Internal TNMM, A Cheap and Easy Way to Avoid Transfer Pricing Correction

The Framework of Transfer Pricing under PMK 172

Transfer Pricing refers to the determination of prices in Controlled Transactions. In accordance with Minister of Finance Regulation (PMK) Number 172 of 2023, these prices must be determined based on the Arm’s Length Principle (ALP). The ALP is applied by comparing the conditions of a Controlled Transaction with the conditions and price indicators of a comparable Uncontrolled Transaction.

A mandatory step in applying the ALP is selecting the most appropriate Transfer Pricing method. The Transactional Net Margin Method (TNMM) is commonly used, particularly when comparable data at the price level (CUP method) or gross profit level (RPM and Cost Plus methods) is unavailable. TNMM compares the net operating profit level of the tested party with that of a comparable entity.

The Primacy of Internal Comparables

In applying TNMM, finding reliable comparables is paramount. The ideal benchmark is often an Internal Comparable, which is the primary focus of this discussion. An Internal Comparable is defined as a transaction conducted between an independent party and:

• The Taxpayer (the tested party); or
• The Affiliate who is the counterparty to the transaction.

PMK 172 reinforces the priority principle in selecting comparables. Internal comparables must be selected and used in cases where both internal and external comparables are available with the same level of comparability and reliability. Generally, internal data is deemed more reliable because it shares higher situational similarities with the controlled transaction.

Comparability Analysis: The Heart of ALP

To ensure the reliability of Internal TNMM, it must be applied to the business segment with the simplest Functions, Assets, and Risks (FAR). The comparability analysis aims to prove that the Transfer Price is "arm's length" by evaluating relevant economic characteristics, including:

• Contractual terms.
• FAR Analysis (Functions performed, Assets used, and Risks assumed).
• Product characteristics.
• Economic circumstances.
• Business strategies.

Taxpayers must provide a detailed explanation in the Local File regarding these characteristics. If material differences exist, appropriate and accurate adjustments must be made.

The Critical Role of Segmented Financial Statements

Applying Internal TNMM is impossible without Segmented Financial Statements. This segmentation must be systematic and detailed to isolate financial data related to Controlled Transactions from those with independent parties.

The importance of segmentation includes:

• Isolation of Net Operating Profit (PLI): It ensures the PLI only reflects the specific business activity or characterization being tested.
• Performance Measurement of the Tested Party: It allows for the separate measurement of sales, COGS, and operating expenses related to the controlled transaction.
• Facilitating Internal Benchmarking: Segmentation provides the "Independent Transaction" column which serves as the benchmark for a fair profit range.

Documentation Requirements in the Local File

The Internal TNMM analysis and its supporting data are integral parts of the Local File, which must be available no later than four months after the end of the tax year. The Local File must contain:

• Application of the ALP: Comparability analysis, search criteria for comparables, and the rationale for choosing TNMM.
• Fair Price Determination: The use of an arm's length point or range.
• Financial Information: Segmented financial statements based on business characterization and a summary of the comparable's financial information.