necessitating a reliable enhancement of the results from uncontrolled transactions.
Reliability and Practical Use
Transactional profit methods, especially the TNMM, are frequently employed by taxpayers for practical reasons. TNMM often serves as a valuable check on the accuracy and reasonableness of traditional transaction methods or supplements these methods. Additionally, finding comparable is generally easier when applying the Transactional Net Margin Method.
Transactional Net Margin Method (TNMM)
Principle
The TNMM assesses the net profit margin relative to an appropriate base (e.g., costs, sales, or assets) earned by the tested party in a controlled transaction. This margin is then compared to the profit margins of comparable uncontrolled transactions.
Application
TNMM is particularly useful when reliable comparable transactions are hard to find, making it a practical alternative. The choice of the profit level indicator and the selection of comparable are crucial aspects of applying TNMM.
Profit Split Method (PSM)
Principle
The Profit Split Method allocates the combined profits of associated enterprises involved in a controlled transaction based on the relative contributions each entity makes to the overall value creation.
Application
PSM is applicable in cases where contributions cannot be reliably evaluated, but the overall value creation can be determined. It involves identifying the economically significant contributions of each party and then dividing the profits accordingly.
Transactional Net Margin Method (TNMM)
Overview of TNMM:
The Transactional Net Margin Method (TNMM) is a transfer pricing method that focuses on examining the net profit margin relative to a suitable base, such as costs, sales, or assets, that a taxpayer realizes from controlled transactions or transactions appropriate for aggregation. The TNMM, similar to the Cost Plus Method and Resale Price Method, assesses the profits of one of the related parties in a transaction, known as the tested party.
Comparison of Net Profit Margins:
The TNMM involves comparing the net profit margin (relative to an appropriate base) earned by the tested party in controlled transactions with the net profit margins earned by the same tested party in comparable uncontrolled transactions or those of independent comparable companies. Unlike the more direct Cost Plus and Resale Price Methods that compare gross margins, the TNMM is less direct, as it analyzes net profit margins. It is even more indirect than the Comparable Uncontrolled Price (CUP) Method, which directly compares prices. Various factors may influence net profit margins, and these factors might be unrelated to transfer pricing considerations.
Applicability and Considerations:
The TNMM is employed to address transfer pricing issues involving tangible property, intangible property, or services. It becomes particularly relevant when one of the associated enterprises utilizes intangible assets, and the appropriate return for these assets cannot be determined directly. In such cases, the TNMM determines the arm’s length compensation for the associated enterprise(s) not utilizing the intangible asset by analyzing the margins realized by enterprises engaged in similar functions with unrelated parties. The remaining return is then attributed to the associated enterprise controlling the intangible asset.
The TNMM is often applied to the least complex of the related parties involved in the controlled transaction. This approach has several advantages, including the availability of more comparable data and a reduced need for adjustments to account for differences in functions and risks between controlled and uncontrolled transactions. Furthermore, the tested party in TNMM typically does not own valuable intangible property.
In practice, the TNMM offers a practical solution for analyzing transfer pricing issues, especially when dealing with intangible assets and when a more straightforward approach is required. Its indirect nature allows for flexibility and adaptability to various business structures and circumstances, making it a valuable tool in the transfer pricing toolkit.
Definition and Choice of Tested Party
Similarities with Other Methods:
The application of the Transactional Net Margin Method (TNMM) shares similarities with the Cost Plus Method and Resale Price Method. However, TNMM requires less product comparability compared to these methods, emphasizing the comparison of net profit margins rather than gross profit margins. The following illustration further explains this distinction.
Consider Associated Enterprise 1, a bicycle manufacturer in Country 1, selling bicycles to Associated Enterprise 2, which then resells them to an independent bicycle dealer in Country 2. Assuming Associated Enterprise 1 is the more complex party with various technology and operating intangibles, the Comparable Uncontrolled Price (CUP) Method, if applicable, would compare prices in controlled transactions with those in comparable uncontrolled transactions. If the CUP Method is not feasible, the Cost Plus and Resale Price Methods become alternatives.
