Module 6 - CASE STUDY: RESALE PRICE METHOD AND TRANSACTIONAL NET MARGIN METHOD

Welcome to Module 6 of the World Bank’s Transfer Pricing Electronic Learning Tool.
This module will focus on two transfer pricing methods: the Resale Price Method and the Transactional Net
Margin Method.
The Module will use a real-life case-study to illustrate these methods and to consider the selection of the most
appropriate method in specific factual circumstances. The case study is based on a real case encountered in a
developing economy but has been anonymised to protect the taxpayer’s confidentiality. We will start by
describing the two methods.

Slide: 3
The OECD Transfer Pricing Guidelines describe five methods available to tax authorities and taxpayers to
determine an approximation of the arm’s length outcome of a related-party transaction. Most countries import
these methods into their domestic rules and they are:
 The Comparable Uncontrolled Price Method (CUP)
 The Cost-Plus Method (CPM)
 The Resale Price Method (RPM)
 The Transactional Net Margin Method (TNMM)
 The Profit Split Method (PSM)
In this module, we are going to focus on the two highlighted methods, the resale price method and the
transactional net margin method commonly referred to as TNMM.
Slide: 4
In common with the other transfer pricing methods, the resale price method compares the results of a related
party transaction (what we call ‘the controlled transaction’) with those of one or more comparable unrelated
party transactions (referred to as ‘the uncontrolled transaction’). In this case, the comparison is between the
resale price margin, at the gross profit level, earned in the controlled transaction and those made in comparable
uncontrolled transactions.
The method is most often used where a person purchases products from a related party (the controlled
transaction) and resells those products to one or more unrelated parties (which are uncontrolled transactions).
Therefore, the resale price method is potentially available for testing the return of a distributor or other entities
with similar function.
Slide: 5
To take an example, assume that a distributor in Country A purchases agricultural machinery from its parent
company in Country B, and then sells the machinery to independent customers in Country A.

In this case, the resale margin earned by the distributor is $25 million (that is calculated by deducting purchases
of $50 million from sales of $75 million). This resale margin is also the gross margin earned by the distributor,
and, in common with the cost plus method, the resale price method is a ‘gross margin’ method.
In this case the resale price margin (or gross margin) rate is 33% (calculated by dividing the gross profit of 25
million by sales of 75 million and then multiplying by 100 to express the number as a percentage). Now the gross
profit margin of 33% can be tested using the resale price method.

Slide: 6
The resale price method can be used either to establish an arm’s length gross margin in order to set an arm’s
length price, or it can be used to retrospectively test whether an earned margin meets the arm's length
standard.
In order to do this, the method requires:
the identification of entities that perform comparable functions to the tested party (in this case the Country A
distributor) in relation to products acquired from non-related persons.
the identification of the resale price margins earned by those comparable entities, and
the comparison of those margins with that of the tested party.
This analysis can be based on internal or external comparable transactions.
Click here for an illustration based on internal comparables.
Click here for an illustration based on external comparables.
Slide: 7
Before we delve further into the case study, we need to take a look at the Transactional Net Margin Method
(which is referred to as TNMM for the rest of the module).
The TNMM has a many features in common with the resale price method. However, the main difference is that
the comparability analysis compares the operating margin earned in the controlled transaction and the
operating margin (or operating margins) observed in comparable uncontrolled transactions whereas the resale
price method compares gross margins.
In this context, the ‘operating margin’ is normally interpreted as ‘earnings before interest and taxation’,
abbreviated as EBIT. In some countries the operating margin for transfer pricing analysis is referred to as net
profit margin, therefore care should be taken to apply accounting definitions consistently throughout a transfer
pricing analysis.
Slide: 8
Let’s look at the example again.
If Country A distributor incurs operating expenses (or ‘sales, general, and administrative costs’ referred to as SGA)
of 20 million, its operating profit is 5 million. (That is, sales of 75million less 50 million for the purchases less 20
million of operating expenses which leaves a profit of 5 million), and its profit margin (as a percentage of sales) is
6.6% (that is calculated by taking the profit of 5 million divided by the sales of 75 million and then multiplied by
100 to express the profit as a percentage of sales). Now the profit margin of 6.6% can be tested using the TNMM.
In the same way as the resale price method, the TNMM requires:
 the identification of entities that perform comparable functions to the tested party (in this case the Country
A distributor) in relation to transactions with non-related persons
 and the identification of the operating margins earned in those transactions
 which are then compared to the operating margins of the tested party
In this example, the TNMM is applied using an operating margin expressed as a return on sales revenue. The
method can also be used, however, by reference to the operating profit margin over costs, or the operating
profit return to assets. (The different ratios available are referred to as financial indicators or ‘profit level
indicators’ – or PLIs).
As before, this analysis can be based on internal or external comparable transactions.
Click here for an illustration of the application of the TNMM using a sales-based financial indicator.

