The net transaction margin method (hereinafter: TNMM) is one of the five methods indicated by the Act that can be used in a transfer pricing study. The applicability of this method should be verified, as with the other methods, before applying other valuation methods or techniques. Therefore, it is worth familiarising oneself with the assumptions of this method, as it may prove to be the best choice when examining the transfer price in the transaction we are implementing.
Basic assumptions of the TNMM
The MMTN method involves the determination of a financial ratio, reflecting the relationship of the net profit margin that the audited entity obtains in a controlled transaction to the relevant base. The financial ratio expresses the profitability at the level of the controlled transaction calculated on a financial basis.
Under this method, a net profit margin determined by deducting the costs associated with the controlled transaction from the revenue generated by the controlled transaction must be calculated. The net profit margin is then applied to the cost base, which may be revenue, costs, assets or elements thereof. By ‘net profit margin’ is meant the various profit categories (including mark-up). The underlying profit categories are indicated in the 1 December 2021 Tax Notes on the TNMM method (pages 6 and 7 of the TNMM Notes).
The TNMM makes it possible to verify that the level of ‘net profit margin’ achieved in a given controlled transaction has been set at market level. TNNM is used in particular in transactions involving production or the provision of services that are commonly found in the market. The principle is to compare profitability at transaction level, but it is permissible to test indicators on the whole activity if the entity in question carries out a homogeneous activity, or if it carries out several types of activity, but one type is the main activity and the others are complementary.
The TNNM method should not be used if the entity in question carries out activities in which it carries out different types of transactions that do not, even after aggregation, allow for a valid comparison.
TNMM comparability criteria
When proceeding to verify the transfer price using the net transaction margin method, the first step is to select the party to be analysed, followed by determining the gross profit margin and the cost base. The next step is to select a financial indicator and compare profitability.
When applying the TNMM, the focus has to be on the comparability of entities in a functional sense, which makes it applicable to a wide range of transactions. The functional profile is important in this method. In principle, the party to be tested should be the one with the simpler profile. Also, the choice of indicator to be analysed should take into account the assets, risks and functions involved in the transaction. It is crucial for the application of this method that the same financial indicator is compared against a comparable base.
According to the TNMM Explanatory Notes, the comparability analysis using this method should take into account, in particular, criteria such as:
- the course of the controlled transaction, including the functions performed by the entities, the assets they involve
- their assets and the risks incurred,
- the characteristics of the goods (services),
- the terms of the controlled transaction specified in the contract,
- the economic conditions prevailing on the market at the time,
- economic strategy
The advantages of this method are that the comparability of the goods or services has less impact on the net profit margin than on the price, access to comparative data is easier due to the fact that data is extracted from publicly available financial statements. In addition, TNMM often uses statistical ranges, which leads to minimising the risks associated with incomplete comparisons.
The advantages of this method are that comparability of products or services has less of an impact on the net profit margin than on price, access to comparative data is easier due to the fact that data are extracted from publicly available financial statements. In addition, TNMM often uses statistical ranges, which leads to minimising the risks associated with incomplete comparisons.
Difficulties in applying the TNMM
As with other methods, here too there may be some difficulties or challenges in applying TNMM. Among the difficulties associated with this method, point out the lack of adequate financial data for the calculation of ratios, e.g. due to the P&L available only in the comparative variant. Another difficulty may be the contribution to the transaction by each party to the transaction of unique and valuable inputs such as trademarks, know-how, employee skills, business contacts, etc. this makes the method unreliable.
In summary, the TNMM method has greater versatility than the other methods because of its applicability to different types of transactions. Functional comparability is more important than comparability of goods or services. Taxpayers using this method have easier access to comparable data – data extracted from financial statements. This is perhaps why this method is one of the most commonly used. However, its appropriateness to our transaction should always be analysed, because although it is universal, it will not always be the right method for every transaction.