Reliability and Choice of Tested Party:
The Cost Plus Method might be relatively unreliable in this case, treating the more complex entity, Associated Enterprise 1, as the tested party. Since Associated Enterprise 1 owns valuable intangible property, the Resale Price Method could be considered. Under the Resale Price Method, the tested party is the sales company, typically the least complex of the entities involved in the controlled transaction. The analysis involves searching for distributors selling similar products, performing comparable functions and incurring comparable risks.
Choosing TNMM and Consideration of Net Profits:
In certain situations, it may be more reliable to choose the TNMM and compare net profits. For instance, if there are differences in reporting the cost of goods sold and operating expenses for the tested party and comparable distributors, making gross profit margins incomparable, the Resale Price Method may be relatively unreliable. However, such accounting inconsistencies do not affect the reliability of the TNMM, which examines net profit margins instead of gross profit margins. The TNMM’s greater tolerance for product differences and cost accounting variations is a significant practical benefit compared to traditional transaction methods.
Application of TNMM and Analysis:
The application of the TNMM involves analyzing the least complex party in the transaction, such as the distributor in this case. This analysis requires searching for comparable distributors, considering the comparability standard of the TNMM. For example, if Associated Enterprise 1 is a contract manufacturer, the TNMM might focus on this entity as the tested party, considering that contract manufacturers are typically the least complex entities due to the separation of ownership of valuable technology intangibles from the manufacturing function. If the CUP Method cannot be applied, the TNMM using a financial ratio based on net profit margin may be appropriate, such as return on total costs for a manufacturer.
Mechanism of the Transactional Net Margin Method
Transfer Pricing Determination:
The key question in the application of the Transactional Net Margin Method (TNMM) is how to determine the transfer price. The mechanism of the TNMM shares similarities with the Resale Price Method and Cost Plus Method, and the following examples illustrate its application.
Example with a Related Party Distributor:
Let’s consider the scenario of a related party distributor. Applying the Resale Price Method involves establishing an arm’s length transfer price by knowing the market price of products resold by the distributor to unrelated customers (sales price). The arm’s length gross profit margin is then determined through benchmarking analysis. The transfer price or cost of goods sold of the related party distributor becomes the unknown variable.
Example: Assuming a resale price of $10,000 and a gross profit margin of 25%, the transfer price can be calculated using the following formula:
[Equation]Transfer Price=Resale Price−(Resale Price×Gross Profit Margin)
Transfer Price = $10,000 – ($10,000 \times 0.25)
Transfer Price = $10,000 – $2,500 = $7,500
In this example, the transfer price amounts to $7,500.
Application of TNMM:
The TNMM follows a similar approach but focuses on the net profit margin. It involves determining the net profit margin earned by the tested party in the controlled transaction and comparing it to the net profit margins of comparable uncontrolled transactions or independent comparable companies. The transfer price is then calculated based on this analysis.
Example with TNMM: If the net profit margin of the related party distributor in the controlled transaction is determined to be 15%, and comparable distributors in uncontrolled transactions have an average net profit margin of 12%, the TNMM may suggest an adjustment to align with the arm’s length principle.
[Equation]Transfer Price=Cost of Goods Sold+(Cost of Goods Sold×Net Profit Margin)
Transfer Price = $7,500 + ($7,500 \times 0.15)
Transfer Price = $7,500 + $1,125 = $8,625
In this TNMM example, the suggested transfer price is $8,625 based on the tested party’s net profit margin. This ensures alignment with the arm’s length principle and considers the comparability with independent entities engaged in similar transactions.
Example 1: Transfer of Tangible Property Resulting in No Adjustment
Background:
Fictitious Corporation FP, a publicly traded entity in Country A, has a subsidiary named BCO located in Country B. BCO is undergoing a tax audit for its 2009 taxable year. FP manufactures a consumer product for global distribution, and BCO imports and distributes the assembled product within Country B at the wholesale level under the FP name. No uncontrolled taxpayers are permitted to distribute the product, and similar products in the market are not sold to uncontrolled distributors.