Slide: 9
Now we will commence the case study which concerns Healthy Start (A), a company resident in Country A.
Healthy Start (A) is a member of a large multinational group (‘Healthy Start Group’), whose head office and
ultimate parent company is located in Poland. The group manufactures and sells breakfast cereals in markets
throughout Europe and South America.
Healthy Start (A) manufactures and sells breakfast cereals in Country A.
Click here to view a summary of the company’s financial results for the period 2015 – 2019.
Click here to view an analysis of the company’s gross profit and operating profit margins for the period 2015 -
2019.
Slide: 10
The auditing team in the Large Business Unit of Country A’s tax administration decided to make enquires of the
Company to establish the reasons behind the history of losses. They carried out a review of the taxpayer files,
held a fact-finding meeting and requested the transfer pricing documentation.
A summary of their analysis and review can be found on the next slide.

Slide: 11
The tax administration established the following facts:
 Healthy Start (A) commenced operations in 2001
 It has made operating losses in all years but one, and paid no corporate income tax to date
 It is a 100% subsidiary of Healthy Start Holding Ltd, a company resident in Poland
 It manufactures a range of breakfast products under the well-known Healthy Start brand and tradenames
 It sells and distributes these products to third party customers in Country A and one neighbouring country
 The main ingredients of Healthy Start products are cereals, nuts and sugar. These are purchased from
another Healthy Start group company, Healthy Start (Procurement) Ltd, based in Genovia
 The manufacturing process includes roasting grains and nuts and mixing and processing them to form
‘clusters’ and flakes used in some products
 Most products are sold in boxes as breakfast cereals
 Healthy Start (A) employs 123 people in Country A, including 45 in the manufacturing and packaging plants,
15 in the sales department, and 21 in the warehouse and distribution sections
A more detailed functional analysis, summarised from the transfer pricing documentation, can be viewed by
clicking here.

Slide: 12
At the beginning of the audit, the Country A auditor requested the taxpayer to submit the transfer pricing
documentation for 2019. In common with many other countries, Country A’s tax law requires taxpayers within
the scope of the transfer pricing rules to document their related party transactions and the analyses they have
carried out to establish that they have conformed with the arm’s length principle. In Country A, the taxpayer
must submit this documentation within 30 days of a request by the tax administration.
The transfer pricing documentation identifies the purchase of raw materials (grain etc) as the main related-party
transaction entered into by Healthy Start (A) and used the resale price method to test the terms of this
transaction against the arm’s length standard.
The documentation concludes that the purchase price of raw materials meets the arm’s length standard. These
purchases are made from a related company, 'Healthy Start Procurement Ltd'.
The next few screens look at this analysis in more depth.
Slide: 13
The transfer pricing documentation, which was produced by the company’s advisors, describes the comparability
analysis undertaken in the application of the resale price method.
The analysis used a commercially available database, which contains details of over 300 million companies
throughout the world, including financial data drawn from those companies’ statutory accounts. The database
allows the data to be searched and analysed. In common with many other countries, the Country A tax
administration does not have access to this or equivalent databases.
The company’s advisor searched the database for companies for stand-alone companies (that is, not part of a
group of companies) that conduct broadly the same functions as Healthy Start (A). This analysis rejected
potential comparable companies for which details of gross profit was not available. This is because gross profit
data is essential for the application of the resale price method. A total of nine independent entities were
selected for the comparability analysis.
The summary of the business description of the nine selected entities can be viewed here, and the results and
analysis of the database search can be viewed here.
Slide: 14

The taxpayer’s transfer pricing documentation concluded that the application of the resale price method
demonstrated that the transfer pricing between Healthy Start (A) and Healthy Start (Procurement) Ltd is at arm’s
length.

This is because Healthy Start (A)’s gross profit margin for 2019 (but also for earlier years) falls within, or exceeds,
the interquartile range of 15% to 19%. At this stage you might have some questions about the taxpayer’s analysis
and conclusions. If so, the following questions and answers may be useful.

