The profit split method is a toll for establishing the transfer price of highly integrated transactions
There are different approaches to benefit sharing, and two of them, listed in the OECD guidelines, are more important. These approaches are contribution analysis and residual analysis. — Stock photo
The profit split method (PSM) is one of the five transfer pricing methods provided for in guidelines issued by the Organization for Economic Co-operation and Development (OECD). It is an alternative transactional profit method to assess the arm’s length price of highly integrated related party transactions.
In the OECD guidelines, it has been stated that PSM is “A transactional profit method that identifies the combined profit to be allocated for associated enterprises from a controlled transaction (or controlled transactions that should be aggregate under the principles of Chapter III) and then allocates those profits among the associated enterprises on an economically sound basis that approximates the allocation of profits that would have been anticipated and reflected in an arm’s length agreement “.
From the above definition, it is evident that the method requires the identification of combined profits and that they should be allocated among the associated enterprises on the basis of comparables or on the basis of functions performed, risk incurred and assets used if comparables are not available. The resulting profit would be an indicator of whether the transaction was affected by terms different from those that would have been made by independent enterprises in otherwise comparable circumstances. If the profits were fairly allocated between each party on an economically sound basis, then we can assume that the transaction was executed at arm’s length.
There are different approaches to benefit sharing, and two of them, listed in the OECD guidelines, are more important. These approaches are contribution analysis and residual analysis.
As part of the contribution analysis, the total profits of the transaction under review are allocated among the associated enterprises on a comparable basis. If comparable data is not available, total profit is divided according to risk taken, functions performed and assets used. Each party will receive its share of the profit based on the value of the contribution made by each party. The degree of contribution depends on the role played by each party, such as the provision of services, the development expenditure incurred and the capital invested.
In the residual analysis, the combined profits of the transaction under review are divided into two stages. In the first stage, profits are assigned to each party based on routine functions. In the second stage, the residual profits are distributed among the parties based on allocation keys such as asset-based allocation, cost-based allocation, incremental sales, headcount, time spent, etc. . Stage one profits are usually allocated by applying one of the traditional methods. as CUP, RPM or cost plus, and the attribution of the second stage is based on the contribution made by each party.
This method is applicable when there are highly integrated operations and the functions are so interdependent that they cannot be performed in isolation. The functions, cost and role of each part are well defined. Related parties share the risk and related rewards. This method helps us eliminate the effect of profits made due to influence and conditions imposed by related parties.
This illustration would be very helpful in understanding the application of PSM. A United States beverage company (USC) has developed a formula for making the energy drink (PIYO) and has had the formula registered with the competent authority in the United States. A United Arab Emirates company (eSkitters), wholly owned by USC, manufactures and markets the PIYO in the United Arab Emirates. eSkitters obtains a license from the authorities of the United Arab Emirates to manufacture and market the PIYO. Both companies invest in R&D for product improvement.
In the United Arab Emirates, 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 review of UAE companies, it was determined that for companies performing similar marketing functions, their arm’s length return on assets is 12.5 percent. In addition, USC capitalizes R&D expenses at the rate of 0.3 per dollar of worldwide protection product sales, while eSkitters capitalizes R&D expenses at the rate of 0.5 per dollar of PIYO UAE sales.
From the example above, it is clear that marketing services are routine services provided by eSkitters, and the return on these services is $50 million ($400 million * 12.5%) . The residual profit is $250 million ($750 million – $450 million – $50 million). These residual profits were divided between USC and eSkitters according to the distribution key, which is the capitalization of R&D. USC’s fair profit share is $93.75 million, while eSkitters’ profit share is $156.25 million.
In this illustration, in the first stage, we have divided the profits according to the non-routine functions, and in the second stage, the profits have been distributed on the distribution key which is the R&D cost.
This method is very efficient for complex and interdependent transactions. PSM is a two-sided and most appropriate method, where each side makes unique and valuable contributions. We can assign the cost to each function and can assess the contribution of each part. PSM is appropriate when independent comparables are not available to split the data.
It is not an essential method but a complex method to determine the transfer price. The biggest challenge in applying the PSM is accessing information from foreign subsidiaries. In addition, it may be difficult to measure the combined revenues and costs of all associated enterprises participating in controlled transactions, requiring books and records on a common basis, and making adjustments in accounting practices and currencies. In addition, when PSM is applied to operating profit, it can be difficult to identify the appropriate operating expenses associated with transactions and to allocate costs between transactions and other activities of associated businesses.
Mahar Afzal is Managing Partner at Kress Cooper Management Consultants. The above is not an official opinion but a personal opinion of the author based on the Public Consultation Paper on Corporate Tax and the OECD Transfer Pricing Guidelines. For any questions/clarifications, please write to him at [email protected]