CPM and TNMM
Test the simpler company's profit against independent companies. Pick the right profit level indicator, see where the result falls in the range, and work out the adjustment in dollars.
First, a bet
The Canada Distributor buys goods from the US Entrepreneur. To check the price, you compare one of the two companies with independent companies. You only test one side.
Which company would you test?
Pick the indicator, test the result
Buys finished goods from the US Entrepreneur and resells them to Canadian customers for $10.0m. Spends $1.5m of its own on sales and delivery. No brand, no patents, little risk: the simple side of the deal.
Pick the profit level indicator that fits the Canada Distributor to see the comparables.
Net profit against comparable companies
The Comparable profits method (CPM)A US method that tests a company's operating profit against the operating profit of comparable companies, using a profit level indicator such as operating margin (Treas. Reg. § 1.482-5). It is close to the OECD's TNMM.Open in the Glossary (CPM) asks: what operating profit would the Tested partyThe company in a transaction whose results are compared with comparables. It is usually the simpler, less complex party, such as a routine distributor or manufacturer.Open in the Glossary have earned if it had done as well as independent companies doing similar work? You do not need the other side's numbers. You test the simpler company and the complex one, here the US Entrepreneur, keeps the Residual profitThe profit left after every routine function has been paid its routine return. It usually goes to the principal.Open in the Glossary.
The tested party is the company with the most reliable data that needs the fewest adjustments, and for which good comparables exist. That is usually the least complex one, with no valuable intangibles of its own: a distributor, a contract maker, a service provider.
| PLI | Formula | Usually fits |
|---|---|---|
| Operating marginOperating profit divided by sales. It is the most common profit level indicator for distributors.Open in the Glossary | operating profit / sales | distributors that sell to outsiders |
| Net cost plusOperating profit divided by total costs (cost of sales plus operating expenses). It is the usual profit level indicator for routine manufacturers and service providers.Open in the Glossary | operating profit / total costs | Contract manufacturerA company that makes goods for another group company, to that company's orders and specifications, often using its technology. It bears little risk and earns a routine return, usually a markup on its costs.Open in the Glossary, service providers |
| Berry ratioGross profit divided by operating expenses. It is often used for distributors and service providers whose value comes mainly from their operating activities.Open in the Glossary | gross profit / operating expenses | sellers with no stock whose value is their team |
| Return on assetsOperating profit divided by the operating assets a company uses. It is a profit level indicator sometimes used for manufacturers whose assets drive their profit. US rules call it the rate of return on capital employed.Open in the Glossary | operating profit / operating assets | companies whose assets drive profit |
The base (the bottom of the ratio) must not depend on the price you are testing. That is why a contract maker that sells everything to its parent is not tested on its sales, and why a distributor is not tested on its costs. US rules name return on capital employed, operating margin and the Berry ratio, and allow others, such as net cost plus, when they are reliable. The comparables' data should cover at least the year under review and the two years before it.
The range. Comparables are rarely perfect, so the US uses the Interquartile range (IQR)The middle 50% of comparable results, from the 25th to the 75th percentile. The US rule (Treas. Reg. § 1.482-1(e)(2)(iii)(C)) picks actual comparable results or averages two of them, while Excel's PERCENTILE.INC interpolates between values, so the two can give slightly different ranges.Open in the Glossary, the middle half of the results, picked by the IRS rule. A result inside it needs no change. A result outside it is ordinarily moved to the Median adjustmentIf a US taxpayer's result falls outside the interquartile range, the IRS will ordinarily adjust it to the median of the comparables (Treas. Reg. § 1.482-1(e)(3)).Open in the Glossary. The two quartile rules can differ: switch US and OECD on the Mexico maker or the service distributor and watch the range move. Show as table puts both side by side.
Strengths and weak spots. Operating profit shows up in every set of public accounts, and it does not care whether a cost is booked in cost of goods sold or below it. So the CPM needs looser comparability than the gross methods and is the most used method in practice. But operating profit is also moved by things other than the price, such as a bad year, a new competitor or a costly start-up. Gross vs net is covered in the cost plus lesson.
Source: Treas. Reg. § 1.482-5(b), the CPM, the tested party and PLIs; § 1.482-1(e), the interquartile range and the median; § 1.482-9(f), the CPM for services
Check yourself
Three quick questions. Each answer explains itself, right or wrong.
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