Page 152 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
9.7.2 Application
Although the TNMM is classi ed as a transactional pro t method, it is more closely aligned to the CP and RP methods than to the pro t split method. As with the CP and RP methods, the TNMM focuses on the functions performed by an enterprise. The difference is that the TNMM compares net pro t rather than gross pro t.
The TNMM is, however, considered less reliable than the traditional transaction methods. This is because the net margins which are used in the TNMM are very sensitive to the relative cost structures of the entities being compared, as they include operating expenses in their calculations.
For example, if a multinational operates a more ef cient distributorship than the independent rm, the application of the TNMM would result in a lower net pro t being determined for the distributorship than if the RP method were used. Thus, unless an adjustment could be made to re ect the relative ef ciency of the rms being compared, use of the TNMM would not provide a reliable result.
In order to maximise the reliability of the TNMM, the member of the multinational and the independent rm being compared would need to be structurally similar. In practice, rms are structurally unique and comparisons of indicators between rms will tend to be less reliable than comparisons made at the gross margin level. For this reason the TNMM, along with the pro t split method are considered to be methods of last resort in international practice.
This observation does not preclude the TNMM from being used. It must be recognised that reliable information on gross margins may be dif cult, if not impossible, to obtain. Thus information constraints may dictate the TNMM as the only practical approach in many cases.
The connected party (tested party) whose pro t level will be compared to the pro t level of the independent parties, will usually be the party for which reliable data on the most closely comparable transactions can be identi ed. It is also usually the enterprise that is the least complex and that does not own valuable intangible property.
9.7.3 Practical problems
(a) The net margin of a taxpayer can be affected by factors that do not necessarily have an in uence on price or gross margins, thereby reducing the reliance that can be placed on the results in applying the TNMM.
(b) Information about the taxpayer, required to apply the TNMM may not be available at the time of determining
an arm’s length price. It may, for example, not be possible to determine the net margin that will result from
the controlled transaction.
(c) Information on the uncontrolled transaction may not be available.
(d) As with the CP and RP methods, the TNMM is a one-sided analysis, as it does not consider the effect of
the determined price on the other party to the transaction. However, because operating expenses affect the calculations, the result for the TNMM is likely to be less reliable than that determined under the other methods. It is important, therefore, to check that the pro t resulting from applying the TNMM is consistent with what one may expect, based on rst principles.
(e) It is often dif cult to determine a transfer price once an appropriate margin has been determined.
9.7.4 Example
CCP is a manufacturer of dehydrated food. Its products are distributed by subsidiaries throughout Europe. CCP does not sell to independent distributors at all and no comparables could be located that would allow the application of the CUP, cost plus or resale price methods. The pro t split method is not applicable and the only remaining method is thus the TNMM.
Research on comparable independent companies resulted in the determination of an arm’s length range of 15 per cent to 18 per cent. This percentage is determined by expressing operating pro t as a percentage of turnover. After adjustments were made for differences between CCP and the comparable independent companies, in respect of stock holding and debtors days outstanding, the range of arm’s length margins is 17,5 per cent to 19 per cent.
The transfer price for the sale of the dehydrated food from CCP to its subsidiaries should thus be set at a level that will result in operating pro t as a percentage of turnover of between 17,5 per cent and 19 per cent.
9.8 The Pro t Split method
9.8.1 Description
The rst step in the pro t split method is to identify the combined pro t to be split between the connected parties in a controlled transaction. In general, combined operating pro t is used, ensuring that both income and expenses of the multinational are attributed to the relevant connected person consistently.
That pro t is then split between the parties according to an economically valid basis approximating the division of pro ts that would have been anticipated and re ected in an agreement made at arm’s length.
9.8.2 Application
The pro t split method is usually applied where transactions are so interrelated that they cannot be evaluated separately. Under similar circumstances, independent enterprises may decide to set up a form of partnership and agree to some form of pro t split.
Two alternative approaches to the pro t split method are outlined in the OECD Guidelines. Under both approaches, the rst step is to determine the combined pro t attributable to the parties to the transaction. The combined pro t is then allocated as follows:
• Under the residual pro t split approach, each of the parties to the transaction is assigned a portion of pro t according to the basic functions that it performs. The residual pro t or loss is then allocated between the parties on the basis of their relative economic contribution in respect of the amount to be allocated.
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SAIT CompendIum oF TAx LegISLATIon VoLume 2