Transactional Net Margin Method (TNMM) is a transactional profit method that compares the net profit earned by a tested party of a controlled transaction with the net profit earned in uncontrolled transactions. TNMM relies on the principle that functionally similar companies operating in a similar market tend to make similar returns (measured through a profit level indicator) over time. 
 

TNMM has a twin-brother method in the US transfer pricing regulations, called the comparable profits method (CPM). If you are working within the US or supporting US companies with transfer pricing, you should be aware that the comparable profits method is, in essence, TNMM under a different name (differences are rather theoretical). 
 

In the last decade, TNMM became almost a default transfer pricing method for many taxpayers. The TNMM/CPM was used for 86% of transactions in APAs that IRS faced in 2018, while all other methods combined accounted for the other 14% only. This makes understanding TNMM critically important for every tax and transfer pricing specialist. 
 
TNMM is very similar to the resale price method and the cost plus method, as it assesses the profits of one of the parties of the transaction (one-sided profit method) and allocates residual profits to the other party. The main difference, however, is that TNMM compares net/operating profit indicator, while RPM and CPM look at gross profit margin/mark-up. This leads to several significant differences between these methods:
 
• Operating profits are less affected by variations in accounting policies. For instance, some costs like insurance, transportation, or warranty expenses may be reflected as CoGS or operating costs. This potential difference in treatment affects gross profit and gross margin, but operating profits are not affected.
• Operating profits are less affected by functional differences. Some functions or risks may have a significant impact on gross margins, while operating margins are smoother.
• Information about gross profits of potentially comparable companies is less widely available compared with operating profits.
• TNMM is used at a high aggregation level, assessing a series of transactions or even results of the entity as a whole, while traditional transactional methods lean towards testing separate transactions.
 
This makes TNMM easier to apply in cases where there is no significant intangible property involved.
  

1) Overuse - TNMM is often seen as a default method; therefore, other methods are ignored (even though they may provide more reliable results). For example, it is not rare for a taxpayer to “forget” about existing internal comparables and jump straight to TNMM, even though these internal comparables may allow the reliable application of traditional methods. Another case is where significant intangible assets are ignored. 
 

2) Oversimplification – transfer pricing advisors can sometimes use template studies with generic analysis. For example, the crucial step in the TNMM application is the selection of the tested party (that is based on findings of functional analysis and actual business activity of the company), and you need to ensure that your functional analysis is detailed and takes into account both contractual terms and actual conduct. It is not rare for tax authorities to challenge the tested party selection, which can question all transfer pricing methodology. 
 

3) Incorrect margin/mark-up analysis – even though TNMM allows a certain level of aggregation, it does not mean you can take a total P&L of the tested party and calculate the profit indicator from there. Segmentation of the P&L is a crucial step of TNMM analysis, and you must ensure it is done properly. 
 

4) Generic benchmarking studies – TNMM application is almost always based on external comparables (uncontrolled taxpayers), and therefore having proper benchmarking study is a key. It is not rare for advisors to prepare standard generic benchmarking studies that are not tailored to the facts and circumstances of a particular transaction and use the same interquartile range in every case. Tax authorities, in contrast, become more aware of the benchmarking technologies and approaches, and they start challenging taxpayers’ benchmarking studies more and more often. In other words, there is a disconnect between standards of comparability. 
 
And remember that in cases where significant intangible assets are involved, it makes sense to closely assess the use of the profit split method instead of TNMM!