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Back to Basics: Profit-based Methods

For years, the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations recommended a “hierarchy of methods,” when it came time to perform an economic analysis. Traditional transactional methods were top choice and profit-based methods—which compare profitability instead of unit prices—were seen as a last-resort, if-you-must kind of thing. Well, in a relief to many transfer pricing practitioners, the OECD changed its mind. The 2010 edition of the Guidelines abolished the hierarchy and instead recommended applying the “most appropriate method” to transfer pricing transactions—a change that has enabled experts to openly embrace the two OECD-approved profit-based methods: The Transactional Net Margin Method (TNMM) and the Profit-split Method. How do they work? When is it wise to use them? What are the pros and cons? We’ve got it all for you right here.

Transactional Net Margin Method (TNMM)

How it works: The transactional net margin method compares net profit margins between companies. Using an external comparable, it compares a controlled entity to similar companies that are operating independently. Comparing the profit margin against actual costs determines the arm’s-length transfer price.

Pros: The TNMM’s relatively relaxed comparability requirements make it one of the most widely used transfer pricing methods. Net-profit data is often publicly available, and the TNMM is less sensitive to minor differences between comparable transactions. Plus, given it’s a one-sided method, you only have to determine the profit margin for the tested party—not the other party in the transaction.

Cons: Relying on public data is risky in terms of determining true—indisputable—comparables. Available information can be insufficient for transfer pricing purposes. Also, this method is hard to use if each party makes unique and valuable contributions, and it relies on profit-level indicators, which can be volatile in terms of determining transfer prices.

Uses: Service transactions, tangible good sales, and transactions involving low-risk R&D.

Profit-Split Method

How it works: The profit-split method is as the name implies: It’s used to determine how profits in a related-party transaction would be split between independent parties. It can also be used to determine how to divide losses between related parties. The method hinges on the contributions of each entity, based on a FAR analysis and of course, available data. Tax professionals compare earnings to a baseline percentage—anything above the baseline is split depending on the value each entity contributes.

Pros: The profit-split method looks at a group’s profits in a holistic way by including both parties’ contributions, and it provides an accurate picture of an MNE’s financial performance. When entities contribute unique and valuable intangibles, it can be challenging to find comparable transactions—and in those cases, the profit-split method becomes a great solution. Ditto for when companies have such interwoven operations, whereby one-sided methods–like the TNMM—can’t be justified. The profit-split method offers more wiggle room than other methods—helpful when each party is assuming significant economic risks.

Cons: The profit-split method tends to be complicated, nuanced, and at times, subjective. It can be difficult to determine how profits should be shared and that can mean a high risk of arm’s-length uncertainty.  The application of this method still requires detailed facts—revenue, costs, operating expenses—about the related parties. Allocating costs and determining the factors that dictate profit allocation can be challenging. In fact, tax authorities want to see exactly how the method was applied and how you arrived at the profit-splitting factors.

Uses: Co-development of unique intangibles.

SIDEBAR: Smooth Sailing with Transfer Pricing Methods

The OECD recommends applying the Most Appropriate Method Rule to give taxpayers flexibility in choosing transfer pricing methods. Of course, what’s most appropriate can be subjective. Here are a few quick tips to get it right.

  1. Pick a method that is organic to your transaction—and one where you have the data you need to use it. Some methods require more precise data than others. Look at the data you have from the onset. Is that adequate for the method you plan to use?
  2. Know which method is preferred by local tax authorities. Some jurisdictions have preferences as to which transfer pricing method should be employed. For example, France prefers the TNMM. Generally, it’s in your best interest to treat those preferences as regulations. If a preferred method doesn’t work, be sure to explain why and why another method was a better choice.
  3. Make a case for the method you employ—and explain why you reject others. Every economic analysis should include a clear explanation as to why a particular method works—and why others don’t. If you’re anticipating questions about your methodology from a tax authority, be proactive and answer them before they’re asked.

How do traditional transactional methods compare to profit-based methods? Find out in Back to Basics: Traditional Transactional Methods.