There are five accepted transfer pricing methods. Three are traditional transaction methods that compare prices or gross margins. Two are transactional profit methods that compare net profitability. Every transfer pricing textbook covers all five at equal length. This article does not, because in practice, they are not equally important.
TNMM/CPM is the method applied in the vast majority of benchmarking studies for routine intercompany transactions: services, distribution, contract manufacturing. If your company has a subsidiary providing services to a related entity, TNMM/CPM is almost certainly the right method. The question is not which method to use. The question is which profit level indicator and which comparables.
This article covers all five methods, but it spends time where the time is deserved.
The Three Traditional Methods (in Brief)
Traditional transaction methods compare prices or gross margins at the transaction level. They are conceptually the most direct tests of arm’s length pricing, but they require a level of comparability that is difficult to achieve for most intercompany transactions.
CUP (Comparable Uncontrolled Price) compares the controlled price directly to a price in a comparable uncontrolled transaction. Same product, same terms, same market conditions. When a reliable CUP exists, it is the strongest evidence of arm’s length pricing. The problem is that reliable CUPs almost never exist outside of three areas: commodity transactions (where market prices are published), standardized financial instruments, and certain licensing arrangements where comparable agreements are publicly available.
For intercompany services? There is no CUP. There is no public market for “software engineering services provided by a subsidiary to its parent at a specific scope and quality level.” Anyone who claims otherwise is probably confusing a CUP with a general market rate for outsourced IT, which is not the same thing.
Resale Price (RPM) and Cost Plus (C+) compare gross margins: the resale margin for distributors, the gross markup for manufacturers and service providers. Both are conceptually sound. Both have been largely displaced by TNMM/CPM in practice, because finding reliable comparable gross margins is harder than finding reliable comparable net margins. Gross margins are more sensitive to product differences, accounting classifications, and cost structure variations than net margins are.
RPM still appears occasionally for distribution arrangements where the distributor adds minimal value. Cost Plus at the gross level has been mostly replaced by net cost plus markup under TNMM/CPM. For a detailed discussion of net cost plus markup, see our dedicated article.
TNMM/CPM: The Method That Covers Most Cases
TNMM (the OECD term) and CPM (the US term under §1.482) compare the tested party’s net profitability to that of comparable independent companies. The tested party is the entity in the controlled transaction whose profitability can be most reliably benchmarked, typically the less complex entity.
The profit level indicator depends on the function. For service providers and contract manufacturers: net cost plus markup. For distributors: operating margin. For entities where the cost base or revenue base is unreliable: Berry ratio.
Why does TNMM/CPM dominate? Three reasons. First, comparable companies at the net margin level are widely available through commercial databases and public filings. Second, net margins are less affected by product differences between the tested party and the comparables than gross margins or prices. Third, the method accommodates the reality that most intercompany transactions do not have a directly comparable uncontrolled transaction.
The CompPress library is built around TNMM/CPM: pre-built benchmarking studies covering ten common intercompany service profiles using net cost plus markup, with FY 2022-2024 financials from SEC EDGAR and Financial Modeling Prep.
Profit Split: When One-Sided Methods Do Not Work
Profit split divides the combined profits of both parties based on their relative contributions. It is the right method when both sides of the transaction make unique and valuable contributions that cannot be reliably benchmarked independently.
When does this apply? Consider a pharmaceutical group where one entity performs drug discovery (contributing research IP) and another performs clinical development and commercialization (contributing regulatory expertise and market access). Both contribute unique intangibles. Neither can be reliably characterized as the “routine” party. A one-sided TNMM/CPM study that benchmarks only one of them would miss the contribution of the other.
Other common profit split scenarios: integrated technology platforms where both entities contribute proprietary algorithms, joint ventures with shared IP, and highly interdependent manufacturing-distribution arrangements where neither party operates at arm’s length independently.
Profit split is more complex than TNMM/CPM. It requires detailed data on each party’s contributions (often measured by R&D spending, headcount, capital employed, or a combination), and the split itself needs to be benchmarked against comparable arrangements, which are scarce. Most mid-market companies do not need profit split. If the FAR analysis characterizes one party as a routine service provider or distributor, TNMM/CPM is sufficient.
Documenting the Choice
Most jurisdictions require the transfer pricing study to explain why the selected method is the most appropriate. Germany requires an explicit discussion of each rejected method. The US requires a “best method” analysis.
For a routine service provider benchmarked using TNMM/CPM, the documentation can be concise: CUP rejected because no comparable uncontrolled transactions exist for the specific service. RPM not applicable because the entity does not resell products. Gross cost plus rejected in favor of net cost plus because net margin comparables are more reliable. Profit split not appropriate because only one party makes unique contributions.
This section does not need to be long. But it needs to exist. Its absence is a documentation gap that invites scrutiny.
The Mistakes That Matter
Choosing the method that produces the best result. If the tested party falls within range under TNMM/CPM but outside range under another method, selecting TNMM/CPM for that reason is not defensible. Method selection follows from the facts, not from the outcome. If an auditor suspects the method was chosen for the result, the credibility of the entire study suffers.
Using CUP without true comparability. A third-party service contract for IT outsourcing is not a CUP for intercompany software engineering. Different scope, different terms, different risk allocation. An unreliable CUP is worse than no CUP, because it creates the impression of a direct comparison where none exists.
Not revisiting the method when the business changes. A subsidiary that was a contract manufacturer three years ago may now own production IP. The method that was appropriate then may not be appropriate now. Method selection should be reviewed alongside the functional analysis as part of each annual update.
A Closing Note
Method selection is often treated as a formality, and for routine transactions, it usually is. TNMM/CPM with the right PLI covers the vast majority of cases. But “the method is obvious” is not the same as “the documentation is not needed.” A study that does not explain why it chose its method has a gap that an auditor can walk through.
Frequently Asked Questions
What is the most appropriate transfer pricing method?
The OECD requires the 'most appropriate method' based on the facts. The US uses a 'best method rule' under §1.482. There is no fixed hierarchy. In practice, TNMM/CPM dominates for routine transactions because reliable net margin comparables are more widely available than transaction-level price data.
What is the difference between TNMM and CPM?
TNMM (Transactional Net Margin Method) is the OECD term. CPM (Comparable Profits Method) is the US term. The mechanics are substantially the same: both compare the tested party's net profitability to comparable independent companies. For a detailed comparison, see our article on TNMM vs CPM.
When should I use the profit split method?
When both parties make unique and valuable contributions that cannot be reliably benchmarked on a one-sided basis. Common scenarios: integrated value chains where both entities contribute IP, joint R&D, highly interdependent operations. Profit split is more complex and data-intensive than TNMM/CPM.
Can I change methods from year to year?
Method selection should be consistent unless the underlying facts change. A change in business model or functional profile can justify a switch, but it must be documented. Changing methods to achieve a more favorable result is exactly the pattern tax authorities look for.