The Profit Split Method (PSM) is among the five transfer pricing methods outlined in the guidelines published by the Organization for Economic Cooperation and Development (OECD) and provided in detail in the transfer pricing guidance (CTGTP1) issued by the Federal Tax Authority.
In the OECD’s guidelines, it has been stated that PSM is “A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions that it is appropriate to aggregate under the principles of Chapter III) and then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length”.
The method necessitates identifying and dividing combined profits between associated enterprises, using comparables or considering functions, risks, and assets when comparables are unavailable. The OECD guidelines highlight two prominent approaches for splitting profits: contribution analysis and residual analysis, among various available methods.
In contribution analysis, the total transaction profits are divided between associated enterprises using comparable data. When comparable data is unavailable, profits are divided based on risk, functions, and assets. Each party receives a share based on its contribution value, determined by factors like services provided, development expenses, and invested capital.
Residual analysis involves dividing the total profits from the examined transaction into two stages. Initially, profits are allocated to each party based on routine functions, and then residual profits are divided using allocation keys such as assets, costs, sales, headcounts, and time spent. The first stage typically applies traditional methods like CUP, RPM, or cost plus, while the second stage allocates based on each party's contribution.
This method is suitable for highly integrated operations where interdependent functions cannot be performed in isolation, and where the functions, costs, and roles of each party are clearly defined. All parties share the risks and rewards.
For example, A UK beverage company (UKB) creates a formula for an energy drink (EZEE) and registers it in the UK. A wholly owned UAE subsidiary of UKB, Dudlee Ltd, produces and sells EZEE in the UAE under a local license. Both companies invest in research and development to enhance the product.
During the initial tax year in the UAE, EZEE sales amounted to $750 million, with expenses totaling $450 million. The operating assets utilized in the EZEE business in the UAE amounted to $400 million. Following an evaluation of similar marketing functions performed by other companies, the arm’s length return on assets is determined to be 12.5%. Additionally, UKB capitalizes R&D expenditure at a rate of 0.3 per dollar of global product sales, while Dudlee capitalizes R&D expenditure at a rate of 0.5 per dollar of EZEE sales in the UAE.
In the preceding example, routine marketing services offered by Dudlee yield a return of $50 million ($400 million * 12.5%). The remaining profits total $250 million ($750 million - $450 million - $50 million). These residual profits are allocated between UKB and Dudlee based on the R&D capitalization key. UKB's equitable profit share amounts to $93.75 million, while Dudlee' share of profit is $156.25 million.
In this example, profits were initially divided based on non-routine functions and then allocated in the second stage based on R&D costs. The PSM is highly effective for complex and interdependent transactions, particularly when each party makes unique and valuable contributions. It is a suitable two-sided method that enables the allocation of costs to each function and the assessment of each party's contribution, making it an appropriate choice when independent comparables are unavailable for data division.
The Profit Split Method is a complex approach for determining transfer prices and is not the primary choice. Its main challenges include accessing information from foreign affiliates, difficulty in measuring combined revenue and costs, and identifying appropriate operating expenses and allocating costs between transactions and other activities of associated enterprises when applied to operating profit.
Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official opinion of Kress Cooper but an opinion of the writer. For any queries/clarifications, please feel free to contact him at mahar@kresscooper.com
