The residual profit split method initially focuses on the company in a

The residual profit split method initially focuses on

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The residual profit split method initially focuses on the company in a controlled transaction which performs the most routine functions, for example toll-manufacturing or (limited risk) distributing services. Routine functions are functions which are low value-added compared to the overall profitability. Such company is generally referred to as 'least-complex entity'. The residual profit split method seeks to set the appropriate arm's length remuneration for such least-complex entity, whereby the remaining profit is allocated to the other company of the controlled transaction. An example: Company A sells widgets through its subsidiary, a limited-risk distributor, in the Turkish market. Assume that an overall profit of 100 is made on the sale. The limited-risk distributor should receive an at arm's length return of 5. Then, the residual profit of 95 would be allocated to Company A, being the complex entity or entrepreneur. In case of an overall loss, the Turkish subsidiary should, in principle, continue to receive the arm's length return of 5.
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165 Transactional Net Margin Method (TNMM) TNMM, meanwhile, is a method that focuses on the arm's length operating profit (earnings after all operating expenses, including overhead, but before interest and taxes) earned by one of the entities (the tested party) in the transaction. It stipulates that relative operating profit (relative to sales, costs, or assets to allow comparisons between different companies or transactions) may be a more robust measure of an arm's length result when close comparables, as required for the traditional methods, are not available. For example, two distributors may sell different products that require different sales efforts per unit sold. This may lead to very different gross margins (and hence the resale price method may not be easily applicable). However, the operating margins would not be expected to be materially different since the margins reflects a competitive return only. The margin is measured pre-interest since the level of interest expense is a function of how a company decides to finance its operations and unrelated to the transfer pricing. Although not one of the traditional three methods, the TNMM and its counterpart under the U.S. transfer pricing regulations, the Comparable Profits Methodor CPMis one of the most-widely used transfer pricing methods. See for example, the IRS' annual APA report which publishes details on the transfer pricing methods used in APAs. MULTIPLE CHOICE QUESTIONS
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