How is the arm’s length price determined? Two transactional profit methods

The previous article covered the three traditional transaction methods. This article introduces two methods that rely on profit, which are used when comparable transactions are hard to find or the transaction is complex.
 

What are transactional profit methods?

Transactional profit methods determine the arm’s length price based on the profit realized from a transaction rather than on the transaction price. In Korea, Article 8, Paragraph 1 of the Law for the Coordination of International Tax Affairs (LCITA) provides for the transactional net margin method in Item 4 and the profit split method in Item 5. This article looks at the profit split method and the transactional net margin method in turn.

Profit Split Method (PSM)

The profit split method allocates the combined profits arising from an intercompany transaction between the parties based on their relative contributions. It is used when the transaction is so closely integrated that one party cannot be evaluated separately, or when both parties make unique and valuable contributions to the transaction, for example through key technology or brands. 

For example, suppose a parent and its overseas subsidiary jointly develop and sell a new product and earn a combined operating profit of KRW 100. If an analysis of their relative contributions supports a 60:40 split, allocating KRW 60 to the parent and KRW 40 to the subsidiary would be consistent with the arm’s length principle.

Relative contributions are assessed using reasonable criteria, taking into account the functions performed, assets used, risks assumed, and expenditure on key activities such as research and development and marketing. However, the assessment of contributions can be subjective, and the financial data of both companies is required, which makes the method demanding to apply.

Transactional Net Margin Method (TNMM)

The transactional net margin method compares the net margin (such as the operating margin) earned by the tested party from an intercompany transaction with that earned by independent companies in comparable transactions. Because only one party’s margin needs to be tested, it is usually applied to the party with simpler functions (for example, a subsidiary that buys and resells products).

For example, suppose an overseas subsidiary buys products from its parent and resells them, generating sales of KRW 1,000 and earning an operating profit of KRW 20 (an operating margin of 2%). If comparable independent distributors earn operating margins of 3% to 5% (the arm’s length range), the subsidiary’s operating margin falls below that range. All else being equal, the parent’s supply price can be lowered so that the subsidiary’s operating margin falls within this range.

The TNMM is one of the most widely used methods in practice. It compares margins rather than prices, so it is less affected by product differences. Operating profit is also less affected by differences in how costs are classified between cost of goods sold and operating expenses. In addition, publicly available financial data on companies can make it relatively easier to identify potential comparables. However, operating profit is also influenced by factors other than the transaction price, such as operating expenses and economic fluctuations, so comparables should be selected carefully on the basis of similar functions, assets, and risks.
 

Which method should you choose?

LCITA Article 8(1) requires the most reasonable of the methods in Items 1 to 5 to be used and does not set a priority among them, so there is no single answer for every transaction. If the arm’s length price cannot be determined under Items 1 to 5, other methods recognized as reasonable under Presidential Decree may be applied under Item 6.

The OECD Transfer Pricing Guidelines prefer the traditional transaction methods over the transactional profit methods where both can be applied with equal reliability. That preference applies only when reliability is equal. In practice, however, limited comparable transaction data or the complexity of a transaction may make traditional transaction methods less reliable or more difficult to apply. In such cases, the transactional profit methods, and the TNMM in particular, are widely used. Whichever method is chosen, the reasons and the basis of the comparability analysis should be documented in the transfer pricing report.

An arm’s length analysis goes beyond calculating profit margins. Businesses should be able to explain whether the resulting profits appropriately reflect each party’s actual role and the risks it assumes. Changes in the transaction structure or the parties’ roles should therefore prompt a review of whether the existing transfer pricing policy remains appropriate.