The profit split method is one of the accepted by the OECD to determine transfer prices when there are related party transactions. It is mainly employed when the transactions are highly integrated or when the companies involved contribute valuable intangibles that hinder the application of other traditional methods. Its objective is to equitably allocate the profits generated by the transaction under the Arm’s Length Principle. This method is regulated in the OECD Guidelines, particularly in Section C, Part III, Chapter II.
Application of the Profit Split Method
The implementation of this method is based on two main approaches:
- Contribution analysis: This approach allocates the total related party transaction profits according to the relative value of contributions. These contributions are evaluated by considering functions performed, assets used, and risks assumed. This allocation must be supported with external market data reflecting the splitting process of profit in similar circumstances.
- Residual analysis: In this case, profits are split into two categories. First, a base remuneration is allocated to each party, employing a traditional Transfer Pricing method or the Transactional Net Margin Method for contributions that can be compared to independent transactions. Then, any residual profit attributable to single contributions or high integration is allocated according to the relative value of these specific contributions.
Determination of the Profits to Be Split
For an accurate application of the method, relevant profits derived from the controlled transaction must be identified. Operating profits are usually considered, but in particular cases of market or production risks, gross profit should be used. A common accounting base must be adopted before combining profits and their expression in a uniform currency.
Criteria for the Profit Split
The profit split must be based on economically valid criteria reflecting the relative contributions of the involved parties by aligning with the Arm’s Length Principle, as set out in section C5 of the Revised Guidance on the Application of the Transactional Profit Split Method.
The factors or criteria used for splitting must comply with the following characteristics:
- Independence: They must be unrelated to the internal Transfer Pricing policy and based on objective data, not on figures related to controlled transactions.
- Verifiability: The criteria must be verifiable through adequate documentation.
- Comparable data support: The allocation must be supported by external comparable data, internal information, or a combination of both.
Selection of Splitting Factors
The correct allocation of profits according to this method requires selecting objective criteria reflecting the relative contributions of each entity. Their selection depends on functional analysis and the transaction context, which must be supportable and verifiable economically.
One of the main factors used is the value of tangible and intangible assets employed by each party. In industries where intellectual property and technology play a determining role, the value of these assets becomes crucial to setting the profit split. In addition, the capital employed in the operation is considered since companies that invest more tend to take on more risk and should, therefore, receive more share of the profits.
Another common criterion is the level of operating expenses incurred by each entity, especially costs related to strategic activities such as research and development and marketing or distribution. In specific industries, the costs of these activities may accurately reflect the level of each company’s contribution to the transaction success.
Conversely, using these factors is not exempt from challenges. Appraising intangibles can sometimes be complex due to the lack of market benchmarks, which the former requires the use of specialized methodologies. Likewise, data used to determine the profit split must come from reliable sources and be consistent with the economic reality of the parties involved.
Challenges in Applying the Method
Despite its advantages, the profit split application has significant challenges:
- Complexity in obtaining information: This method requires access to detailed and, often, confidential data from all parties involved in the transaction. Conversely, collecting this information can be complicated, specifically when companies operate in multiple jurisdictions with different tax regulations.
- Difficulty in measuring contributions: Accurately quantifying the relative value of each entity’s contributions is a significant challenge, especially when intangible assets such as proprietary technology, trademarks, or specialized know-how are involved. The absence of reliable market benchmarks can lead to subjective estimates, increasing potential discrepancies between companies and tax administrations.
- Need for reliable market data: In order to support the allocation of profits under this method, benchmark information on comparable independent-party transactions is essential. Conversely, this information is not always available or may be difficult to obtain. The lack of adequate comparables can lead to increased scrutiny by tax authorities, who may question the methodology employed and require adjustments to the profit allocation.
Due to the complexity of these challenges, companies adopting the profit split method should ensure detailed documentation and well-founded economic studies to support their approach. In addition, implementing advanced data analysis tools and the support of specialized consultants can be crucial to mitigate risks and ensure compliance with Transfer Pricing regulations in each jurisdiction they operate in.
Conclusion
The profit split method is valuable in Transfer Pricing, especially in transactions where the parties are closely integrated or bring unique and worthy elements. Its correct application ensures a fair allocation of profits, according to the Arm’s Length Principle, and reduces tax risks and potential disputes among tax jurisdictions.
Call to Action
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Source: OECD. (2018). Revised guidance on the application of the transactional profit split method: BEPS Action 10. / OECD. (2010). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010.