Transfer Pricing - Concept of Profit Level Indicator

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Overview

The UAE Corporate Tax Law, effective from 1 June 2023, enforces the transfer pricing (TP)

provisions and related documentation. Recently, the FTA issued the Transfer Pricing Guide 1

elaborating various concepts of TP. In this write-up, we have explained an important

aspect of the Transactional Net Margin Method (TNMM) method – the Profit Level Indicator

(PLI).

TP Methods

To evaluate the arm’s length price of transactions with related parties or connected

persons, TP provisions mandate use of any one of the five internationally accepted

methods 2 viz. Comparable Uncontrolled Price (CUP) Method, Resale price Method (RPM),

Cost plus Method (CPM), Transactional Net Margin Method (TNMM) and Profit Split Method

(PSM).

In situations where direct comparability of commercial and financial factors is not

feasible, transactional profit methods are recommended. TNMM is one such method. It is

used where each party to the transaction makes a valuable and unique contribution, or

the transaction involves highly integrated activities or where the availability of third party

data poses a challenge. TNMM is one of the most popular methods in TP.

Profit Level Indicator

The TNMM uses an important indicator for comparison of a controlled transaction with

comparable uncontrolled transactions – the profit level indicator. The ratio of net profit to

an appropriate base of cost (or expenses), sales or assets, is known as the profit level

indicator (PLI). This ratio is then compared with ratios of similar comparables – internal or

external.

Selection of an appropriate PLI depends on the functions performed, risks assumed and

assets used by the parties to the transaction (FAR analysis). The table below illustrates

some of the commonly used PLIs and their practical applications:

Selection of an Appropriate PLI

The selection of the most appropriate PLI is a factual exercise and can change from year

to year. The selection depends of many factors including:

- Nature of the controlled transaction – for instance, a cost-based PLI is commonly

used for pricing intra-group services;

- Scale of operations of the company – for instance, the operating margins of a

company with a high turnover may not be suitable for a small scale or medium

sized companies;

- Strengths and weaknesses of various PLIs – for instance, return on assets employed

may be suitable for an entity with substantial intangibles rather than for a trading

entity;

- Availability of reliable information required to apply that PLI – comparables

operating in multiple segments may be rejected in the absence of segmental data;

- Adjustments needed to eliminate differences between controlled and uncontrolled

transaction – for instance, while comparing PLI of the entity with that of

comparables, adjustments have to be made for differences in accounting practices,

foreign exchange, tax year, exceptional events like mergers, spin-offs etc.

Conclusion

Considering the popularity of the TNMM method globally, selection of the most appropriate

PLI is critical to ensure better accuracy in determination of arm’s length pricing of

controlled transaction. The entire process of selection of the most appropriate PLI, while

rejecting the others, must be adequately justified and documented in case of an inquiry

from the tax authorities in the future.

Disclaimer : The content on this website is provided for general informational purposes

only. It is not intended as professional advice and should not be construed as such. The

information is based on the knowledge and experience available at the time of writing

and is subject to change.