When conducting a transfer pricing study, one must select the most appropriate comparison method to show that the prices set in a controlled transaction (i.e., a transaction between related parties) are at arm’s length. Within its transfer pricing guidelines, the Organization for Economic Cooperation and Development (OECD) outlines the methods that can be employed and categorizes them into two distinct groups: traditional transaction methods and the transaction profit methods. The profit split method is categorized within the transaction profit methods group, along with the transactional net margin method.
The profit split method is a transfer pricing method used to allocate profits between related entities in different tax jurisdictions. It is designed to ensure that each entity involved receives an appropriate share of the overall profits based on the functions performed, risks assumed, and assets employed by each entity.
In certain situations, companies engage in interconnected transactions that cannot be easily observed on an individual basis. For instance, two related companies might collaborate on a joint venture, such as developing and launching a new brand. In such cases, the profit split method (PSM) can be used to determine a fair division of profits between the organizations involved.
How does the profit split method work?
The PSM can be applied through two approaches: the contribution profit split method, and the residual profit split method. The selection of an approach depends on the structure of the transaction and the available data.
The contribution profit split method involves assessing the relative financial or other contributions made by the companies involved in the transaction. A fair distribution of profits is determined based on these contributions.
The residual profit split method considers the total profits generated, deducts the profits derived from routine functions of both parties (calculated using one sided transfer pricing methods, for example the cost plus method), and allocates the residual profits using the profit split method. Generally, the allocation is based on each party’s investments and relative expenditures.
The division of the profit is done, in most cases, according to the relevant profit split factors. The functional analysis and the circumstances of the transaction are needed to determine the profit split factor, and when more then on factor is used, their wight. The factor can be a figure, for example 40% to one party, as in similar transactions between unrelated transactions, a variable, for example
The PSM is commonly employed by companies operating in complex industries with significant profit margins, such as high-tech and pharmaceutical organizations. It is particularly valuable when dealing with intangible assets like intellectual property, as these transactions often involve intricate considerations that make other methods less applicable.
Example of the application of the Profit Split Method
Let’s look at a simple example of the PSM. Consider a multinational enterprise (MNE) with two entities, Company A and Company B. Each of the companies uses valuable intangible assets in the making of the product that the MNE sells.
Using the profit split method, specifically the contribution profit split method the contributions of each entity are evaluated. It was determined that Company A contributes 60% to the value creation, while Company B that contributes 40%.
If the MNE’s total profit is $10 million, the profit split would be:
- Company A: $6 million (60% of $10 million)
- Company B: $4 million (40% of $10 million)
This ensures a fair distribution of profits, reflecting each entity’s role in value creation.
Suitability in different contexts
The suitability of the profit split method can vary depending on the specific context and characteristics of the transaction. Here’s an overview of the some of the different scenarios the method applicable in:
- Complex Transaction – The profit split method is well-suited for complex transactions that involve multiple interdependent activities and contributions. It can effectively allocate profits when the transaction is highly interconnected and requires a comprehensive assessment of each entity’s value contribution.
- Unique and Valuable Contributions – When related entities make unique and valuable contributions to a transaction, such as in joint ventures or collaborations, the profit split method is particularly relevant. It ensures that the profit distribution reflects the significance of each party’s contribution.
- Intangible Asset Transactions – The profit split method fits transactions involving intangible assets, such as intellectual property. It allows for a thorough evaluation of the contributions related to the development, utilization, and exploitation of intangible assets, resulting in a more accurate profit allocation.
Advantages
The profit split method offers several advantages within the realm of transfer pricing, including the following:
- Equitable Allocation and Handling Complexity – By considering the relative contributions of entities involved in a transaction, the profit split method ensures a fair and equitable distribution of profits. This approach acknowledges the value added by each party, fostering fairness in profit allocation. This approach recognizes that different entities within a multinational enterprise may perform various functions, provide valuable assets, and assume different risks. The profit split method seeks to evaluate and quantify these contributions accurately, thereby ensuring that each entity receives a proportionate share of the profits generated by the MNE. Additionally, the profit split method is adept at managing complex transactions that involve multiple interdependent activities and contributions. It considers the interconnectedness of entities and offers a framework for profit allocation that accurately reflects the overall value generated.
- Flexible Approach – The profit split method provides flexibility when determining the factors for profit division. It considers various elements like functions performed, assets used, and risks assumed by each entity, allowing for a tailored approach that suits the specific circumstances of the transaction.
- Highly Integrated Business Operations – The profit split method is utilized when highly integrated business operations are involved in controlled transactions. According to the OECD guidelines, this level of integration implies that the functions performed, assets deployed, and risks assumed by the parties involved are closely interconnected. For instance, they may be engaged in the same stage of the value chain. As a result, it is not feasible to reliably assess them separately using a one-sided method.
- Intangible Asset Transactions – The profit split method proves advantageous in transactions involving intangible assets, such as intellectual property. It enables a comprehensive evaluation of contributions, encompassing the utilization and development of intangible assets. This leads to a more accurate allocation of profits.
Disadvantages
While the profit split method offers advantages, it is important to also consider its potential disadvantages and challenges. Some of the drawbacks associated with the profit split method include:
- Subjectivity – The profit split method involves subjective judgments in determining the relative contributions of each entity. Assessing the value added by each party and quantifying their contributions can be subjective, leading to potential disagreements and disputes between the related entities and tax authorities. Due to the subjectivity involved in determining the profit split factors and the complexity of the method itself, there is an increased risk of disputes and disagreements with tax authorities. The interpretation and application of the profit split method can vary, leading to potential challenges in achieving consensus on the appropriate profit .
- Data Availability – The profit split method heavily relies on the availability of accurate and reliable data. Obtaining the necessary information on functions, assets, risks, and financial contributions may be challenging, especially in transactions involving complex intercompany arrangements or intangible assets. While the needed data might seem relatively accessible for both the taxpayer and the tax authority, it may be difficult to for them to access this data. Because it can be difficult to calculate the relevant revenues and costs for all of the parties, this might require the parties to start books together and keep records on a common basis and change the accounting practices they already have.
- Increased Compliance Burden – Implementing the profit split method requires comprehensive documentation and analysis to support the allocation of profits. This adds to the compliance burden for companies, as they must provide detailed explanations and justifications to the tax authorities to ensure the method’s defensibility.
Considerations when applying the Profit Split Method
- Transaction description – An accurate description of the tested transaction is necessary as it is an important factor in determining the applicability of the PSM method in said transaction. To have an accurate description a two sided analysis needs to be done, one must understand the commercial and financial relations between the parties, including, but not limited to, the functions performed by each party that are related to the tested transaction and circumstances surrounding the tested transaction.
- Lack of comparables – It is important to note that the lack of comparables in itself does not automatically mean that the profit split method is the most appropriate method. Three are cases in which the application of the profit split method would be less accurate than the application of another method even if this means using only comparable, and not identical, transactions. One should examine the facts and circumstances of the specific transaction and make sure that the PSM is the most appropriate method, even if there aren’t identical transactions to compare to the tested transaction.
- Industry practice – The common practice in an industry can be an indicator that the PSM is the most appropriate method for the test transaction, for example, if unrelated parties do profit split in similar situations.
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