Transfer pricing is central to the management of intra-group transactions for multinational companies, having a significant impact on profit distribution and tax compliance. This article presents a case study from the IT industry, where a fictitious multinational (TechIT) applies the Transactional Net Margin Method (TNMM) to transfer pricing, using the Rate of Return on Total Costs as a profitability indicator.

I. Background of the Fictitious Company

TechIT is a (fictitious) multinational company operating in the IT industry, with subsidiaries in Germany (headquarters), Romania and India. The branch in Romania is responsible for providing software development services, while the branch in India provides technical support and maintenance services. TechIT sells software products to customers around the world, and transfer pricing for services provided by the branch in Romania to the head office is essential for a fair allocation of profits between entities.

II. Transfer pricing

TechIT is faced with the challenge of establishing a fair transfer price for the software development services provided by the branch in Romania to the head office in Germany. Given the specific nature of the services and the need to correctly reflect the costs involved, the net margin method was applied.

III. Applying the net margin method with the rate of return on total costs

The total cost return ratio measures the ratio of operating profit to the total costs incurred by the subsidiary. This indicator is ideal for comparing financial performance in the context of the provision of services to affiliated companies, as it provides a clear insight into the efficiency in the use of resources.

The key steps for applying this method are:

1. Selection of Profitability Indicator: TechIT’s contracted tax consulting company chose Total Cost Return Ratio as its primary profitability indicator because it best reflects the operational efficiency relative to the costs associated with providing software development services.

2. Identification of Comparables: The tax consulting company contracted by TechIT carried out a comparability study to identify independent companies in Romania that provide similar software development services. These companies were used as comparables to evaluate the rate of return.

3. Calculation of the rate of return for the branch in Romania: Based on the financial data, the rate of return on total costs for the branch in Romania was calculated, including all direct and indirect costs associated with the provision of software development services.

4. Comparison with comparable entities: The rate of return on total costs of the branch in Romania was compared with similar rates of comparable companies. If the rate of return on total costs calculated for the branch in Romania fell within the interquartile range resulting from the comparability study, the transfer price was considered in accordance with the arm’s length principle.

5. Transfer price adjustment: If the rate of return on total costs of the branch in Romania was outside the interquartile range resulting from the comparability study, the TechIT company had the possibility to adjust the transfer price so that the rate of return on total costs of the branch in Romania was falls within the interquartile range resulting from the comparability study, the transfer price being considered in accordance with the market value principle (arm’s length principle).

IV. Results and benefits

By applying the net margin method with the rate of return on total costs, TechIT was able to establish a transfer price that correctly reflects the value of the software development services provided by the branch in Romania. This allowed for a fair distribution of profits between the affiliated entities while complying with international tax regulations.

Using the rate of return on total costs provided significant advantages:

• Relevance to services: This indicator was relevant to service-related transactions, such as software development, providing a clear picture of operational efficiency.

• Tax compliance: TechIT was able to demonstrate compliance with international standards and minimize tax risks by adopting a well-founded transfer pricing policy.

Therefore, the rate of return on total costs has proven to be an appropriate indicator for TechIT in setting transfer prices for software development services. This allowed the company to align profits between affiliated companies according to the market value principle and ensure tax compliance globally. This case study highlights the importance of the right profitability indicator selection and rigorous documentation to meet the tax challenges faced by a multinational.

If you are facing similar transfer pricing policy challenges, our team of experts is ready to help you develop and implement customized and compliant solutions.