Transfer Pricing within a Group: a Case Study

The TNMM would compares the net profit margin earned by a company in the controlled transactions to the same net profit margins earned by the same company in a comparable uncontrolled transaction or by independent enterprises. Unlike traditional methods focusing on the single transaction, where the basis of the comparison are either the price (CUP method) or gross margins (Resale Price and Cost Plus), in the TNMM the basis of the comparison are net margins. For this reason this method is considered “more indirect” than the cost plus/resale price method.

One of the main advantage in applying the TNMM is that the net margin is less sensitive (than the CUP method) to the differences among transactions. Another important strength of this method is the ease of application since it is used only to one party (the “tested party”), on the basis of availability of data. The same situation would happen also to the resale price and cost plus method.

So, results from applying TNMM may be less influenced by transactional differences than results from using CUP method. There is, also, no need to verify all parties’ books are filed on a coherent basis.
But, a lot of weaknesses deserve to be mentioned.

First of all, some factors may influence the net profit indicator of the taxpayer, affecting prices or even gross margins. These elements may have negative effects on the determination of net profit indicators satisfying the arm’s length principle. Therefore, this method requires a number of detailed information about uncontrolled transactions, not always available at the time in which the controlled transactions occur.

Determining revenue and operating expenses, useful to establish the net profit indicator to measure transaction, is equally hard. There may be also difficulties in evaluating an appropriate “corresponding adjustment when applying the TNMM”.
One of the weaknesses of TNMM is “the flip side of one of its advantages”. In accomplishing a TNMM analysis, it would be necessary to analyze the functions and risks of only one side of the controlled transaction and only one set of financial information. This is undoubtedly a real advantage when financial information from the counterparty to the controlled transaction is unavailable. On the contrary, focusing only on one side of the transaction does not consider overall multinational company profits from intra group transactions, leaving the other parties with high or low profits.

There are some steps to follow in order to apply a Transactional Net Margin method:
The first would consist in performing a functional analysis: analyzing the activities carried out by the affiliate as well as the risks assumed. It is also necessary to verify whether the affiliate owns valuable intangible property.
The second step is evaluating the existence of potential comparable transactions or companies. It would be preferable to use internal comparables, because companies have much more detailed information at their disposal. Once identified the potential comparables, it is then possible to carry out a function and risk assessment. Since the main goal is to determine the arm’s length price, the potential differences, if any, that can affect profitability must be identified and adjusted.
After deciding the comparables to be utilized and the adjustments to consider, it would be necessary to choose the right profit method (return on assets, return on sales, etc.).
Obviously, the measure adopted may influence the value of transfer prices. Return on sales is suitable when evaluating a distributor, while return on assets is generally the best method to adopt in evaluating a manufacturer.
The forth step would consist in determining the appropriate time period for analysis: the profit method chosen must be then applied to each comparable and to controlled transactions.

There are two possibilities:
1) using multiple years data that offer some advantages: for example it eliminates short-run issues, or it supports companies performing market penetration strategies;
2) opting for an appropriate number of years. This choice allows the company to determine a specific time period according to the different strategies performed.
The final step to follow is testing the “reasonableness of results” by using different and alternative methods.
This is the method that we will use in the case study of the third chapter. The reasons leading to this choice will be described afterwards.