Why did the analysis not include comparable data from 2019, which is the year under review? For an answer
click here.

Many country rules require the transfer pricing documentation to be in place by the time the corporate tax
return is due. For the year ended 31st December 2019, and assuming the company tax return is required to be
submitted by 30th September 2020, this means that the analyses and documentation needs to be carried out
during the first part of 2020. At this time, 2019 financial data relating to independent comparable entities may
not be available.

Is it acceptable to base the analysis on a data-set that aggregates three previous years? For an answer click here.
Countries have differing rules or guidance on conducting comparability analyses, but it is not unusual for advisors
to use, and tax administrations to accept, aggregated data spanning a number of years. Such data may have the
advantage of taking account of variances caused by short-term market changes or business cycles.

What is the ‘interquartile range’ and why is it relevant? For an answer click here.

Most tax administrations (and the OECD Transfer Pricing Guidelines) incorporate the concept of an ‘arm’s length
range’ in their rules or guidance, and many accept an ‘interquartile range’ as a proxy for the arm’s length range.
The interquartile range is the range between the first quarter and third quarter points of the full range. Where
such as range is employed, the taxpayer’s result is considered to be acceptable if it falls within the range.
However, it should be noted that the inter-quartile range is usually applied to improve the reliability of the range
and in the case that the selected comparables are all of a very high calibre and are equally reliable it would be
appropriate to use the full range.

Can the tax administration challenge this analysis? For an answer click here. If there is a good reason to, yes. We
will see in the next slides that the tax administration had strong arguments to do so in this case.

Slide: 15

The Country A tax administration took the view that the resale price method is unlikely to be appropriate to test
against the arm’s length standard for the pricing of goods (cereals, nuts, sugar etc) purchased from a related
party by Healthy Start (A).

Their concerns are as follows.

1. The resale price method is most appropriate where the purchaser does not add significant value to the
product before resale. In this case, Healthy Start (A)’s functions consist of much more than simply purchase and
sale of the same product. The manufacturing process they undertake adds significant value and changes the
nature of the product. Click here for further details of this argument.

2. Reliable gross margin data on potential comparable entities is difficult to find. Commercial databases
frequently do not capture gross margin data. This may explain why the comparability search in this case
identified comparables from only two countries, despite using a global database. Click here to read the
commentary on this issue from the World Bank Transfer Pricing ‘Handbook for Policy Makers and Practitioners’.

3. There may be variances of accounting practices on the reporting of costs between ‘cost of goods sold’ (which
affect gross margin) and operating expenses (which affect net margin, but not gross margin). These are difficult
to identify and adjust for, which means that the resale price method may be unreliable in some circumstances.
Click here to view an excerpt from the 2017 OECD Transfer Pricing Guidelines that discusses this issue.

4. Healthy Start (A) has made losses consistently since 2001. An independent entity, transacting at arm’s length,
would not be willing to make such long-term commercial losses. It would either renegotiate contracts, cease
business, change the business or be taken over by another entity. This suggests that the pricing is not at arm’s
length, and further suggests that the resale price method is not a reliable method in this case.

5. The companies identified and used as ‘comparables’ in the taxpayer’s analysis do not appear to match the
functions conducted by Healthy Start (A). They appear to be mostly distributors, which is how the taxpayer
appears to be characterising Healthy Start (A)’s business in the transfer pricing analysis. In reality, it seems that
Healthy Start’s business appears to be closer to a manufacturer who also distributes, perhaps even a ‘licenced’
manufacturer sometimes referred to as a fully-fledged manufacturer. Then, if this is the case, many of the
‘comparables’ may be unreliable, and the resale price method again is unlikely to be an appropriate method in
this case.

Although, in this case study, the tax administration has made a plausible argument to reject the resale price
method, this will not be the case in all circumstances. In some circumstances, the method may be robust and
appropriate – we will discuss this later in the module.

Slide: 16
The Country A tax administration auditor may make a number of contentions.
1. The Resale Price Method is unreliable and gives rise to an uncommercial and implausible result. The method
is more suited to test the return to a business that primarily consists of reselling products acquired from a
related party.

