Transfer pricing: Methodologies: OECD Guidelines: Profit split
Profit split method
The profit split method is, along with the transactional net margin method (INTM421080), one of the two transactional profit methods discussed by the OECD Transfer Pricing Guidelines.
The method can offer a solution for very complex trading relationships involving highly integrated operations, where it is sometimes genuinely difficult to evaluate those transactions on a separate basis. The profit split method attempts to eliminate the effect of a control relationship on profits accruing to each connected party by determining the division of profits that independent enterprises would have expected to realise from engaging in the tested transactions. The profit split method is therefore a ‘two-sided’ transfer pricing method. By contrast, the other methods specifically recognised in the OECD Guidelines are ‘one-sided’ methods which seek to price the appropriate return to one of the parties to a controlled transaction without necessarily any regard to the results of the other party.
The OECD Guidelines make clear that application of a profit split methodology should split the profits on an economically valid basis (see paragraph 2.108 of the Guidelines) which approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. Use of hindsight should be avoided. Case teams should consider what would the parties have done at the time the deal was struck.
So, what is an economic basis? Generally, at arm’s length profits will follow economic function and risk. This is a fundamental principle of transfer pricing.
Using a ‘contribution analysis’ profit split, the combined total profits from the controlled transactions made by all the enterprises involved in earning those profits are split between those enterprises based on the relative value of the functions that each carries out. To make this decision requires careful judgement and the criteria should always include a firm understanding of the overall trade and of what adds value to it. How economically important were the functions carried out by each party in earning the profits? For instance, case teams should consider whether it was the intrinsic nature of the product being sold that generated the profits (more profit to R & D function) or whether it was the success of the marketing activity that generated sales (more profit to distribution function). Of course, under a simple example like this you would hope to find a CUP and not have to consider profit split at all.
Using a ‘residual analysis’ profit split, the combined, total profit of the overall trade made by the connected parties is again considered. Firstly, each participant is allocated sufficient profit to provide it with a basic return appropriate to the functions carried out. An appropriate return should be considered by reference to similar types of transactions undertaken by independent enterprises. On that basis, the basic return would not take into account any return due to any valuable contributions (notably intangibles) made by the participants. Secondly, any profit (or loss) left after the allocation of basic returns would be split as appropriate between the parties - based on an analysis of how this residual would have been split between third parties. The valuable contributions and the relative bargaining positions of each party should be taken into account.
From both these ways of applying a profit split it can be seen that it is vital that there is a full knowledge of both the overall trade of the enterprises and the profits made by all the connected parties.
The OECD Guidelines state that the criteria or allocation keys used to split the profits should be based on objective data such as sales to independent parties and be supported by comparables or internal data (paragraph 2.132).
See the OECD Guidelines from paragraphs 2.108 to 2.145.