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HMRC internal manual

International Manual

Transfer pricing: Methodologies: OECD Guidelines: Transactional net margin method

Use of transactional net margin method

The transactional net margin method (‘TNMM’) and the profit-split method are described in the OECD Transfer Pricing Guidelines as the transactional profit methods (also called ‘other’ methods) for establishing the arm’s length price. They concentrate on finding the arm’s length net profit margin as opposed to the gross profit margin sought by the ‘traditional’ methods of CUP, resale minus and cost plus. The Guidelines consider TNMM at paragraphs 2.58 - 2.107.

TNMM is the OECD method most commonly used for justifying the transfer pricing of a company. In some cases the case for a TNMM approach is based on little more than a list of supposedly comparable companies, whose results are within a range that encompasses those of the company under review. It is then argued that the company’s prices are arm’s length.

The OECD Guidelines make it clear that any attempt to use TNMM should begin by comparing the net margin which the tested party makes from a controlled transaction with the net margin it makes from an uncontrolled one (an “internal comparable”). Where this proves impossible (perhaps because there are no transactions with uncontrolled parties), then the net margin which would have been made by an independent enterprise in a comparable transaction (an “external comparable”) may serve as a guide. Note the strict criteria of an independent enterprise, carrying out a comparable transaction, and the caveat that this will be only a guide. The emphasis is very clearly on finding a comparable transaction. In addition, a functional analysis of both the associated enterprise and the independent enterprise is required to determine if the transactions are comparable. It might of course be possible to adjust results for minor functional differences, provided that there is sufficient comparability to begin with, The standard of comparability for application of TNMM is no less than that for the application of any other transfer pricing method.

The Guidelines acknowledge that there are a number of weaknesses peculiar to TNMM, which can be compounded by its inappropriate application. Amongst these weaknesses is the fact that the net profit indicator of a company can be influenced by a range of factors that either have no effect or a different effect on gross margins or the actual price of a transaction. This makes comparing the tested party with another company very difficult if that company is not affected by the same factors. For instance, the supposedly comparable company may have been managed and run very badly, while the tested party may have been run very well. Would it be proper then to draw any conclusions relevant to the transfer prices of the tested party from the fact that it made a 10% operating margin but the company which is said to meet the comparability criteria made an operating margin of 6%? It is easy to see from this simple example that incorrect conclusions can easily be drawn from the use of TNMM.

Range of results

Although the use of ranges of results, in accordance with the guidance provided at INTM484090 and INTM485120, may be applicable whatever pricing methodology is adopted, in the light of the difficulties outlined above it may, in some cases, be particularly useful to take into account a range of results when using TNMM. A range of results may mitigate unquantifiable differences between the tested party and independent companies carrying out comparable transactions. A range would allow results which would occur under a variety of business conditions. Note however that the range of results has to be constructed from the results of companies carrying out comparable transactions. Acceptance of the existence of a range should not be taken to imply acceptance of the inclusion in that range of companies which are not comparable or which carry out transactions which are not comparable. See the additional comments on arm’s length ranges at INTM484090.