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How to use profit split method in transfer pricing

Profit split method is a toll to establish the transfer price of highly integrated transactions

The Profit Split Method (PSM) is one of the five transfer pricing methods provided in the guidelines issued by the Organisation for Economic Cooperation and Development (OECD). This is an alternative transactional profit method to assess the arm’s length price for the highly integrated transactions between related parties.

In the OECD’s guidelines, it has been stated that PSM is “A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions that it is appropriate to aggregate under the principles of Chapter III) and then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length”.

From the above definition, it is evident that the method requires the combined profits to be identified, and it should be divided between the associated enterprises based on the comparables or based on the functions performed, the risk involved, and the assets utilised if the comparables are not available. The resultant profit would be an indicator to assess whether the transaction was affected by conditions that differ from those that would have been made by independent enterprises in otherwise comparable circumstances. If the profits have been fairly allocated to each party based on an economically valid basis, then we can assume the transaction has been executed at arm’s length.

There are various approaches to split the profit, and two of which, given in the OECD’s guidelines, are more prominent. These approaches are contribution analysis and residual analysis.

Under the contribution analysis, the total profits from the transaction under the examination are divided between the associated enterprises based on comparable data. If comparable data is not available, then total profit is divided based on the risk involved, functions performed, and assets utilized. Each party will get its share of the profit based on the value of the contribution made by each party. The degree of contribution depends upon the role played by each party like provision of services, development expenses incurred, and capital invested.

In the residual analysis, the combined profits from the transaction under examination are divided into two stages. In the first stage, profits are allocated to each party based on routine functions. In the second stage, the residual profits are divided between the parties based on allocation keys like assets-based allocation, cost-based allocation, incremental sales, headcounts, time spent etc. First stage profits are usually allocated by applying any of the traditional methods like CUP, RPM or cost plus, and second stage allocation is based on the contribution made by each party.

This method is applicable where there are highly integrated operations, and functions are so interrelated that these cannot be performed in isolation. The functions, cost and role of each party are well defined. The related parties share the risk and related rewards. This method helps us to eliminate the effect of profits made due to the influence and conditions imposed by the related parties.

This illustration would be quite helpful in understanding the application of the PSM. A USA beverage company (USC) developed a formula to manufacture the energy drink (PIYO) and got the formula registered with the respective authority of the USA. A UAE company (eSkitters) which is 100 per cent owned by USC, manufactures, and markets the PIYO in the UAE. eSkitters takes a license from the UAE authorities to manufacture and market the PIYO. Both companies invest in R&D for the betterment of the product.

In the UAE, for the first tax year, PIYO sales were $750 million, and expenses were $450 million. Operating assets employed in the PIYO business were $400 million. Based on the examination of the UAE companies, it has been determined that the companies performing similar marketing functions, their arm’s length return of the assets is 12.5 per cent. Moreover, USC capitalises the R&D expenditure at the rate of 0.3 per dollar of the global protective product sales, while eSkitters capitalises the R&D expenditure at the rate of 0.5 per dollar of the PIYO UAE’s sales.

From the above example, it is clear that marketing services are routine services provided by eSkitters, and the return on these services is $50m ($400m*12.5 per cent). The residual profits are $250 million ($750m - $450m-$50m). These residual profits have been divided between the USC and eSkitters at the allocation key, which is R&D capitalisation. USC’s fair share of profit is $93.75 million, while eSkitters’ share of profit is $156.25 million.

In this illustration, at the first stage, we have divided the profits based on non-routine functions, and at the second stage profit has been allocated on the allocation key which is R&D cost.

This method is highly effective for complex and interrelated transactions. The PSM is a two-sided and most appropriate method, where each party makes unique and valuable contributions. We can allocate the cost to each function and can assess the contribution of each party. The PSM is appropriate where independent comparables are unavailable to split the data.

It is not a go-to method but a complex method to ascertain the transfer price. The biggest challenge in applying the PSM is to access information from foreign affiliates. In addition, it may be difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions, requiring books and records on a common basis, and making adjustments in accounting practices and currencies. Further, when the PSM is applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises' other activities.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax and OECD transfer pricing guidelines. For any queries/clarifications, please write to him at compliance@kresscooper.com