Return on Total Costs: A key Profit Level Indicator in Transfer Pricing
When applying the Transactional Net Margin Method (TNMM), selecting the right Profit Level Indicator (PLI) is critical to ensure compliance with transfer pricing rules. Return on Total Costs (ROTC), also known as the Net Mark-Up Ratio, is one of the most widely used PLIs for entities performing routine, low-risk functions. It is particularly relevant for companies operating on a cost-plus basis, where costs are the main value driver. Both Philippine regulations and Organisation for Economic Co-operation and Development (OECD) guidelines recognise ROTC as a reliable measure for benchmarking profitability in such cases.
What is ROTC?
- ROTC measures operating profit relative to total costs incurred by the tested party. It is commonly applied when the tested entity performs support or manufacturing functions without owning significant intangibles or assuming major risks.
- Formula: ROTC=Total Costs/Operating Profit×100%
Industries and companies that typically operate under cost-plus arrangements, making ROTC the most reliable indicator for benchmarking, are as follows:
- Contract manufacturing: electronics (e.g., semiconductor assembly), automotive parts, pharmaceuticals
- Shared service centers: finance and accounting back-office, HR services
- Business Process Outsourcing: call centers, IT-enabled services
- Contract research and development: engineering design, product testing
- Information Technology (IT) support and managed services: routine IT maintenance and helpdesk
- Third-party logistics providers: warehousing and distribution services
- Routine consulting and administrative support firms
(Chapter II, Section on TNMM for OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, Revenue Regulations No. 2-2013 on Philippine Internal Transfer Pricing Guidelines, and Revenue Audit Memorandum Order No. 1-2019 on Transfer Pricing Audit Guidelines)
Taxpayers engaged in routine manufacturing or service activities should review their intercompany pricing policies to ensure that ROTC applied is consistent with arm’s length principles. Maintain robust comparability analysis and documentation to mitigate transfer pricing audit risks.