INTM463060 - Transfer Pricing: OECD and methodologies: Transactional Profit split

The profit-split method is, along with the transactional net margin method (INTM463080), one of the two transactional profit methods discussed by the OECD Transfer Pricing Guidelines. These are sometimes described as the methods of last resort, which implies that the possibility of using the more traditional methods should have been exhausted before these two are considered.

The method can offer a solution for very complex trading relationships involving highly intergrated operations, where it is sometimes genuinely difficult to evaluate those transactions on a separate basis. There are circumstances where independent companies might set up a form of partnership or joint venture and agree to a form of profit split which splits the profit (or the loss) which results from their combined trade. The profit-split method attempts to eliminate the effect of a control relationship on profits accruing to each connected party. The profit-split method should do this by determining the division of profits that independent enterprises would have expected to realise from engaging in the transactions.

This is an area where contemporary evidence is needed. The OECD Transfer Pricing Guidelines make clear that the profits should be split on an economically valid basis - one that 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. 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, you 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. You would consider what was appropriate 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 unique assets (notably intangibles) possessed by the participants. You would of course need to consider the value of those assets. 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. Any contributions of intangible property and the relative bargaining positions of each party should be taken into account.

You can see from both these ways of applying a profit split that it is vital that you have a full knowledge of both the overall trade of the enterprises and the profits made by all the connected parties. For an example of how the profit split method was applied in the case of DSG Retail Ltd and others v HMRC (TC00001), see INTM463065.

See OECD Transfer Pricing Guidelines from Para 2.108 - 2.145 (3.5 - 3.25).