Transactional Net Margin Method
The application of Arm’s Length Principle while implementing the provisions of Transfer Pricing, to arrive at the price of a transaction between unrelated parties is essential. However different situations call for application of different methods of the ALP principle, depending on the mitigating factors in every transaction. One such method is the Transactional Net Margin Method. Let’s take an in- depth look into this concept.
|Principle of International Taxation||Transfer Pricing|
|Transaction between||International Parties|
|Transfer Price||Price charged between two Associated Enterprises|
|Arm’s Length Price Principle||Price charged between two unrelated parties|
|Governing Provision||Section 92C, Income Tax Act, 1961|
|Type of Method||Transactional Profit Method|
|Application of method||Comparison between the operating profit derived by tested party, from a controlled transaction with the operating profit of an independent uncontrolled third party, relative to an appropriate base.|
Under Transactional Net Margin Method Transfer Pricing (TNMM), a comparison is made for the operating profit derived by tested party, from a controlled transaction, relative to an appropriate base (i.e., costs, sales, assets, etc.) . The results so obtained are then compared with the operating profit of an independent uncontrolled third party , engaged in comparable transaction, relative to the appropriate base .
The ratios most commonly used, express net profits as a percentage of : –
- Costs (full cost or operating costs),
- Particular Balance sheet category (example Assets, Capital Employed, etc.) or
- Sales/ Service receipts.
Steps involved in Transactional Net Margin Method (TNMM) Transfer pricing
Step 1 : – Determine Net Margin Realised
The net margin realised by the enterprise from an international transaction entered with an Associated Enterprise (Related party transaction) is computed, with regards to base discussed above, both for
- the unrelated party ; and
- the party under consideration.
Step 2 : – Net Margin is adjusted for differences
The net margin so derived is adjusted for any differences, between : –
- international transaction between related parties, and the comparable uncontrolled transaction, or
- between the enterprises entering into such transactions
Note : –
Adjustment should be made only when differences could materially affect the amount of net profit margin in the open market.
Step 3 : – Arring at the Arm’s Length Price
The margin so established is taken into account to arrive at an arm’s length price for the international transaction.
Let us understand this with the help of an example : –
Example 1 – Transactional Net Margin Method (TNMM) Transfer pricing
XYZ India procures computer software (“Z”) from SB Singapore @ Rs. 1,500 per Software. Subsequently the company incurs an additional advertisement expenditure in India of Rs. 600 per pack and the product is ultimately sold at Rs. 3,000 per Software. XYZ India also procures packaged software (“T”) from its subsidiary company in UK @ Rs. 700 per Software.
The company incurs an additional expenditure of Rs. 200 per Software and the product is ultimately sold at Rs. 1,200 per Software. Compute the arm’s length price as per TNMM, assuming the difference in product is not material ?
Solution : –
Computation of Net profit margin realized from an unrelated party in a comparable uncontrolled transaction :
|Sale price of product Z||3,000|
|Additional expenditure in India||600|
|Net Profit Margin||900|
|Net profit margin ratio (% of sale)||30%|
Computation of Arm’s length price of international transaction with the AE : –
|Sale price of T – (A)||1,200|
|Net profit margin ratio||30%|
|Net profit margin – (B)||360|
|Total Cost (A – B)||840|
|Additional expenditure in India||200|
|Arm’s length price per unit||640|
|Transfer price per unit||700|
|TP adjustment per unit||60|
Judicial Rulings on Selection of Transactional Net Margin Method (TNMM) Transfer Pricing
|Schutz Dishman Biotech Private Limited vs. DCIT –  60 taxmann.com 50 (Ahmedabad – Trib.)||Schutz Dishman Biotech Private Limited was manufacturing medicines for export. It applied TNMM for benchmarking its transactions, which was rejected, and AO applied CUP.
The Court however accepted TNMM on the basis that margin earned by Schutz Dishman Biotech Private Limited PBIT was exactly similar or nearby with that earned by other uncontrolled transactions of unconnected enterprises.
- Comparable Uncontrolled Price Method (‘CUP’)
- Resale Price Method (‘RPM’)
- Cost Plus Method (‘CPM’)
- Profit Split Method (‘PSM’)
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