Transfer Pricing Methodology:
Given the circumstances, Country B’s taxing authority determines that the Transactional Net Margin Method (TNMM) is the most reliable measure of an arm’s length result. BCO is chosen as the tested party because it engages in activities that are less complex than those undertaken by FP.
Comparable Selection:
To apply the TNMM, data is gathered from independent operators of wholesale distribution businesses. The potential comparables are narrowed down to select companies in the same industry segment that perform similar functions and bear similar risks to BCO.
Profit Level Indicator:
After analyzing the information, the ratio of operating profit to sales is identified as the most appropriate profit level indicator. This ratio is relatively stable when at least three years are included in the average.
Results and Adjustments:
For the taxable years 2007 to 2009, BCO’s operating results are as follows:
2007 2008 2009 AVG
- Sales: $500,000, $560,000, $500,000 $500,000
- COGS (Cost of Goods Sold): $393,000, $412,400, $400,000 $401,800
- Operating Expenses: $80,000, $110,000, $4,600 $98,200
- Operating Profit: $27,000, $37,600, ($4,600) $20,000
Comparable Operating Profit Analysis:
Uncontrolled distributors are identified, and their operating profit to sales ratio (OP/S %) and Comparable Operating Profit (COP) are calculated. The interquartile range is determined, resulting in a range from $19,760 to $34,840.
Decision:
Despite BCO reporting a loss of $4,600 in 2009, the tax authority decides not to make an allocation. This is because BCO’s average reported operating profit of $20,000 falls within the arm’s length range. Therefore, in this scenario, no adjustment is needed, and the transfer of tangible property is deemed to be at arm’s length.
Example 2: Transfer of Tangible Property Resulting in an Adjustment
The scenario is the same as Example 1,
Revised Financials and Interquartile Range:
In this modified scenario, BCO reported different income and expenses for the years 2007 to 2009. The interquartile range of comparable operating profits remains unchanged from Example 1, ranging from $19,760 to $34,840.
Financials
For the taxable years 2007 to 2009, BCO’s operating results are as follows:
2007 2008 2009 AVG
- Sales: $500,000, $560,000, $500,000 $520,000
- COGS (Cost of Goods Sold): $370,000, $460,000, $400,000 $410,000
- Operating Expenses: $110,000, $110,000, $110,000 $110,000
- Operating Profit: $20,000, $(10,000), ($10,000) $0
Taxing Authority’s Determination:
BCO’s average operating profit for the years 2007 to 2009 is $0, falling outside the previously established arm’s length range. Consequently, the taxing authority determines that an allocation may be appropriate.
Allocation Calculation:
To determine the allocation amount, the district director compares BCO’s reported operating profit for 2009 to the comparable operating profits derived from uncontrolled distributors’ results for 2009. The ratio of operating profit to sales in 2009 is calculated for each uncontrolled comparable and applied to BCO’s 2009 sales.
Comparable Operating Profits for 2009:
- Uncontrolled Distributor F: $14,000
- Uncontrolled Distributor B: $14,500
The median of the comparable operating profits for 2009 is calculated as $14,250 (average of $14,000 and $14,500).
Allocation Amount:
BCO’s income for 2009 is increased by $24,250, representing the difference between BCO’s reported operating profit for 2009 and the median of the comparable operating profits for 2009.
Example 3: Multiple Year Analysis
Background:
The scenario remains consistent with Example 2, where Fictitious Corporation FP’s subsidiary, BCO, is under audit for the 2009 taxable year. In this modified example, the taxing authority expands its examination to include the 2010 taxable year. Similar to Example 2, an allocation was made for the 2009 taxable year, increasing BCO’s income by $24,250.
