This piece came out of a review request from a listed Japanese manufacturer. The client was not satisfied with the transfer pricing method their tax firm had applied, and wanted a quick second opinion on it.

My own transfer pricing work was three years spent on documentation for three companies, about a decade ago — when there was far less precedent on which method was standard, and a good deal of seminar attendance and reading to get up to speed.

This is written for people in accounting rather than for tax specialists, so it is deliberately broad-brush.

What TNMM actually is

The transactional net margin method determines the arm’s length price for a controlled transaction by reference to the level of operating profit derived from it.

Which, as a definition, tells you very little. In practice: you are documenting Company A, so you identify Company B, which performs similar functions. If B’s operating margin is 20%, you set the import or export price so that A lands within a band of a few percentage points either side of that 20%.

Why it is almost always TNMM

Roughly two-thirds of documented cases use TNMM, and there is a reason for that.

Where another method genuinely applies, it fits the transaction far better than TNMM does. The problem is that the circumstances allowing it are rare, and finding true comparables is very hard.

TNMM constrains you only on margin, which is a looser test, so comparables are easier to identify. In most cases the method is arrived at by elimination: nothing else works, so TNMM it is.

One caveat on “easier to identify” — that is relative to the other methods only. Selecting comparables in-house is effectively impossible for an accounting department, and I have never seen a company do it. Why that is, and what it means for how much you outsource, is the subject of the next piece.