The Profit Split Method: it logically follows that the residual profits will be allocated to those entities contributing the unique and valuable intangibles and making the crucial strategic decision (entrepreneurs), while entities performing supporting functions will be allocated a small and stable (routine) remuneration.
The aim is aligning profits with value contribution. It is useful when compensation is more reliably valued through the relative value of contributions vis a vis each other, than by a direct valuation of those contributions (OECD para. 2.114).
Accurate delineation of a transaction is important to determine if TPSM is applicable. It therefore requires a two- sided analysis irrespective of the transfer pricing method.
Where one party performs only simple functions, does not assume economically significant risks and does not make any unique and valuable contribution, TPSM is not appropriate (2.125-127).
It is important to note the factors determining the application TPSM, they include but not limited to;
- Unique and valuable contributions by each party: Contributions are “unique and valuable” where they are not comparable to contributions by uncontrolled parties in comparable circumstances, and they represent a key source of actual or potential economic benefits.
- Transactions involving unique and valuable intangibles: For instance, where each party legally owns unique and valuable intangibles ask if they each assume the economically significant risks for those intangibles.
- Highly integrated business operations: A high degree of integration may require the TPSM. A high degree of integration means the way parties perform functions is highly interlinked.
- Shared assumption of economically significant risks, separate assumption of closely related risks: TPSM can be appropriate for shared economically significant risks or separate economically significant risks which are closely related and cannot be isolated.
Approaches to Splitting Profits: There are a number of approaches, e.g. by considering the relative contributions of each party contribution analysis, or a residual analysis considering less complex contributions. They include;
- Contribution Analysis: Here, the profits are divided to reasonably achieve the same results independent enterprises would, supported by comparable if available. Otherwise, it is based on the relative value of contributions.
If the relative value of contributions can be measured, it is not necessary to estimate their actual market value. The relative value might be estimated by comparing the nature and degree of parties’ contributions and assigning a percentage to it.
- Residual Analysis: Where some contributions can be valued by a one-sided method, a residual TPSM is appropriate. It divides the profits into those attributable to benchmarkable contributions and unique and valuable contributions, and ones involving economically significant risks.
Example of profit splitting factors include;
- Asset-based profit splitting factors: Asset-based or capital-based profit splitting factors can be used if assets, or capital correlate to value creation and is applied consistently. See paragraph 2.104 for comparability issues for asset valuation.
- Cost-based profit splitting factors: A profit splitting factor on expenses is appropriate when expenses incurred correlates to value contributed. E.g., marketing expenses if advertising generates unique and valuable marketing intangibles; R&D expenses for manufacturers. But if parties contribute different valuable intangibles, a cost-based factor generally does not work
Therefore, when applying the cost-plus method, the following steps should form as a guide;
- Did we manage to identify a clear cut tested party?
- If yes, then no need to look more closely at the TPSM
- If no, then;
- Are we dealing with a value chain that is highly integrated and features intangibles?
- If yes, then carefully look at the TPSM at the very least as the secondary method.
- If no then make sure that none of the red flags (highly integrated value chain, parties contributing unique and valuable intangibles, the business model is focused on exploiting IP and lastly the business relationship to customers is not focused on individual products and services) exist to trigger the use of TPSM.
In conclusion, the TPSM is an important method. By conducting a thorough (quantitative) value chain analysis, you can ensure that the essential features of the tested transaction (business relationship) are accurately captured. The analysis will give you a good idea about the proportion of the value contributions made by individual parties.
In cases where the identification of a tested party is difficult (subject to potential challenges), applying the TPSM as a secondary method to validate the arm’s length nature of the profit allocation resulting from the application of other (one-sided) methods.
Author: Eddie Opiyo