Business transactions have grown complex over the year. It takes a split second to pay for something online, however, we barely realize how many companies have actually participated in that single transaction. Let’s say you purchase a mobile phone online using your credit card. So, the two obvious parties involved here are you – the buyer and the e-commerce platform. However, since it is an e-commerce platform, there will be another party who is listed on the platform as a seller and is actually selling the product to you, the merchant. Then there is your bank who issued the credit card to you, the bank of the merchant seller and also the bankers of e-commerce platform, who all came together to complete the payment, taking our tally to six. That’s not the end of the list.Your credit card has an issuing brand e.g. Mastercard, Visa, Discover, etc. who collect transaction fees from the platform when you use the card issued by them. Besides, online payments occur through a payment gateway maintained by different companies e.g. Securepay, CCAvenue, Payubiz, etc. who make sure that the transaction is secure and hassle-free.
Thus, there are at least eight parties involved and we haven’t even discussed the courier agency, the number of group companies involved at the backend of the e-commerce platform itself who ensure delivery of your product, the credit card rewards point or loyalty program company, the bankers providing low or no-cost EMI or such schemes, the various brand companies who issue cashback or the loyalty vouchers on purchase of some other product, and many more such parties who are involved in that transaction. So, the tally can go up to 15-16 parties for one single transaction and each of them is making profits out of your purchase. Now, let’s assume for a moment that all these companies are associated and you have to calculate the transfer price of these intercompany transactions, which method do you feel would be appropriate? Well, it would be cumbersome to define costs and profits using the Cost Plus Method or the Resale Price Method, while there may not exist appropriate data for using Comparable Uncontrolled Price Method. Traditional methods cannot operate in complex scenarios of the new business world and the same gave emergence to the usage of the Transactional Net Margin Method.
What is the Transactional Net Margin Method?
The Transactional Net Margin Method(also referred to as TNMM) is typically used when other methods fail to provide an answer to the arm’s length pricing owing to the complexities involved in the transaction. The Transactional Net Margin Method examines the net profit margin of the entire transaction and measures the same relative to a base. These bases may include Sales, Assets, Costs, etc. and thus, the net profit margin would be Return on Total Costs, Return on Assets, Operating Profit to Net Sales, etc. Unlike the Cost Plus Method or Resale Price Method which are based on Gross Profit Margin, the Transactional Net Margin Method is less direct and uses Net Profit Margin as the basis of arriving arm’s length price. This rescues us from the lengthy calculations involved in arriving at cost of goods sold, the direct and indirect costs, or the gross profit margin. Many factors may affect the Net Profit Margin, however, the same may not be relevant for or affect the transfer price.
Choice of ‘Tested Party’
The application of Transactional Net Margin Method is similar to Cost Plus Method or the Resale Price Method, except that this method does not require detailed analysis of the product as in the case of other two methods. In this method, one of the parties involved is examined for the net profit margin, and the same is referred to as the ‘Tested Party’. The choice of the tested party is a key starting point and the goal is to select a party where data is more easily available and thereby transfer price can be determined.
Example –If Alpha produces umbrellas and sells it to Beta who in turn sells it to customers at INR 500 per piece. Now, in this case, Beta is a less complex entity as it only a sales company and does not manufacture the product. We also have the price of the umbrellas readily available. Thus, we would take Beta as the tested party, and Resale price as the base. Thus, if we earn INR 100 per piece overall, the Transactional Net Margin would be 20% of the Sale Price. This margin has to be compared with other transactions and it has to be established if the same is comparable.
In the Comparable Uncontrolled Price Method, we would have compared the Price charged by Alpha to Beta with similar uncontrolled transactions. Meanwhile, the Cost Plus Method would have considered Alpha as the base party to calculate its cost and arrive at transfer price, and the Resale Price Method would have considered Beta as the base party to reverse calculate the additional costs and arrive at transfer price. Thus, the traditional methods would have involved finding comparable data, maintaining detailed cost records, adjusting accounting policies and numerous other complexities, which can be done away by using Transactional Net Margin Method. The choice of least complex entity as the tested party makes this method easier to implement than other methods.
Arm’s Length Net Profit Margin
When the profit margin is compared to a base, the resultant percentage or ratio is referred to as ‘Profit Level Indicator’ (PLI). Profit Level Indicator is a measure of a company’s profitability to compare the historical data with the same for tested party. Following are a few commonly used Profit Level Indicators:
- Return of Assets (ROA)–ratio of operating profit of the transaction to the operating assets
- Return on Capital Employed (ROCE)– Ratio of operating profit of the transaction to the capital employed which is usually computed by deducting cash and investments from total assets
- Operating Margin–Ratio of operating profit to the sales
- Return on Total Costs–Ratio of operating profit to the total costs
- Return on Cost of Goods Sold–Ratio of gross profit to the cost of goods sold
- Berry Ratio–Ratio of gross profit to the operating expenses
Depending on the availability of data, the choice of tested party, and the nature of the transaction, an appropriate profit level indicator has to be used to arrive at arm’s length net profit margin. This profit level indicator is then compared to the comparables derived from similar uncontrolled transactions.
