Transactional profit methods

Despite the fact that traditional transaction methods are found to be to be more preferable, there are cases when transactional profit methods are considered to be more adequate. Those are the cases when “each of the parties makes valuable and unique contributions in relation to the controlled transaction, or where the parties engage in highly integrated activities, may make a transactional profit split more appropriate than a one-sided method”, or when there is available reliable

information (OECD,2010).

The application of the arm’s length principle in the case of these methods changes comparing with the application regarding traditional transaction methods. According to paragraph 2.108 of Review of Comparability and of Profit Methods, OECD: “Arm’s length principle in the case of a transactional profit split method, it is based on an approximation of the division of profits that independent

enterprises would have expected to realize from engaging in the transaction(s)” (OECD, 2010). Still, they are only appropriate if they are in compliance with the Article 9 of the OECD model Tax

Convention.

There are two transactional profit methods:

 Profit split method;

 Transactional Net Margin Method.

2.6.3.1. Profit split method

It is known that when a company redistribute the income in favor of the parent company affiliated divisions hold up prices not only when they supply goods, but also when they forward various services, patents, licenses and "know-how". When this type of situation is encountered, to justify the application of transfer pricing it is recommended to use the method of profit distribution.

Application of the profit split method is based on the calculation of gross margin (loss) from the affiliated companies marketing products that is later divided between them based on the actual contribution to the formation of the total profit. In practice, as a criteria for the distribution of profit it is possible to use the indicators of average number of employees or the amount of labor costs.

The basis for the choice of the method of determination of the transfer price both by the taxpayer and the tax authority should take into account the advantages and the disadvantages of the examined methods, their compliance with the requirements, as well as the availability of the information on comparable transactions and companies.

For example, in Russia, the Federal Law № 227-FZ makes it possible to conclude Advance Pricing Agreements for tax purposes between large taxpayers and tax authorities. The object of such agreements is to establish methods for determination of the transfer prices, which must include:

sources of information on comparable companies, transactions, prices; Comparable objects; the procedure for making allowances; the calculations, determination of the gross profit margin.

The fulfillment of the provisions of such an agreement by the taxpayer should facilitate the release from taxpayers’ liability (Lemeskina, 2012).

Talking about the strengths, the profit split method can be the most appropriate method when both parties make unique and valuable contributions to the transaction. Moreover, this method can take into account “possibly unique, facts and circumstances of the associated enterprises that are not present in independent enterprises, while still constituting an arm’s length approach to the extent that it reflects what independent enterprises reasonably would have done if faced with the same

circumstances” (OECD, 2010). Furthermore, it evaluates all the parties that make any contribution to the transaction.

 Despite its advantages, the profit split methods have some drawbacks;

 It is quite difficult to apply this method as you can face obstacles trying to get information from foreign affiliates and analyze combined revenue and costs of all the parties participated in the transaction;

 It is used quite seldom and is more considered to be a theoretical method;

 It can be difficult to differentiate between transaction and the rest of the processes income, costs and property;

 The method is used on a basis of historical data, not on the current one. It is always easier to analyze what has already happened (Bjerke, 1997).

2.6.3.2. Transactional net margin method (TNMM)

Profit comparison methods (TNMM/CPM) – methods of comparing profits. There are two varieties of this group of methods: Transactional Net Margin Method (TNMM) – net margin method and the Comparable Profits Method (CPM) – a method of profit comparison. The basis of these methods is the determination of the price based on the comparison of profit on the controlled transaction with a profit of independent businesses.

This method allows us to neutralize the drawbacks by changing the price of the transaction's gross profit margin to the operating margin of the company. Depending on the circumstances, the different financial indicators can be used. A specific indicator is chosen in the way that better reflects the factor on which the profit depends. The algorithm of this method includes the following steps:

 selection of the source of information;

 functional analysis;

 selection of the examined side;

 choosing a financial indicator;

 selection of comparable companies;

 calculation of the market gross profit margin;

 comparison of profit margin obtained by the test company, with a market gross profit margin (Simonov, 2014).

Advantages and disadvantages of TNMM.

Advantages:

 Comparing this method with the CUP method, net profit indicators («e.g. return on assets, operating income to sales, and possibly other measures of net profit») are less influenced by the transactional differences, what’s more, these indicators are more tolerant to these

mentioned differences;

 Sometimes it is hard to get information on the operating expenses due to some problems with public data in some countries and the use of net profit margin can face this problem;

 It is not necessary to analyze the financial statements of all the participants in the transaction unlike it is the case with the profit split method (OECD, 2010).

The point 2.77, B.3.3 says that «only those items that (a) directly or indirectly relate to the controlled transaction at hand and (b) are of an operating nature should be taken into account in the

determination of the net profit indicator for the application of the transactional net margin method».

Disadvantages:

 It’s difficult for taxpayers to apply the TNMM for controlled transaction when there is no reliable information on the uncontrolled transaction what impose obstacles on the forming the correct sample of the companies.

For example, Russian Classification of the economic activities includes different types of activities that can not be compared one with another (Lemeskina, 2012).

It is applied to only one of the affiliated parties that can give bias results due to the one-sided approach.

The determination of the corresponding adjustment may impose some difficulties as there can appear uncertainty about which of the company’s profits of the group should be adjusted.