Transactional Net Margin Method (TNMM): Flexible Approach in Applying Arm's Length Principle

In the application of Transfer Pricing, Taxpayers often face obstacles regarding the absence of perfect comparable data to apply traditional methods like CUP, Resale Price, or Cost Plus. When market price or gross margin data is unavailable or insufficiently reliable due to functional and accounting differences, the Transactional Net Margin Method (TNMM) becomes the solution most commonly used globally, including in Indonesia.

Definition and Basic Concept of TNMM

Based on MoF Regulation (PMK) 172 of 2023, TNMM is defined as a transfer pricing determination method carried out by comparing the net operating profit level of the tested party with the net operating profit level of comparables from comparable independent transactions.

Philosophy of TNMM

TNMM tests transaction fairness by looking at the "bottom line" or operating profit (EBIT - Earnings Before Interest and Tax). The basic principle is that in a perfect competition market, companies performing similar functions, using similar assets, and assuming similar risks, should yield similar net profit returns, even though the products sold might be different.

OECD TPG 2022 and UN Manual 2021 affirm that TNMM operates in a way similar to the Cost Plus or Resale Price methods, but the comparison is carried out at the net operating profit level relative to a certain basis (such as sales, costs, or assets), not at the gross profit level.

Usage Criteria: When is TNMM Appropriate?

In Indonesia, method selection must follow the The Most Appropriate Method principle. Based on Article 9 paragraph (7) of PMK 172/2023, TNMM can be selected if traditional transactional methods (CUP, RPM, CPM) cannot be applied reliably, and the transaction meets the following characteristics:

1. One Party Simple: The transaction is carried out by one party that does not possess unique and valuable contributions (such as unique intangible property) to the transaction.
2. Not Fully Integrated: The business activities of the parties are not highly integrated (non-highly integrated).
3. Separate Risks: The parties do not mutually share business risks that are economically significant, or separately assume business risks that are closely related.

If both parties possess unique contributions or operations are highly integrated, then TNMM is inappropriate and one must switch to the Profit Split Method.

Mechanism of TNMM Application

A. Selection of the Tested Party (Tested Party)

TNMM is a one-sided method (one-sided method), meaning we only need to test the profit fairness of one party. Based on UN TP Manual 2021 and PER-22/PJ/2013, the tested party must be the entity possessing the simplest functions/assets/risks and does not possess unique intangible property.

B. Selection of Profit Level Indicator (Profit Level Indicator - PLI)

PLI is a financial ratio to measure profit. The following are PLIs commonly used:

• Operating Margin (OM): Operating Profit / Net Sales. Commonly used for distributors.
• Full Cost Mark-up (FCMU): Operating Profit / Total Costs. Suitable for manufacturers or service providers.
• Return on Assets (ROA): Operating Profit / Operating Assets. Appropriate for capital-intensive industries.
• Berry Ratio: Gross Profit / Operating Costs. Limited to intermediary distributors without significant inventory risk.

Comparability Analysis in TNMM

The main advantage of TNMM is its tolerance for product differences. However, OECD TPG 2022 emphasizes that Taxpayers must still ensure:

• Functional Comparability: Comparables must perform similar functions and risks.
• Economic Conditions: Industry and geographical markets must be comparable.
• Business Strategies: Considering start-up stages or market penetration.

Application Case Study

TNMM is a method that is very powerful and flexible, but its usage must not be indiscriminate. This method is not an "automatic method" if other methods fail. Its application must be based on strong functional analysis to select the appropriate tested party and PLI. Neat documentation regarding the reasons for TNMM selection and the comparable selection process is crucial to mitigate correction risks in tax audits.

References

1. Ministry of Finance of the Republic of Indonesia. (2023). Regulation of the Minister of Finance of the Republic of Indonesia Number 172 of 2023 concerning the Application of the Principle of Fairness and Business Prevalence in Transactions Influenced by a Special Relationship.
2. OECD. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing, Paris.
3. United Nations. (2021). Practical Manual on Transfer Pricing for Developing Countries (2021).
4. Directorate General of Taxes. (2013). Regulation of the Director General of Taxes Number PER-22/PJ/2013 concerning Guidelines for Audit of Taxpayers Having a Special Relationship.