Transfer pricing formation using the TNMM
Basic principles of transfer price formation
Currently, fiscal authorities around the world are increasingly attempting to counteract the tax-driven allocation of profits for the exploitation of tax-rate differentials through regulations for determining transfer pricing. A purely unilateral approach, or adjustments that have not been agreed with other countries would result in double taxation on account of the different regulations for determining transfer pricing. In order to address the problem of double taxation, industrialised countries within the framework of the OECD have agreed specific transfer pricing methods, which admittedly have no direct legal effect but, nevertheless, have received widespread attention.
The OECD and national legislators have organised the various transfer pricing methods under the premise of the arm’s length principle, according to which intragroup (‘controlled’) transactions have to stand up to an arm’s length comparison at all times. Yet, the OECD and all the countries involved agree that transfer pricing is not an exact science. While the weaknesses of OECD transfer pricing methods are well known here, nevertheless they form a kind of convention and, to a large extent, all the countries involved adhere to it and have transposed the methods into national law.
Transfer price formation methods
As regards the classification of the methods for determining transfer pricing, a distinction is generally made between the so-called traditional transaction methods and the transactional profit methods.
Traditional transactional methods
For ‘fully comparable’ arm’s length transactions, Section 1(3) of the External Tax Relations Act (Außensteuerrecht, AStG) provides for the priority of the traditional transactional methods. Accordingly, there remains no scope for the transactional net margin method as a transactional profit method.
Although, fully comparable arm’s length transactions – thus, uncontrolled transactions with almost identical business conditions – are rarely observed in practice. If the transactions are comparable only to a limited extent then, besides the traditional transactional methods, the application of transactional profit methods also have to be considered.
Transactional profit methods
These determine the appropriate transfer price retroactively; in other words, after allocating a profit that conforms to arm’s length principles in business terms the necessary transfer price is calculated from this.
While the fiscal authority has a critical stance towards transactional profit methods, an increasing acceptance of them has nonetheless been observed in practice. Moreover, since 2005, the fiscal authority has even officially allowed the use of the TNMM for entities with routine functions, i.e. businesses with simple functions and few risks. Since then the TNMM has been applied more and more frequently.
The mechanism of the TNMM
The TNMM differs from other methods in that it is a so-called one-sided method where, normally, only one of the parties is the subject of an arm’s length analysis. That is why the TNMM usually involves an examination of an entity that only performs routine functions and not, however, its intragroup business partner. Consequently, the amount of the intragroup business partner’s remaining residual profit is not included in the pricing structure. Furthermore, with the TNMM the main focus is rather on the functional comparability of the supplying business. Therefore, the functional and risk characteristics of the supplying business are analysed and less so the specific performance rendered (product or service). The TNMM thus strongly resembles the cost plus method (a traditional transaction method).
If an entity performs routine functions then a comparison is made between its net margin (generally the EBIT margin) and the margin of independent suppliers/service providers, and the intra-group performance is then priced such that the target margin determined in this way, and which complies with the arm’s length principle, is achieved.
In order to determine the net margin, the net profit is set in relation to an appropriate profit level indicator (PLI). In the case of sales entities, for example, the target EBIT margin would thus be fixed in relation to revenues. Such data from comparable companies are frequently readily available and, consequently, a database search will normally display a large number of profitability ratios, which in some cases will deviate greatly from one another.
Example: A German manufacturer opens an independent sales entity in Spain. A database survey shows that independent sales entities in this industry achieve a 2% EBIT margin on sales. The selling prices charged by the German manufacturer to the Spanish sales entity would be determined in such a way that the Spanish sales entity would likewise generate a 2% EBIT margin. The residual profit would remain with the German manufacturer.
An argument that the fiscal authority frequently brings forward against the TNMM is that the comparative profitability ratio is determined on a company-wide basis, but not – as actually necessary – on the basis of individual business relationships. However, this criticism is rooted in the transfer pricing method itself and can likewise be levelled against the cost plus method (a traditional transaction method), which is accepted by the fiscal authority.
Please note: Ultimately, the argument can only be refuted through a careful selection of comparable enterprises that engage solely in a comparable business activity.
An appraisal of the TNMM
The TNMM would be particularly suitable for the pricing of sales functions and services. In practical tax planning, this method is used in outbound cases, in particular also to avoid the consequences of a transfer of functions.
The opinion expressed in the literature is that the transfer of the sales function to an entity that performs routine functions (e.g. to a so-called limited-risk distributor) and the application of the TNMM would rule out the presumption of the transfer of a function, or significantly soften it because, ultimately, the residual profits would remain in Germany. The fiscal authority supports this view and makes reference to a statutory provision in Section 2(2) of the Regulation on the Application of the Arm’s Length Principle (Verordnung zur Anwendung des Fremdvergleichsgrundsatzes, FVerlV), from the text of which it is actually not possible to ascertain whether or not the TNMM may be used. All the same, the fiscal authority is stretching the scope of application to also include the TNMM.