Financial Results (2008-2010):
The taxing authority considers the following financial results for BCO for the years 2008 to 2010:
2008 2009 2010 AVG
- Sales: $560,000, $500,000, $530,000 $530,000
- COGS (Cost of Goods Sold): $460,000, $400,000, $430,000 $430,000
- Operating Expenses: $110,000, $110,000, $110,000 $110,000
- Operating Profit: $(10,000), $(10,000), ($10,000) ($10,000)
Interquartile Range for 2008-2010:
The interquartile range of comparable operating profits is calculated based on average results from uncontrolled comparable and average sales for BCO for the years 2008 to 2010. The range is determined to be from $15,500 to $30,000.
Determination of Allocation for 2007 and 2010:
- Allocation for 2007:
- BCO’s average reported operating profit for the years 2008 to 2010 (excluding the adjustment made for 2009) is ($10,000).
- As this amount falls outside the interquartile range, the taxing authority determines that an allocation may be appropriate for the 2007 taxable year.
- Allocation for 2010:
- BCO’s reported operating profit for the 2010 taxable year is ($10,000).
- The median of the comparable operating profits derived from uncontrolled distributors’ results for 2010 is $12,000.
- The taxing authority increases BCO’s 2010 taxable income by $22,000, representing the difference between the median of the comparable operating profits and BCO’s reported operating profit.
Conclusion:
The taxing authority extends its analysis to cover multiple years (2008 to 2010) and determines that allocations are justified for both the 2007 and 2010 taxable years. These adjustments aim to bring BCO’s reported operating profit more in line with the arm’s length standard, as determined by the interquartile range of comparable operating profits.
Example 4: Transfer of Intangible to Offshore Manufacturer
Transfer Pricing Analysis for DCO and HCO – Tax Year 2009
Background:
DCO is a developer, producer, and marketer of products, and it has a foreign subsidiary, HCO, located in Country H. HCO manufactures a new “high tech product” (HTP) developed by DCO. HCO sells the HTP to JCO, a subsidiary in Country H, for distribution and marketing. The taxing authority is auditing the taxable year 2009, focusing on whether the royalty rate of 5% paid by HCO to DCO for the HTP technology is at arm’s length.
Transfer Pricing Methodology:
The taxing authority determines that the Transactional Net Margin Method (TNMM) is the most reliable measure of an arm’s length result in this case. HCO is selected as the tested party because it engages in relatively routine manufacturing activities, while DCO is involved in complex activities using unique and valuable intangibles. The ratio of operating profit to operating assets is chosen as the appropriate profit level indicator.
Comparable Selection:
Due to the unavailability of uncontrolled taxpayers performing similar functions in Country H, data from Country M and N is chosen as the best match for companies in a similar market performing similar functions and bearing similar risks. While the data is sufficiently complete to identify many material differences and make adjustments, there may still be some incomplete information, especially regarding geographic market differences.
Separate Analysis for HTP Pricing:
In a separate analysis, it is determined that the price HCO charged to JCO for the HTP is at arm’s length. This conclusion adds reliability to HCO’s financial data derived from its sales to JCO.
HCO’s Financial Data (2007-2009):
The financial data for HCO for the years 2007 to 2009 is as follows:
2007 2008 2009 AVG
- Assets: 24,000, 25,000, 26,000 25,000
- Sales to JCO 25000 30000 35000 30000
- COGS (Cost of Goods Sold): 6250 7500 8750 7500
- Royalty to DCO(5%): 1250 1500 1750 1500
- Other 5000 6000 7000 6000
- Operating Expenses: 1000 1000 1000 1000
- Operating Profit: 17750 21500 25250 21500
Applying the ratios of average operating profit to operating assets for the 2007 to 2009 taxable years (derived from a group of similar uncontrolled comparable located in Country M and N) to HCO’s average operating assets for the same period provides a set of comparable operating profits. The interquartile range for these average comparable operating profits is $3,000 to $4,500. HCO’s average reported operating profit for the years 2007 to 2009 ($21,500) falls outside this range. Therefore, the taxing authority determines that an allocation may be appropriate for the 2009 taxable year.
