This part of GOV.UK is being rebuilt – find out what beta means

HMRC internal manual

International Manual

Non-residents trading in the UK: profits of the PE: Case studies exploring the various transfer pricing methods that could be used in attributing profits to a permanent establishment - Profit Split Method

A Ruritanian company has developed an environmentally friendly electric car that can be charged up from a normal household electricity supply. The car has a recommended retail price of £10,000* and quickly becomes the product of choice in many European countries including the UK where 100,000 cars are sold in the year of enquiry.

Initially the group manufactures the car through a few subsidiaries strategically positioned around the world. The cars are then sold either through third party distributors in each sales territory or through group distributors if commercially beneficial to the group. Distributors buy stock at a discount from RRP.

*For the purposes of this case study sterling is used throughout. Also attribution of capital to the permanent establishment is not required as no interest is charged in any case.

In this example, we are in the first period of the Ruritanian company’s attempts to create a mass market for their product. For the first 7 months of the company’s global campaign it manufactures all the cars itself in Ruritania and experiments for a while in deciding what type of marketing and sales operations would best suit the various countries in which they perceive their markets to be. One of the Ruritanian directors moves temporarily to the UK and sets up a sales shop using demonstration vehicles and hiring 4 salesmen who share his office space at the shop. After some detailed market and competitor research he creates a unique marketing package aimed at the niche home to school travel market that he has identified. He reports back to the Ruritanian board in detail using a computer aided design package on specific modifications that he has decided (and they accept) will probably be necessary to make the car a desirable product in the UK. He trains the salesmen on product knowledge and in the sales techniques that he would like to see. The director conducts the marketing campaign, supervises the sales force and gets involved with customers where he thinks it will help secure a sale.

Under their service agreements the salesmen are paid £40 for every draft order that they refer to the stock manager in Ruritania from where the cars are despatched once the customer’s payment has been received.

The UK operations are a permanent establishment of the Ruritanian company because the shop premises are a fixed place of business. It is not necessary to go on to consider whether the salesmen are dependent agents (although they clearly are) because the fixed place of business permanent establishment has already been established. That being the case, all of the profits arising through the permanent establishment are chargeable to CT on the Ruritanian company.

In the 7 month period 10,000 cars are sold to UK customers and the UK salesmen receive £400,000 gross pay. On top of this the costs of the UK operation (including the directors basic salary of £5,000 per month) were a further £400,000. The Ruritanian company returns a self assessment as follows:

Costs of UK operation £800,000
Profit margin 10%
UK ‘turnover’ £880,000
Less costs (£800,000)
Chargeable Profits £80,000

In the CTSA enquiry it is established that, although the Ruritanian company is not selling as many cars into the UK as it would like using this system (and has subsequently changed it) it made a 10% net operating profit on cars manufactured and sold in this way. The designs created by the director specifically for the UK market have continued to be used and have been expanded into other markets. This is also the case with his very successful unique marketing concept and materials. The profits declared for the UK sales operation only amount to 0.08% of the turnover generated to the company from the 10,000 cars sold (10,000 @ £10,000 = £100m turnover x 0.08% = £80,000).

The company argues that the 4 sales agents were more than happy to be earning £100,000 each over the 7 month period and so this must have been the equivalent if not more than the arms length price for the activities that they carried out. Furthermore, they say they have only charged the director’s basic salary to the UK operation and not his significant annual bonus, which he received after his return to Ruritania. Their contention is that the net profits on UK sales above £40,000 are attributable to the original invention, trademarks, designs and manufacturing all of which are within the part of the company’s activities positioned in Ruritania.

Now whilst the relative profits contribution of the non-UK activities are clearly high; the UK permanent establishment activities have also made a valuable profit contribution too. No doubt the director’s subsequent bonus was influenced by his contribution (whilst in the UK) to the company’s performance. And the contributions to product design intellectual property and marketing intangibles will endure after the 7 month accounting period and beyond the UK market sales for the 7 month period. The cost plus 10% treatment that the company have used would only have been suitable for a situation where the UK activities were routine and simple in comparison to the overall commercial activity of the company.

Various factors suggest that profit split is the right transfer pricing method for this fact pattern including:

  • The individuality of the product and lack of an existing market both lead to a lack of comparable controlled prices for the operation as a whole when all its constituent parts are considered (OECD transfer pricing guidelines 3.6). Similarly, independent entities are unlikely to have agreed an advance price for the full scope of the activities eventually performed by the UK permanent establishment because this was an evolving experiment and the contribution to intellectual property is unlikely to have been foreseen and possibly would not have been desired. It is also relevant that in practice, without an advance agreement to the contrary, an independent party would not readily give up the rights to any intellectual property created and could negotiate a separate reward in addition to the advance terms agreed for the selling function.
  • The inter-relatedness of the UK activities (particularly the creation of new intellectual property tested in the UK) and the general improvements that those activities led to in the wider commercial operations of the company (OECD transfer pricing guidelines 3.5).

The OECD transfer pricing guidelines 3.11 - 3.25 provide guidance on application of the profit split method.

Functional split (UK market sales)

Profit split

Compute chargeable profits 

Functional split (UK market sales)

  Entity PE
Original product IP 4  
Manufacturing & warranty 4  
Marketing IP   4
Local design IP   4
Selling   4
Delivery 4  

Top of page

Profit split

Following a) research of the closest approximation to the terms that independents would have adopted and b) application of the OECD guidelines the 10% net operating profit for the UK market of £10m is split as follows:

  Entity PE
Original product IP 2.5%  
Manufacturing & warranty 4.5%  
Marketing IP   0.5%
Local design IP   0.5%
Selling   1.75%
Delivery 0.25%  
Net operating profit share 7.25% 2.75%

Top of page

Compute chargeable profits

Using the profit split percentages the revised UK chargeable profits are £2.75m. Because the profit split method considers net profit allocation there is no need to consider whether the director’s bonus should be allocated in part to the permanent establishment.

See INTM267060 for example of Comparable Uncontrolled Price method

See INTM267070 for example of Resale method

See INTM267080 for example of Cost Plus method

See also INTM463060.