Under Transactional Net Margin Method (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 TNMM
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 : – ARRIVING 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 : –
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 :
Computation of Arm’s length price of international transaction with the AE : –