2. Healthy Start (A)’s business is better considered as a manufacturer that:

- purchases raw materials from related parties
- manufactures finished goods from those products
- conducts sales and distribution functions
- does not have right to a return in key product intangibles (For example patents, designs, know-how etc)

3. The TNMM is a more appropriate method, in this case.

4. If the tax administration has access to data on comparables, it may be able to conduct its own comparables
search and analysis. In this case, the search criteria could be to identify independent manufacturers with similar
functional profiles. If a TNMM is used, the financial comparisons would be at the operating profit level, probably
using EBIT/sales revenue as the ‘profit level indicator’, but possibly a return on assets or return on full costs may
also be a suitable PLI.

5. If the tax administration does not have access to the data needed to conduct a comparability analysis, it could
request the taxpayer to rerun its benchmarking searches, but employing comparability data at the operating
profit level.

6. Otherwise, the determination of a realistic benchmark return may need to be a subject of negotiation or,
ultimately, may be litigated through the courts.

Slide: 17

Module 4 contains a detailed discussion of the strengths and weaknesses of the resale price method. The main
points are:
- In principle, gross margin methods such as the resale price method might, in some respects, be more reliable
than net margin methods because a gross margin should not be affected by factors that affect overhead or
operating costs, but, at arm’s length, would not affect the transfer pricing. Such costs will be reflected in the
financial accounts as operating costs, which do not affect gross margins.
- Gross profit data may not be captured in publicly available financial accounts. This affects the accessibility of
such data for the commercial databases that are often used in transfer pricing, and this means that the gross
margin data required for a comparability analysis may be inaccessible or very limited.
- There may be accounting practice variances between countries and companies in the reporting of costs
between ‘cost of goods sold’ (which affect gross margin) and operating expenses (which affect net margin, but
not the gross margin). These are difficult to identify and adjust for when undertaking a comparability analysis.
- In some cases, reliable gross margin data derived from one or more internal comparables may be available and
therefore more reliable than data extracted from a commercial database.
Slide: 18
The Country A transfer pricing auditor in this case argues that the TNMM is a more appropriate method for this
case. The arguments for this are as follows:

1. TNMM is a better fit to the circumstances. The resale price method relies on testing the gross margin
between related party purchases and third-party sales. It makes sense when testing an entity whose main
function is buy/sell. In this case, this is not the only, or even the primary function carried on by Healthy Start (A),
evidenced by the split of employees between the manufacturing and distribution functions.

2. It is likely that the commercial databases will be able to identify a much larger number of potential
comparable entities. This is because net profit data is more likely than gross profit data to be available on such
databases.

3. A larger pool of potential comparable companies means that it is more likely that comparables with more
accurate functional profile and geographic comparability will be available.

4. The TNMM uses ‘earnings before interest and tax’ or the operating margin as the denominator for the ‘profit
level indicator’. This means that variances in reporting costs between ‘costs of good sold’ and ‘operating costs’
are no longer significant. It also means that all costs involved in conducting the manufacturing and sales
functions are taken into account.

5. The TNMM is likely to give rise to a profit in Healthy Start (A), in line with comparables with a similar
functional profile. In this case, the resale price method has been used to justify a long-term loss, which would
not have been realistic for a stand-alone entity operating on arm’s length terms. Of course, a TNMM cannot
guarantee a profit. There may be industry regional trends that give rise to cyclical or short term losses. These
would be reflected in the comparables data. Alternatively, there may be specific factors in Healthy Start (A)’s
business that would give rise to a short-term loss in a stand-alone business – but long-term losses extending well
beyond the start-up phase would not be commercially realistic.
Slide: 19 - 25

This section allows you to test your understanding of the concepts covered in this module.
Click on ‘Agree’ or ‘Disagree’ on the following statements:

1. The resale price method and the TNMM are both ‘one-sided’ methods that test the return to one of the
parties to the controlled transaction(s).

2. Where the resale price method or TNMM are applied, it does not matter which party is selected as the tested
party.

3. The resale price method and TNMM both implement comparability at the level of gross margin.

4. In the case study, the tax administration considered the resale price method to be inappropriate only because
of the unavailability of gross margin comparability data.

5. In this case, a strength of the TNMM is that the comparability analysis is not distorted by variances in the
reporting of costs.

6. TNMM guarantees a profit in the tested party.

7. The TNMM will always utilise a ‘return on sales’ (i.e. net profit/sales revenue (%)).

This brings us to the conclusion of Module 6 of the World Bank’s Transfer Pricing Electronic Learning Tool, refer
to other modules for more in-depth discussion on various tax technical issues raised in Module 6.