The residual profit split method is one of the most sophisticated tools within the transfer pricing framework, especially in complex business structures where value creation cannot be attributed unilaterally to a single entity within the group. Its application responds to the need to reasonably allocate the profits derived from controlled transactions when there are significant contributions from multiple parties, particularly in the presence of unique or highly integrated intangibles.
This method, recognized by the OECD Guidelines and progressively adopted by various tax administrations, requires in-depth economic analysis and robust documentation, as it is often subject to greater tax scrutiny compared to traditional methods based on direct comparables.
Conceptual framework of the residual profit split method
The residual profit split method is a variant of the profit split method. Its logic is based on a two-stage approach. First, each related entity is allocated routine remuneration for the basic functions it performs, considering assets used and risks assumed that can be valued using market references. In a second stage, the residual profit—that is, the profit that exceeds this routine remuneration—is distributed among the parties that make non-routine contributions, generally associated with valuable intangibles or significant operational integration.
This approach seeks to replicate the behavior that independent parties would adopt in comparable circumstances, where standard functions receive predictable compensation, while the additional value generated by unique elements is distributed according to their actual economic contribution.
Identification of routine and non-routine functions
The correct delimitation between routine and non-routine functions is one of the most sensitive elements in the application of the residual profit split method. The proper determination of the initial profitability assigned to each entity and, subsequently, the correct identification of the residual profit subject to split depend to a large extent on this distinction.
Routine functions
Routine functions correspond to operational or support activities that, although necessary for the development of the business, do not generate unique competitive advantages or extraordinary returns. These functions can usually be valued using market references, given that there are comparable transactions between independent parties.
Routine functions generally include:
- Manufacturing activities under group specifications, with limited risks.
- Distribution of products or services without strategic control of prices or markets.
- Provision of administrative, financial, or support services.
- Low-risk logistics or commercial functions.
Remuneration associated with these functions is usually determined using traditional methods, assigning margins consistent with those observed in independent companies performing similar activities.
Non-routine functions
Non-routine functions are those that contribute significantly to the creation of value for the group and whose return cannot be explained solely by standard market conditions. These functions are usually linked to the generation, management, or exploitation of intangibles, as well as the assumption of relevant strategic risks.
The following are typically considered non-routine functions:
- The development, improvement, and exploitation of unique or difficult-to-value intangibles.
- Strategic decision-making that affects the overall business model.
- The assumption of key risks, such as market, technological, or financial risks.
- The centralized coordination of highly integrated activities between related entities.
These functions justify the existence of residual utility and, therefore, determine the need to apply specific criteria for its distribution among the entities that effectively contribute to the generation of such value.
Determination and distribution of residual profit
Once the profitability corresponding to routine functions has been allocated, the analysis focuses on determining the residual profit, understood as the return attributable to factors that cannot be adequately valued using direct market references. This profit essentially reflects the value generated by non-routine contributions, such as unique intangibles, operational integration, or the assumption of relevant strategic risks.
Determining residual profit is not a purely mechanical exercise. It requires substantial economic judgments and a high degree of consistency between the group’s financial information, the segmentation of results, and accounting traceability. Inconsistencies at this stage can lead to significant distortions in the allocation of profits and significantly increase the risk of tax adjustments.
Once residual profit has been defined, the next step is to establish allocation criteria that reasonably reflect the actual economic contribution of each entity involved. Given that there are no objective market references for this surplus, the selection of such criteria requires a rigorous technical approach and close alignment with the group’s functional analysis and business model. The use of arbitrary indicators or those disconnected from operational reality is often questioned by tax authorities.
Main criteria used for the allocation of residual profit
| Allocation Criterion | Practical Application | Tax Considerations |
| Relevant Expenses (R&D, marketing, development) | Used when value creation is directly linked to sustained investments in non-routine activities | Requires temporal consistency and a clear correlation between expense and value generation |
| Contribution to Intangibles | Suitable when unique intangibles are developed or managed by multiple entities | Should align with DEMPE functions and avoid duplications |
| Combined Financial Indicators | Applicable in highly integrated models where it is not possible to isolate a single value driver | Increases analysis complexity and the risk of challenge |
| Specific Operational Factors | Useful in industries where certain operational indicators better reflect value creation | Must be objectively measurable and verifiable |
The choice of one or more criteria must be properly documented, clearly explaining their relationship to the generation of residual profit and ensuring consistency with available financial and operational information. In practice, tax authorities evaluate not only the result of the distribution, but also the economic logic behind the criteria adopted, reinforcing the need for a technically consistent and defensible approach.
Tax risks, compliance, and documentation requirements
The application of the residual profit split method involves significant challenges from an operational and compliance perspective. Its correct implementation requires a high degree of internal coordination between the entities of the group, as well as information systems capable of supporting segmented financial analyses that are consistent with the operational reality.
From a tax perspective, this method tends to attract greater attention from tax authorities due to its complexity and the margin of technical judgment involved. Inconsistencies in functional analysis, deficiencies in the determination of residual profit, or the use of poorly defensible allocation criteria can lead to significant adjustments and even double taxation if not properly managed.
In this context, transfer pricing documentation takes on a central role. It is essential to clearly substantiate the identification of routine and non-routine functions, the determination of residual profit, and the economic logic behind the allocation criteria adopted, ensuring traceability with the group’s financial and operational information.
OECD framework and current relevance of the method
The residual profit split method occupies a prominent place in the OECD Transfer Pricing Guidelines, particularly in scenarios where related parties make unique, highly integrated contributions or contributions linked to the development and exploitation of intangibles that are difficult to value.
Its relevance has intensified in the context of international reforms aimed at a more accurate allocation of profits in line with value creation. In this sense, the correct application of the method not only responds to a requirement for alignment with international standards, but also constitutes a key tool for managing tax risks in complex multinational structures.
Technical advice for robust application of the method
The application of the residual profit split method requires rigorous functional analysis, technically defensible allocation criteria, and documentation aligned with OECD Guidelines and local regulations. In this context, having the support of TPC Group, a company specializing in transfer pricing, allows the method to be structured in a manner consistent with the economic reality of the group, mitigating the risks of tax adjustments and strengthening the taxpayer’s position in the event of audits.
Source: OECD