Transactional net margin method

Description of the method: the transactional net margin method consists in examining the net profit margin that a party achieves in a transaction or transactions with another related party and setting it at the level of the margin that the same party achieves in transactions with independent parties, or of the margin achieved by independent parties in comparable transactions. The net margin itself may be defined as the difference between total revenue from the transaction analysed and the costs incurred, including general administrative costs. This particular type of cost is deducted from revenue in the proportion that the revenue earned from the given transaction bears to the total revenue achieved by the enterprise.

Analysing and comparing the net margin

When applying the transactional net margin method, particular attention must be paid to the differences between the parties whose margins are compared. Factors to be considered include:

competition from other market participants and from substitute goods,
the effectiveness and strategy of management,
market position,
differences in cost structure and in the cost of raising capital,
experience in the business.

Technical aspects of the transactional net margin method

Technically, the transactional net margin method is similar to the cost plus method. What distinguishes the two is the freedom to choose the profitability indicator against which the net margin is examined. That indicator may be, for example, the operating margin or the return on assets or capital employed, and not only the mark-up on costs as in the reasonable margin method. The methods also differ in that the TNMM calculation takes general administrative costs into account. The operating margin is often used to assess how effectively a company's finances are managed.

Advantages and disadvantages of the transactional net margin method

The main advantage of the TNMM is that net margins are less dependent than gross margins on differences in the functions performed by enterprises in the transactions compared. In addition, the method does not require a detailed functional analysis of the parties to the transaction other than the tested party. Critics of the method nonetheless point to a number of drawbacks. The transactional net margin method takes into account factors that have little or only marginal effect on the profit realised on the transaction, such as the quality and cost of management. Another drawback is that the transaction is analysed from the point of view of only one of the parties involved, which may distort the conclusions and the results obtained with the TNMM.

Comparability of transactions: required by Chapter 2, Examination of the comparability of transactions, in conjunction with Chapter 3, Transfer pricing methods, of the Regulation of the Minister of Finance of 21 December 2018 on transfer pricing for corporate income tax purposes.