To determine the amount, if any, of the allocation for the 2009 taxable year the tax authority compares HCO’s reported operating profit for 2009 to the median of the comparable operating profits derived from the uncontrolled distributors’ results for 2009. The median result for the uncontrolled comparable for 2009 is $3,750. Based on this comparison the district director increases royalties that HCO paid by $21,500 (the difference between $25,250 and the median of the comparable operating profits, $3,750).
Example 5: Adjusting Operating Assets and Operating Profit for Differences in Accounts Receivable
Application of TNMM to MCO – Adjustments for Accounts Receivable Differences
1. Identification of Uncontrolled Comparables:
MCO, a manufacturer of industrial equipment parts, sells its products to its foreign parent corporation. For the TNMM analysis, 15 uncontrolled manufacturers similar to MCO have been identified.
2. Difference in Accounts Receivable:
MCO exhibits a significantly lower level of accounts receivable compared to the uncontrolled manufacturers. To ensure a fair comparison, adjustments are made to both operating assets and operating profits for this difference.
3. Operating Assets Adjustment:
The operating assets of each uncontrolled comparable are reduced by the amount by which they exceed MCO’s accounts receivable relative to sales. This adjustment ensures a consistent base for the calculation of the rate of return on capital employed.
4. Operating Profit Adjustment:
To account for the difference in accounts receivable, each uncontrolled comparable’s operating profit is adjusted by deducting imputed interest income on the excess accounts receivable. The imputed interest income is calculated by multiplying each uncontrolled comparable’s excess accounts receivable by an interest rate appropriate for short-term debt.
5. Purpose of Adjustments:
The adjustments aim to level the playing field by normalizing the impact of the varying levels of accounts receivable between MCO and the uncontrolled comparables. This ensures that the rate of return on capital employed is calculated in a manner that reflects the true operational profitability, considering the specific financial structure of each entity.
6. Ensuring Comparable Profitability:
Through these adjustments, the TNMM analysis becomes more accurate, providing a basis for comparing the profitability of MCO to that of the uncontrolled comparables. The goal is to determine an arm’s length price for the products sold by MCO to its foreign parent corporation, considering all relevant financial factors.
Example 6: Adjusting Operating Profit for Differences in Accounts Payable
Application of TNMM to KCO – Adjustments for Accounts Payable Differences
1. Background:
KCO, a subsidiary of a foreign corporation, engages in purchasing goods from its foreign parent and selling them in the Country K market. To assess the arm’s length nature of these transactions using the TNMM, ten uncontrolled distributors similar to KCO have been identified for comparison.
2. Variations in Accounts Payable:
Significant differences in the level of accounts payable exist among the uncontrolled distributors and KCO. To ensure a fair and accurate comparison, adjustments are made to both the operating profit of KCO and the uncontrolled distributors.
3. Operating Profit Adjustment:
The taxing authority increases the operating profit of both KCO and the uncontrolled distributors to reflect the imputed interest expense associated with their respective accounts payable. The imputed interest expense is calculated by multiplying each company’s accounts payable by an interest rate deemed appropriate for its short-term debt.
4. Objective of Adjustments:
The adjustments aim to normalize the impact of varying levels of accounts payable between KCO and the uncontrolled distributors. By imputing interest expense, the taxing authority seeks to ensure that the TNMM analysis provides an accurate reflection of the operational profitability of both KCO and the uncontrolled distributors.
5. Imputed Interest Expense Calculation:
For each company (both KCO and uncontrolled distributors), the imputed interest expense is determined by multiplying the respective accounts payable by an interest rate suitable for short-term debt. This adjustment is critical to accounting for the financial cost associated with the different levels of accounts payable among the entities.
6. Ensuring Comparable Profitability:
Through these adjustments, the TNMM analysis becomes more robust, allowing for a more accurate comparison of the operating profits of KCO and the uncontrolled distributors. The objective is to ascertain an arm’s length transfer price for the goods sold by KCO in the Country K market, considering all relevant financial factors and ensuring a level playing field for comparison.
Author Bio
