How to use profit split method in transfer pricing

The Profit Split Method (PSM) is one of the five transfer pricing methods provided in the guidelines issued by the Organisation for Economic Cooperation and Development (OECD). This is an alternative transactional profit method to assess the arm’s length price for the highly integrated transactions between related parties.

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”.

From the above definition, it is evident that the method requires the combined profits to be identified, and it should be divided between the associated enterprises based on the comparables or based on the functions performed, the risk involved, and the assets utilised if the comparables are not available. The resultant profit would be an indicator to assess whether the transaction was affected by conditions that differ from those that would have been made by independent enterprises in otherwise comparable circumstances. If the profits have been fairly allocated to each party based on an economically valid basis, then we can assume the transaction has been executed at arm’s length.

There are various approaches to split the profit, and two of which, given in the OECD’s guidelines, are more prominent. These approaches are contribution analysis and residual analysis.

Under the contribution analysis, the total profits from the transaction under the examination are divided between the associated enterprises based on comparable data. If comparable data is not available, then total profit is divided based on the risk involved, functions performed, and assets utilized. Each party will get its share of the profit based on the value of the contribution made by each party. The degree of contribution depends upon the role played by each party like provision of services, development expenses incurred, and capital invested.

In the residual analysis, the combined profits from the transaction under examination are divided into two stages. In the first stage, profits are allocated to each party based on routine functions. In the second stage, the residual profits are divided between the parties based on allocation keys like assets-based allocation, cost-based allocation, incremental sales, headcounts, time spent etc. First stage profits are usually allocated by applying any of the traditional methods like CUP, RPM or cost plus, and second stage allocation is based on the contribution made by each party.

This method is applicable where there are highly integrated operations, and functions are so interrelated that these cannot be performed in isolation. The functions, cost and role of each party are well defined. The related parties share the risk and related rewards. This method helps us to eliminate the effect of profits made due to the influence and conditions imposed by the related parties.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax and OECD transfer pricing guidelines. For any queries/clarifications, please write to him at compliance@kresscooper.com