Transactional Net Margin Method (TNMM)
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Maikel Verhoeven
Managing Director
Transactional Net Margin Method (TNMM)
The Transactional Net Margin Method (TNMM) is the most popular Transfer Pricing Method. It’s widely applied across industries due to its ease of application, effectiveness, and typically reduced chance of scrutiny.
TNMM examines the net profit margin relative to a base such as costs, sales, or assets that a taxpayer realizes from a controlled transaction. It ensures that the profitability of related-party transactions aligns with the arm’s length principle—treating related parties as if they were unrelated.
TNMM is generally applied when:
- No Comparable Uncontrolled Price (CUP) exists due to unique transactions or a lack of reliable data.
- One party performs routine, low-risk functions that are easy to benchmark.
- Other methods (like Resale Minus or Cost Plus) are difficult to apply or defend.
This method is especially useful when one of the entities performs routine functions (e.g. contract manufacturing, limited-risk distribution, or shared services). with the distributor. If a distributor increases their OPEX without increasing sales, they become loss-making—keeping pressure on operational efficiency and margin discipline.
How the Transactional Net Margin Method (TNMM works
TNMM compares the operating profit (EBIT) of the tested party with the EBIT margins of comparable independent companies.
A Profit Level Indicator (PLI)—often cost-based or turnover-based—is selected depending on the function performed.
A benchmark study is conducted using financial databases to find suitable comparables.
The resulting benchmark range (e.g. median EBIT/cost margin) is used to determine if the tested party’s results are at arm’s length.
If the tested entity performs multiple routine services, a segmented P&L is prepared to evaluate each function separately.
Comparison: TNMM vs. Cost Plus
The Cost Plus Method applies a gross mark-up to, for example, costs of goods procured, while TNMM with the Net Cost Plus Margin evaluates profitability at the EBIT level on a net margin. The Operational Expenses are as such also considered for the TNMM and not for the Cost Plus Method.
| TNMM | Cost Plus |
|---|---|
| Net margin based (EBIT) | Gross margin based (before OPEX) |
| Operational expenses included | Operational expenses excluded |
| Benchmarked on EBIT/Costs or EBIT/Sales | Based on markup on direct costs |
| Used for routine functions, tested on a net basis | Used for price setting or internal cost markup |
TNMM – P&L placement
TNMM testing takes place at the EBIT level. It often uses cost or turnover as the base, depending on whether the tested party is a cost center (e.g. service provider) or revenue generator (e.g. distributor).
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Why is TNMM widely used in transfer pricing?
TNMM is:
- Easy to apply
- Leaves relatively small results for routine entities
- Prevents losses in multiple jurisdictions
- Typically tax efficient while reducing chances on audits
Tax authorities have an information disadvantage and can more easily dispute other TP methods than the TNMM. It’s often more difficult for tax authorities to judge whether the entity in their jurisdiction is responsible for, for example, losses, or whether that’s caused by factors like budgeting.
This makes that tax authorities are typically in favor of this method. In addition, the easiest way to increase your tax cash out is to have losses in multiple jurisdictions and (assuming a profitable group) consequently high profits in other jurisdictions. The TNMM ensures a small profit in various routine entities and that the residual result is centralized.
In addition, it is relatively easy to implement and maintain, and can be applied to most function/service types.
Pros and Cons of Transactional Net Margin Method
| Pros of TNMM | Cons of TNMM |
|---|---|
| Widely accepted by both tax authorities and taxpayers | Less insight into actual entity performance |
| Predictable results for routine service or distribution entities | Limited incentive for operational improvement (net margin is pre-set) |
| Applicable across industries and functions | Not always suitable for unique/high-value transactions or intangibles |
These limitations can sometimes be addressed through internal management reporting, but they remain a consideration in method selection.
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