(This is the 6th article of this seminar series composed of 11 articles)
(Part 6) Transactional Net Margin Method: TNMM
1. Transactional Net Margin Method
The Transactional Net Margin Method calculates the arm’s-length price by focusing on the level of operating profit gained in the controlled transactions. It was introduced with the Japanese fiscal 2004 tax reform.
The operating margin, which is used in TNMM, is considered less susceptible to differences in other factors (e.g. functions) compared to the Comparable Uncontrolled Price Method, which requires a strict similarity in inventory assets, etc. The Resale Price Method and the Cost Plus Method also require similarity in the functions performed by a seller or a buyer.
It is possible to deem all the controlled transactions conducted by one of the parties as one transaction. Comparable corporations are selected when the functions performed by one of the parties in the controlled transaction are highly similar to those of the companies that conduct the comparable transactions, and when there are no differences recognized in the functions that objectively and clearly affect the calculation of the Profit Level Indicator. In practice, multiple comparable corporations are selected from the database, and the range of their operating margins when trading at the arm’s-length price is calculated.
As explained in Part 4 of this series, there are three Profit Level Indicators used with the TNMM: (1) the ratio of operating profit to net sales, (2) the ratio of operating profit to full cost, and (3) the ratio of gross profit to operating expenses (Berry ratio).
[Source: Modified version of “Case 6,” in “Reference Case Studies on Application of Transfer Pricing Taxation,” National Tax Agency]
2. Profit Level Indicator (1): Ratio of Operating Margin to Net Sales
In this method, the appropriate arms-length price to be compared with the controlled transactions is determined by calculating the operating profit (the ratio of operating margin to net sales) of comparable companies carrying out comparable transactions.
This method is considered appropriate when the value of the functions performed by the buyer of the inventory assets that are involved in the controlled transactions is seen as connected to net sales, considering the assets used and the risks borne.
Case 6, “Use of the Transactional Net Margin Method,” in the Reference Case Studies explains the transactions described in the chart below (the original chart has been modified by HLS Global by adding “comparable companies”). The ratio of operating margin to net sales for the comparable companies is deemed to be the arm’s-length price and can be compared to that of Company S assuming that it does not engage in any original advertising or sales promotion activities. It is assumed that the company stores and manages a constant inventory of Product A purchased from Company P, and sells it in Country X in accordance with its own sales plan.
3. Profit Level Indicator (2): Ratio of Operating Margin to Full Cost
In this method, the arm’s-length price in the controlled transactions is determined by calculating the appropriate amount of operating profit for the seller of the inventory assets involved in the controlled transactions through the application of the ratio of operating margin to full cost.
This method is considered appropriate when the seller of the inventory assets in the controlled transactions is recognized as having functions not reflected in the operating expenses (e.g. a manufacturing function), considering the assets used and the risks are borne.
As there is no example case available for this method in the “Reference Case Studies,” we have prepared the chart below describing example transactions for the Transactional Net Margin Method using the ratio of operating margin to full cost as the PLI by referring to Case 6. The ratio of operating margin to the full cost for the comparable companies is deemed to be the arm’s-length price on the assumption that the company does not engage in any original manufacturing activities. Instead the company stores and manages a constant inventory of Product A, and sells it to Company P in accordance with its own manufacturing plan.
4. Profit Level Indicator (3): Ratio of Operating Margin to Operating Cost (Berry Ratio)
In this method, the arm’s-length price in the controlled transactions is found by calculating the net sales of the buyer or the seller of the inventory assets and comparing that to the controlled transactions through the application of the Berry ratio found in the comparable transactions (ratio of gross profit to operating expenses: if the operating expense is 100 and the gross profit is 125, the Berry ratio would be 1.25).
This method is considered appropriate when the value of the functions that the buyer or the seller of the inventory assets in the controlled transactions performed: 1) is recognized to have a connection to the operating expenses, 2) is not significantly affected by the value of the product sold and is recognized to not have a connection with net sales, and 3) is recognized to not have a function that is not reflected in the operating expense (e.g. manufacturing functions; for example, when verifying an agent or simple service provider), considering the assets used and the risks borne.
Case 6, “Use of the Transactional Net Margin Method,” in the Reference Case Studies explains the transactions described in the chart below (the same modified chart as in Section 2 above).
The Berry ratio is applicable when Company S below functions as an agent for resale of Product A purchased from Company P and does not assume much risk. In this instance, the Berry ratio of Company S (which is the ratio of the gross profits earned by Company S to its operating expenses should be compared with the Berry ratios of comparable companies to calculate the arm’s-length price of Product A.
(The next article of this “Transfer Pricing Seminar Series for Medium-sized Corporations in Japan” will be published next month.)
For further inquiries, please contact us at Japan@HLS-Global.jp.
Transfer Pricing Seminar Series Articles:
- (Part 1) Working Seminar for Medium-sized Corporations Unfamiliar with Transfer Pricing
- (Part 2) Overview of Transfer Pricing Taxation
- (Part 3) Transfer Pricing Examinations, Advance Pricing Agreements, and Documentation
- (Part 4) Transfer Pricing Methods to determine the Arm’s Length Price
- (Part 5) Traditional Transaction Methods
- (Part 6) Transactional Net Margin Method: TNMM
- (Part 7) Profit Split Method
- (Part 8) Considerations to prepare the Local File
- (Part 9) Considerations When Preparing Local Files
- (Part 10) Selection of the comparable companies and calculation of the profitability range
- (Part 11) Transfer Pricing Policy and Transfer Pricing Documentations
