The Transactional Net Margin Method (TNMM) is one of the most commonly applied methods in transfer pricing. Its flexibility and focus on profitability make it a go-to approach when comparable data for direct price comparisons is limited. Below, we answer frequently asked questions about the TNMM to provide clarity and guidance.

What is the Transactional Net Margin Method (TNMM)?

The transactional net margin method examines the net profit relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction (or transactions that are appropriate to aggregate under the principles of paragraphs 3.9-3.12). Thus, a transactional net margin method operates in a manner similar to the cost plus and resale price methods. 

This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale price or cost plus method is applied. This means in particular that the net profit indicator of the taxpayer from the controlled transaction (or transactions that are appropriate to aggregate under the principles of paragraphs 3.9-3.12) should ideally be established by reference to the net profit indicator that the same taxpayer earns in comparable uncontrolled transactions, i.e. by reference to “internal comparables” (see paragraphs 3.27-3.28). 

Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise (“external comparables”) may serve as a guide (see paragraphs 3.29-3.35). 

A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. 

Further, the other requirements for comparability, and in particular those of paragraphs 2.74-2.81, must be applied (OECD Transfer Pricing Guidelines 2017, para. 2.64).

Examples 

The Transactional Net Margin Method (TNMM) works in similar ways to the RPM and the CPM, in that the trading margins must cover operating costs and a reasonable profit margin. The TNMM examines the net profit that a taxpayer earns from an intercompany transaction relative to an appropriate basis.

The process for analyzing a transaction according to the TNMM method varies from the CPM and the RPM because the profit analyzed is a net profit. In this regard, a profit level indicator (PLI) needs to be chosen. This PLI should be appropriate according to the characteristics of the transaction. Please refer to XXX for the most common PLIs and their descriptions. In principle, the TNMM may only be applied on a "transaction-by-transaction" basis, however product groupings are permissible insofar as this does not impair comparability. The permissibility of product grouping means that comparable transactions may be aggregated and then assessed jointly. As a rule, however, transactions should be assessed individually. 

Example Internal Comparable: A German automotive company manufactures products and sells these to external distributors and other manufacturing companies in the European market. The German manufacturing company also sells similar products within its multinational Group, performing the same functions and taking over similar risks. Even if the products are not the same, the functions, assets and risks (FAR) profile is comparable in the case of internal and external transactions. For transfer pricing purposes the internal and external transactions are found to be comparable according to Chapter III of the OECD Guidelines.

Due to the available comparable transactions, the TNMM utilizing an internal comparable is chosen as the most appropriate method. The German company decides to split the manufacturing Profit and Loss Statement into internal and external transactions. Using this split P/L statement, the company can compare the net profit achieved with related parties and with unrelated parties. 

Example External Comparable: A Mexican distribution company purchases raw material and resells the material in the LATAM market. No internal comparables are available since the transaction takes place only between the French parent company (manufacturing) of the Mexican entity and the Mexican entity (distributor). The Group decides to apply the TNMM by analyzing the Mexican distribution company's PLI. Usually for distribution activities, the operational margin is analyzed. The Mexican entity performs a benchmark study for LATAM net profit distribution indicators to compare the Mexican legal entity results with the public available information.

How Does the TNMM Work?

The TNMM operates in three main steps:

1. Choose the Tested Party: Select the entity within the related-party transaction with the simplest functions and least complex operations to analyze.
2. Determine a Profitability Indicator: Use a ratio such as operating margin, return on assets, or return on sales to measure profitability.
3. Benchmark Against Comparables: Compare the tested party’s profitability indicator to those of independent companies operating under similar conditions. Adjustments are made if material differences exist.

What is a “Tested Party” in the TNMM?

The tested party is the entity in a related-party transaction whose profitability is analyzed. Typically, it is the simpler of the two entities involved in the transaction. For instance, in a transaction between a manufacturer and a distributor, the distributor is often chosen as the tested party because it has fewer functions, risks, and assets.

What Profitability Indicators are Commonly Used in the TNMM?

The most commonly used profitability indicators in the TNMM include:

• Operating Margin: Operating profit as a percentage of sales.
• Return on Assets (ROA): Operating profit relative to total assets.
• Berry Ratio: Gross profit divided by operating expenses.

These indicators are chosen based on the nature of the tested party’s operations and the availability of reliable data for comparison.

How is Comparability Ensured in the TNMM?

To ensure comparability, the TNMM involves:

• Selecting independent companies or transactions operating in the same industry or under similar circumstances.
• Making adjustments for differences in functions, risks, or market conditions that may affect profitability.

For example, if a tested party operates in a high-cost region, adjustments might account for differences in labor or operational costs compared to comparable entities.

What are the Advantages of Using the TNMM?

• Flexibility: The TNMM works well when direct price data is unavailable, making it suitable for complex transactions.
• Stability: Profit margins are generally less volatile than transaction prices, providing more consistent results.
• Broad Application: It can be applied to various industries and transaction types, including services, manufacturing, and distribution.

What Are the Limitations of the TNMM?

Despite its advantages, the TNMM has certain limitations:

• Dependence on Reliable Data: The accuracy of the method depends on the availability of robust comparable data.
• Focus on One Party: The TNMM analyzes only the tested party, potentially overlooking profitability issues in the other related entity.
• Risk of Over-Simplification: By focusing on net margins, the TNMM may not capture nuances of individual transactions.

How Does the TNMM Compare to Other Transfer Pricing Methods?

The TNMM differs from other methods in that it focuses on profitability rather than pricing. For example:

• The Comparable Uncontrolled Price (CUP) Method analyzes individual transaction prices directly.
• The Cost Plus Method and Resale Price Method examine gross profit margins, whereas the TNMM looks at net profit margins.

This makes the TNMM more suitable for transactions where direct price comparisons or gross margin data are unavailable.

What Types of Transactions are Best Suited for the TNMM?

TNMM may be most appropriate method for following types of controlled transactions, amongst others:

1. The provision of services (such as marketing support service, contract R&D service, IT support service, etc.)

2. The distribution of finished goods (particularly where the distributor is a Limited-Risk Distributor);

3. Where only one of the parties to a controlled transaction makes unique and valuable contributions (where both parties make unique and valuable contributions then the Profit Split Method (explained below) may be more appropriate). Product comparability is least stringent of all the methods. Higher emphasis is on the similarity of function, assets and risk in the controlled and uncontrolled transaction.

How Can Companies Ensure Compliance Using the TNMM?

To comply with transfer pricing regulations when using the TNMM, companies should:

• Perform rigorous benchmarking to identify suitable comparables.
• Document the selection process for the tested party and the profitability indicator.
• Regularly review profitability to ensure alignment with arm’s-length ranges.

Proactive planning and robust documentation help companies avoid disputes with tax authorities.

What Are the Common Challenges of Applying the TNMM?

Challenges include:

• Identifying suitable comparables in industries with limited data.
• Adjusting for material differences in market conditions or operational structures.
• Ensuring consistent application of the method across multiple jurisdictions.

These challenges require expertise in benchmarking and transfer pricing documentation.