To demonstrate that transactions are at arm’s length, the UAE CT Law prescribes several methods—one of which is the Transactional Net Margin Method (TNMM).
The Transactional Net Margin Method (TNMM) examines the net profit earned from a controlled transaction relative to an appropriate base, such as costs, sales, or assets. In this way, the TNMM operates similarly to the Comparable Profits Method (CPM) and the Resale Price Method (RPM), and should be applied in a comparable manner. However, unlike CPM and RPM, the TNMM allows the use of multiple bases—including costs, sales, or assets—providing greater flexibility in selecting the most appropriate profit level indicator based on the nature of the transaction and the availability of reliable data.
When applying the Transactional Net Margin Method (TNMM), the net profit margin from the controlled transaction should be determined by referencing the net profit margin from comparable uncontrolled transactions—either internal or external—depending on the specific circumstances:
Types of comparability
Internal Comparable: This involves using the net profit margin from a similar transaction conducted between one of the related parties or connected persons and an independent third party.
External Comparable: This refers to using the net profit margin from a similar transaction carried out between two independent third parties.
Applying TNMM: Key Points and Considerations
- Comparability analysis is essential before selecting and applying TNMM or any Transfer Pricing method.
- TNMM uses net profit indicators: ratios of net profit to an appropriate base (costs, sales, or assets).
- Differences between Related Parties or Connected Persons and independent enterprises in these factors can have material effects on profitability. To achieve reliable comparability and a valid arm’s length result, such differences must be carefully identified and adjusted for where necessary.
- These indicators are generally less sensitive to product or functional differences than price or gross margins but can still be influenced by factors such as expense treatment, capacity utilisation, competition, management, cost structures, financing methods, and business maturity.
PLI’s used
Profit Level Indicator (PLI) in transfer pricing is a financial ratio used to measure a company’s profitability relative to a key value driver (like sales, costs, or assets) to test whether controlled transactions are conducted at arm’s length. Types of PLI’s have been mentioned below:
- Operating margin (return on sales): Operating margin is calculated by dividing operating profit by sales.
- Net cost-plus (full cost mark-up): Cost-plus mark-up is calculated by dividing operating profit by total costs.
- Return on assets (ROA) or return on capital employed (ROCE): Return on assets or capital employed is calculated by dividing operating profit by operating assets or capital employed.
- Berry ratio: Berry ratio is calculated by dividing gross profit by operating expenses.
As a general rule, the denominator of the net margin indicator should be based on an uncontrolled measure that reflects the key value driver for the tested party, considering its functions, risks, and assets. For example, sales may suit reselling or distribution, costs or expenses may suit services or manufacturing, and operating assets may suit capital-intensive activities. Other bases may be appropriate depending on the case.
Selection of an appropriate PLI
Choosing the right profit level indicator under the TNMM depends on the specific details of the controlled transaction. Key factors to consider include:
- How strong or weak each potential indicator is in practice;
- How well the indicator fits the nature of the transaction, based on a thorough functional analysis;
- Whether reliable data is available to support its use; and
- How comparable the controlled and uncontrolled transactions are, and how easily any differences can be adjusted.
In short, the best indicator is the one that aligns with the economic reality of the transaction and is supported by solid, comparable data.
Aggregation of transactions and company-wide analysis using TNMM
While it is generally preferred to apply the Transactional Net Margin Method (TNMM) at the transactional level, there are situations where using it on an aggregate basis may be appropriate—but only when the grouped activities or transactions are economically or commercially interlinked. For example, this could apply when a Taxable Person performs similar sales functions across related product lines.
However, applying the TNMM on a company-wide basis becomes much less reliable when the entity is involved in multiple different Controlled Transactions, performs varied functions, or operates across distinct business segments that cannot be meaningfully aggregated or compared with those of independent parties.
So, what’s the practical takeaway for Taxable Persons?
- Aim to apply TNMM at the transactional level, especially when dealing with specific functions, simpler transactions, or business segments involving Related Parties or Connected Persons.
- Avoid a company-wide TNMM application if the transactions aren’t clearly interrelated, as it may not give a reliable basis for Transfer Pricing analysis.
- However, Taxable Persons may choose to apply TNMM (or another method) on a company-wide basis to support or validate the results of separate, more focused transactional analyses.
Conclusion
The Transactional Net Margin Method (TNMM) is a widely accepted and practical approach for Transfer Pricing analysis, especially when reliable comparables are available. By focusing on net profit margins relative to an appropriate base, TNMM provides a flexible and economically sound means to determine arm’s length pricing. When applied correctly with thorough functional analysis and robust comparability adjustments, TNMM helps ensure compliance with regulatory requirements while minimizing tax risks.
How BCL Globiz Helps?
The Transactional Net Margin Method (TNMM) is a key tool for ensuring Transfer Pricing compliance and managing tax risks. Accurate functional analysis, careful selection of comparables, and precise calculation of net margins are crucial for reliable results. At BCL Globiz, we support businesses by identifying suitable comparable companies, performing detailed financial analyses, and preparing comprehensive documentation to justify TNMM application. Our customized approach ensures alignment with the arm’s length principle and UAE regulations, helping clients maintain robust and defensible Transfer Pricing positions.
For further assistance, reach out to our expert rakesh@bclglobiz.com and check out our website www.bcl.ae.
