If you are looking for more information on the Profit Split Method, this article is for you.
Below, we explain this transfer pricing method in more detail, provide an example and explain when and how you can use it.
Before we continue, it is important to understand that the Profit Split Method is one of the common transfer pricing methods used to examine the “arm’s-length” nature of “controlled transactions.” If these terms do not ring a bell, we advise you to first read our articles What is Transfer Pricing? and The Five Transfer Pricing Methods With Examples.
What Kind Of Transfer Pricing Method Is The Profit Split Method?
The OECD Transfer Pricing Guidelines (the OECD Guidelines) provide 5 common transfer pricing methods that are accepted by nearly all tax authorities. These methods are divided in “traditional transaction methods” and or “transactional profit methods.” The Profit Split Method is a transactional profit method.
A transactional profit method measures the net operating profits realized from controlled transactions. It then compares the profit level to the profit level realized by independent enterprises that are engaged in comparable transactions.
The Profit Split Method
Associated enterprises sometimes engage in transactions that are very interrelated. Therefore, they cannot be examined on a separate basis. For these types of transactions, associated enterprises normally agree to split the profits.
The Profit Split Method examines the terms and conditions of these types of controlled transactions by determining the division of profits that independent enterprises would have realized from engaging in those transactions.
An example of this method is shown in this image:
In the above example, we see two comparable joint ventures. Joint Venture I is owned by associated enterprises Y and X. Opposite to that, Joint Venture II is owned by independent enterprises A and B.
Let’s say that we need to determine the transfer prices to be charged for the transactions related to Joint Venture I.
For that, we can compare the terms and conditions of the controlled transactions by determining the division of profits of comparable uncontrolled transactions. In this example, this means that we can compare Profit Split I with Profit Split II.
Two Kinds Of Profit Split Methods
There are two kinds of Profit Split Methods:
- Contribution profit split method;
- Residual profit split method.
The contribution profit split method splits profit among associated enterprises according to the functions performed and risks assumed. In addition, the assets are analyzed which are contributed by each entity. In particular, intangible assets.
The application of the contribution profit split method requires careful analysis. First of all of the functions performed, risks borne and assets used by each associated enterprise. In addition, the allocation of cost, expense, earnings, and capital of the associated enterprises involved in the transaction needs to be measured.
The residual profit split method requires the identification of the routine profit for an entity as a first step. Any remaining profit is then split based on each party’s contribution to the earning of the non-routine profit, for example the ownership of intangibles.
Use Of Profit Split Method In Practice
The Profit Split Method is usually applied in cases where the controlled transaction is highly integrated. This makes it difficult to evaluate the operating result separately.
Examples are the set-up of a partnership or the joint exploitation of intangible assets such as brands.
This method is not often used in practice, but is rising in popularity. It’s main benefit is that it looks at profit allocation in a mere holistic way rather than on a transactional basis. This can be appropriate for cases where there are multiple controlled transactions instead of one clearly identifiable controlled transaction.
There is an important downside to the Profit Split Method. Due to the subjective profit allocation criteria based on score cards, it can offer tax authorities the possibility to allocate a disproportionate amount of profits to an associated enterprise engaging in a particular transaction. This could lead to a non-arm’s length outcome and disputes with the tax authorities.
Conclusion
The Profit Split Method is one of the 5 common transfer pricing methods provided by the OECD Guidelines. It is a transactional profit method.
The Profit Split Method measures the net operating profits realized from controlled transactions and compares the profit level to the profit level realized by comparable independent enterprises that are engaged in comparable transactions.
There are two kinds of Profit Split Methods: (1) contribution profit split method; and (2) residual profit split method.
The Profit Split Method is not often used in practice but is rising in popularity. Especially in cases where the controlled transaction is highly integrated, it can be a very useful transfer pricing method. However, there are also important downsides, one being the risk of disputes with tax authorities.
We hope you’ve enjoyed reading this article.
