Transactional Net Margin Method (TNMM) is a 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 over time.
TNMM has a twin-brother method in US 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.
In practice, we observe the following issues when TNMM is applied:
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.
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 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 level 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, 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. Tax authorities, in contrast, become more and more aware of the benchmarking technologies and approaches, and they start challenging taxpayers’ benchmarking studies more and more often.
What are other issues with the TNMM method that you observe in practice? Let us know, and we will add them to the list!
In our textbook, we dedicate three detailed chapters for the discussion of the transactional methods and comparability analysis, including 10 practical examples and cases that explain the application of TNMM and benchmarking studies. We also extensively discuss the TNMM in our transfer pricing course.
For more details about the textbook and the course, contact us:
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