Transfer Pricing - Transactional Profit Methods in a Nutshell
In recent years transfer pricing has been attracting a lot of attention from tax authorities worldwide. The term “transfer prices” refers to the prices set in controlled transactions (i.e., transactions between related parties). In order to combat artificial shifting of profits abroad, most international and domestic tax laws worldwide require that transfer prices be set in line with the arm’s length principle.
The arm’s length principle requires that transfer prices reflect the prices that would have been set between independent enterprises in comparable transactions and comparable circumstances. To reduce transfer pricing risks, multinational enterprises calculate transfer prices using recognized transfer pricing methods. The OECD TP Guidelines outline five distinct transfer pricing methods. They are divided into two general categories: traditional transaction methods and transactional profit methods.
Traditional transaction methods comprise:
- the comparable uncontrolled price method,
- the resale price method and
- the cost plus method.
Transactional profit methods include:
- the transactional net margin method and
- the transactional profit split method.
Below we outline the two transactional profit methods. Traditional transaction methods are described in our separate article on Traditional transaction methods.
Key Legal Issues
- To establish the arm’s length price, TP specialists apply transfer pricing methods.
- TP methods are divided into two general categories: traditional transaction methods and transactional profit methods.
- Tax authorities may scrutinize the choice of the method, as well as the way it is being applied to the particular transaction.
Transactional Net Margin Method
The transactional net margin method (TNMM) examines an operating (net) profit that a taxpayer realizes from a controlled transaction divided by an appropriate metric, such as costs, sales, assets. One of the most frequently used profit indicators is net profit divided by sales, i.e., net profit margin. Ideally, transfer prices are established using the TNMM by reference to the profit indicators earned by the tested party in transactions with independent entities. Otherwise, the review could refer to profit indicators of comparable transactions by enterprises independent from the tested party. TNNM is often used when it is hard to obtain data necessary to apply CUP or cost plus methods.
Example of Transactional Net Margin Method
BlenderCo manufactures and sells kitchen appliances to its parent company HomeCo, on orders and according to the specifications set by the parent company. BlenderCo owns only manufacturing-related assets, assumes limited risks and does not own any IP rights related to manufactured products (e.g., product designs, trademarks, trade names). Let’s assume that BlenderCo sells products solely to HomeCo and thus no internal comparable for the purposes of the CUP method is available. Let’s also assume that it is not possible to obtain information on gross mark ups earned by comparable independent enterprises (so the cost plus method cannot also be applied). For more details on the CUP and cost plus methods, please refer to our article on Traditional transaction methods.
The TNNM is thus chosen as an appropriate TP method, with earnings before interest and taxation to sales – EBIT to sales – as the net profit indicator. Based on the search of publicly available data it is established that there are 6 sufficiently comparable independent enterprises. The review of their accounts indicates that their EBIT to sales ranged in relevant period from 3.5%-6%. Therefore, it will be at arm’s length if BlenderCo retains profitability within that range.
Profit Split Method
The profit split method (PSM) identifies and splits profits from a controlled transaction between the associated enterprises. The PSM aims to arrive at an arm’s length split, i.e., an approximate division of profits (and losses) that would have been agreed between independent enterprises in comparable circumstances. The PSM is particularly useful if both parties to a transaction make unique and valuable contributions (e.g. contribute unique and valuable intangibles) to the transaction.
Example of Profit Split Method
Companies ProdCo and MarketCo form part of an MNE active in the automotive industry. ProdCo is responsible for research and development, product design, quality control, manufacturing scheduling and testing. It owns unique and valuable IP such as patents, product designs and know-how. MarketCo deals with global marketing and distributions. It has non-routine functions as it creates unique marketing campaigns and is responsible for setting marketing strategies on national level, budgeting and control thereof.
Since each ProdCo and MarketCo make unique and valuable contributions to the operations of the MNE group, it would be appropriate to use the PSM in this scenario. It would be necessary to identify the profit split factor reflecting the value of relative contributions of each party to the controlled transaction.
What this means for you
In November 2022, Malta has introduced its first Transfer Pricing Regulations. Starting from year 2024, the Regulations impose transfer pricing documentation obligations on Malta resident companies engaging in intra-group transactions. It is expected that Malta tax authorizes will ramp up their efforts in the fields of transfer pricing. Taxpayers involved in transactions with related entities should make sure that their transfer prices conform with the arm’s length principle. Transfer prices should be calculated using an appropriate TP method and ideally supported by comprehensive TP documentation.
How we can help
Our team of experienced advisors can help to identify, assess and mitigate potential transfer pricing risks in your business and to develop a sustainable, tax efficient transfer pricing policy for the future. As a collaborating firm of Andersen, leading global Tax & Legal advisors, we offer the comfort of years of experience in this highly contentious area.
Get in touch with us to learn how we can help you to manage your transfer pricing risks so that your business remains in compliance with Malta TP laws whilst retaining its operational effectiveness.