The comparability standard for the purpose of the Transactional Net Margin Method has to be maintained higher than other methods as the method directly deals with the Net Profit Margin. However, unlike traditional methods, Transactional Net Margin Method does not depend on product comparability or functional comparability. Net Margin is usually affected by factors that may have little or no impact on the Price or the Gross Profit of the product or service. These factors can include:
- Competitive position
- Barriers to entry into the market/industry
- The efficiency of the management
- Individual strategies of the businesses
- Threat from substitute products
- Variation in the cost structures of the product e.g. the expired life of plant and equipment
- The business experience of the enterprise e.g. a start-up vs an established business
The profit level indicator may be arrived at by applying the formula to transactions in particular or at enterprise-wide, however, care must be taken that the results are not significantly different in either case. The profit level indicator must reflect the results in consistency whether applied to a particular case or at enterprise-wide. Multiple year data may also be used to arrive at the comparables to provide better comparability.
Computation of Arm’s Length Price under Transactional Net Margin Method
Step 1 – Choose thetested party. Select the enterprise forming part of the transaction which is least complex as the tested party.
Step 2 – Select the profit level indicator to be used. Care must be taken that the profit level indicator appropriately reflects the profit made out of the transaction and does not provide consistent results if applied in different situations.
Step 3 – Determine the profit level indicator for uncontrolled transactions and arrive at a comparable range of profit level indicator which can be used as a basis for determining if the net margin is at arm’s length range. It is important that the comparable is derived using a reasonable range of data which may pertain to multiple transactions of the same nature or the enterprise as a whole. The consistency of results is a key factor.
Step 4 – Determine the profit level indicator for the transaction between the associated enterprises.
Step 5 – Analyse the differences between the controlled transactions and the uncontrolled transactions considered as comparable, which have an impact on the Net Margin. Quantify the differences in terms of impact on the net margin and make necessary adjustments to arrive at the appropriate net margin.
Step 6 –Compare the Adjusted Net Margin arrived in Step 5 with the comparables determined in Step 3. If the net margin is within the range of comparable data, it would be considered as at arm’s length.
Step 7 – Transfer Price can be arrived using the arm’s length margin as determined in step 6. For e.g., if the operating margin of the buying enterprise (associated enterprise who is buying from the other associated enterprise) is considered as the Profit Level Indicator, then the transfer price can be arrived by applying the operating margin on the sales to customers and the COGS so derived can then be adjusted by the costs incurred by the buying enterprise and balance figure would be considered as Transfer Price.
Advantages and Disadvantages of the Transactional Net Margin Method
- Product comparability and functional comparability play a less important role in arriving at arm’s length price and thus, make the process easier than other methods.
- It can be applied to any party, irrespective of assets or intangibles held by each party.
- The results of this method resemble the results of the Resale Price Method or the Cost Plus Method.
- The factors affecting net margins usually have a little to do with price or the gross profit margin. Thus, it is imperative to consider these qualitative factors while determining the arm’s length price.
- If the tested party is involved in multiple kinds of transactions, measurement of revenues, costs or assets can become a difficult task as the same may have to be split into segments before arriving at the profit level indicator.
- The results in the Transactional Net Margin Method are arrived using one party as the basis while the balance goes to the other party. This may result in unfavorable results for the other enterprise involved.
When to use the Transactional Net Margin Method?
The Transactional Net Margin Method works only under specific circumstances and therefore, one must firstly brainstorm on the following points, before proceeding with this method, to ensure the viability of its results:
- Broad Comparable Functions–The Transactional Net Margin Methodis useful when the transfer price is being derived for broad functions regularly performed. This method is not ideal for determining arm’s length price for transactions that are non-repetitive or not functional.
- The Fall Back Method–This method should be used when it is not possible to arrive at transfer price using the Resale Price Method or the Cost Plus Method, as these methods require an enormous amount of data which may not be readily available, however, provide a better basis of arriving at arm’s length price than transactional net margin method. For e.g. the associated enterprise may treat warranty costs differently from the comparables available from the uncontrolled transactions. In such a case, one may first try to eliminate the differences and apply the traditional method. If the same is not accurately possible, then one may fall back to the transactional net margin method.