In the management of intra-group transactions carried out by multinational companies, the correct determination of the profit margin is an essential pillar of the transfer pricing regime. The objective is to ensure that transactions between related entities are carried out under arm’s-length conditions, in accordance with the international standards contained in the Organization for Economic Cooperation and Development (OECD) and adopted by many jurisdictions.
This article analyzes the fundamentals for determining an appropriate profit margin in intra-group transactions, the key steps in functional and comparability analysis, profit level indicators (PLIs), and the practical challenges faced by taxpayers.
Regulatory and methodological basis
The OECD defines in its “OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” that the transfer pricing method should reflect what an independent company would have agreed to under comparable conditions.
Among the recognized methods, “transactional profit methods” such as the Transactional Net Margin Method (TNMM) or the Profit Split Method are used when it is not feasible to apply traditional transaction-based methods.
Therefore, the determination of the profit margin is based on three essential phases:
- Functional analysis: identification of functions, risks, and assets of the intragroup parties.
- Identification of an appropriate profit level indicator (PLI).
- Comparability and establishment of an arm’s-length margin range based on comparable independent companies.
Step 1: Functional analysis and selection of the tested party
Functional analysis consists of examining what functions each related entity performs (e.g., manufacturing, distribution, service provision), what risks it assumes (e.g., market risk, credit risk, technological risk), and what assets it uses or owns. This analysis is key to choosing the most appropriate method and defining the level of complexity of the tested party.
In many cases, the tested party is selected as the least complex intragroup entity (e.g., a pure distributor or routine service entity) that does not possess unique tangible assets or assume significant risks. This facilitates the application of unilateral methods.
This approach is particularly useful because, as it is a less complex party, it is easier to find independent comparables and apply a net margin indicator.
Step 2: Selection of the profit level indicator (PLI)
The PLI is the ratio that relates profit (or margin) to a relevant base (sales, costs, assets). The OECD mentions that these may include: the ratio of operating income to sales, return on assets, Berry ratios, among others.
The choice of PLI depends on the nature of the business of the party being evaluated:
- For an entity that only distributes, net profit/sales can be used.
- For a manufacturing entity with intensive assets, return on assets could be considered.
- For a routine services entity, perhaps margin on costs.
Once the PLI has been selected, the margin realized by the evaluated party in the intra-group transaction is calculated.
Step 3: Comparability and establishment of the arm’s-length margin range
After the functional analysis and selection of the PLI, the taxpayer must seek independent (external) or internal (where applicable) comparables that perform similar activities under comparable conditions, in order to generate a margin range that an independent entity could achieve.
During this phase, comparability adjustments must be made to eliminate significant differences between the evaluated party and the comparables (e.g., geographic location, volume of operations, risk diversification).
Finally, it is verified whether the margin of the intragroup entity is within the established range. If it is, the application is considered to be in line with the arm’s length principle. Otherwise, adjustments must be analyzed, intragroup prices modified, or justified differences documented.
An illustrative example of the method: In an evaluated entity with sales of USD 1,000,000, costs of USD 700,000, operating expenses of USD 200,000, and operating profit of USD 100,000, the operating margin on sales would be 10% (100k / 1,000k). If independent comparables show a range between 8% and 11%, then 10% is within the range and is considered acceptable.
Challenges and best practices for taxpayers
Frequent challenges:
- Shortage of reliable comparables, especially for intangibles or highly specialized activities.
- Comparability adjustments that may be questioned by the tax authority.
- Risk of margin deviation without documentation to justify operational or risk differences.
- Need for periodic updating of documentation to reflect changes in the economic environment or group structure.
Recommended best practices:
- Perform a robust functional analysis that clearly documents functions, assets, and risks.
- Carefully choose the PLI that best reflects the reality of the business of the party being evaluated.
- Maintain a database of comparables and document comparability adjustments transparently.
- Obtain internal or external audit support to reinforce the credibility of the analysis.
- Periodically review margins and intragroup pricing policy to ensure they remain consistent with the reality of the group and the market.
Conclusion
Determining a profit margin in intragroup transactions is a technical process that requires rigor: a detailed functional analysis, the choice of an appropriate profit level indicator, and a reliable comparability check. The correct use of methods such as TNMM allows taxpayers to demonstrate that their intragroup transactions were carried out in accordance with the arm’s length principle, mitigating the risk of tax adjustments or penalties.
For multinational companies and groups with intra-group transactions, adopting a documented, up-to-date, and consistent transfer pricing policy is not only good practice but a necessity to ensure alignment with OECD international standards.
Source: OCDE