The Profit Split Method is arguably the method likely to give most complete answer as to arm’s length pricing provided the activities performed by the taxpayer and its associated enterprises are inextricably linked and both entities contribute to the value chain. Unlike other methods, it is less susceptible to leave one party with an outcome that may be non-arm’s length. The code, in pertinent part, states that:
(a) The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).
(b) The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of § 1.482– 1(d)(3). Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity. The profit allocated to any particular member of a controlled group is not necessarily limited to the total operating profit of the group from the relevant business activity. For example, in a given year, one member of the group may earn a profit while another member incurs a loss. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally, or in any other arbitrary proportion. The specific method of allocation must be determined under paragraph (c) of this section.[1]
The Transactional Profit Split Method as proscribed by the Organization for Economic Co-operation and Development (OECD) is analogous to the United States of America § 1.482–6, profit slip method. This method involves identifying the combined profits – – either actual or anticipatory profits – – to be divided between the associated enterprises from the controlled transactions in which the associated enterprises are engaged. Once the combined profits are identified, the combined profits must then be divided between the associated enterprises on an economically valid basis. That is, this division must be based on objective data (such as a transaction with unrelated parties), rather than on data relating to the remuneration of controlled transactions (such as a transaction with associated enterprises). The Guidelines portends that transactional profit split methods may be the most appropriate method in cases where both parties make “unique and valuable contributions” to a transaction, in particular, where both parties contribute unique intangibles. The new guidelines describe splitting profits on an economically valid basis in two broad ways – – the first approach of splitting profits is to combine and split anticipated profits, and the second approach involves combining and splitting actual profits. A transactional profit split of anticipated profits is a type of pricing arrangement whereby the principles of splitting profits on an economically valid basis are applied to the anticipated profits of an enterprise resulting from its own contributions and also from those made by an associated enterprise in order to determine a price for the contributions from that associated enterprise.[2]
Example:
Company A, transfers rights in an intangible to an associated enterprise, Company B. Company B combines that intangible with its own intangible to commercialize a product using the intangibles in combination. Assuming that the facts of this arrangement lead to the conclusions that a transactional profit split of anticipated profits is the most appropriate method to apply, the profits anticipated to be generated by Company B from commercializing products using its own intangible and the rights to an intangible contributed by Company A over an appropriate period are determined. The respective contributions made by each of the associated enterprises (both Company A and Company B contribute intangibles, and Company B makes additional inputs to commercialize the product using both intangibles) are then used to determine a pricing arrangement at the time of the transfer based on the anticipated profits of Company B resulting from the combined contributions of the enterprises that seeks appropriately to reward each company for its contribution to those anticipated profits at the time of the transfer.[3]
A transactional profit split of anticipated profits, however, does not require the level of integration or risk sharing required for a transactional profit split of actual profits. Instead, the value of a party’s contribution for which reliable comparables cannot be found may be derived from the splitting of appropriate projected income or cash flows of the transferee based on a splitting factor that reflects the respective contributions of the transferor and transferee to those projected incomes or cash flows.[4]
In a transactional profit split of actual profits, the profits of the enterprises are combined and the respective contributions of each enterprise are used to split the actual profits derived in each taxable period from commercializing products using the intangibles.
The primary focus in the overall analysis is the application of the transactional profit split method to actual profits but the basis on which combined profits are to be calculated and split must be determined ex-ante. In order words, the basis for splitting the combined profits must be calculated before the risks are known.
Example:
Company A, transfers the rights in an intangible to an associated enterprise, Company B. Company B also transfers the rights in an intangible to Company A. Each company commercializes a product using the intangibles in combination. Assuming that the facts of this case lead to the conclusions that a transactional profit split of actual profits is the most appropriate method to apply, the respective contributions made by each company are determined ex-ante (prior to risks being known) and used to split the combined actual profits of both Company A and Company B from commercializing the product in each taxable period covered by the arrangement.[5]
The division of combined actual profits under the guidelines require that the parties share in the outcome of the business activities and risks associated with those outcomes. A key indicator that a transactional profit split may be appropriate is the risks assumed by the parties. Each of the parties involved remains exposed to the effects of the risks associated with the business activities of the other parties. Thus, the appropriateness of the method will depend on the accurate delineation of the actual transaction, including the assumption of economically significant risks, the nature of the contributions of the parties, how those contributions drive profit outcomes, and the identification of the profits to be split. The overriding objective of the method is that the split of profits that would have been realized had the parties been independent enterprises is approximated as closely as possible. One significant difference between the two approaches to the application of the transactional profit split method is that combining the profits of each associated enterprise under a transactional profit split of actual profits requires a high level of integration of activities while a transactional profit split of anticipated profits does not, as stated above.
The key driver of the profit-split method is the relative value of the contributions of respective associated enterprises to that profit or loss. The profit-split method is appropriate in situations where it can be quite difficult to determine the relative contributions of respective associated enterprises, including when both parties have intangible assets or make valuable unique contributions. The combined operating profit or loss must be derived from the most narrowly identifiable business activity covering the controlled transaction. Thus, the relative value of the contributions of each associated entity must be determined reflecting the functions performed, risks assumed and resources employed. Equally important is the value chain which can be categorized into primary activities and supporting activities to identify which of the activities contribute to the profit. In order to identify value chain between the associated entities, a value chain analysis, in conjunction with a functional analysis must be conducted. The value chain analysis would help map out the value‐adding activities involved in a particular transaction (that is, product line or line of business) that are performed by related parties in a multinational enterprise (MNE), as well as the conduct of the related parties in terms of their functions performed, assets contributed and risks assumed. A key distinction between a Value Chain Analysis and a functional analysis is that a functional analysis typically focuses only on the two related parties directly involved in the transaction: the seller (typically, the manufacturer) and the buyer (typically, the distributor); in other words, a dyadic relationship’ while a Value Chain Analysis, on the other hand, maps out all the activities for all the related parties involved in a particular value chain, with the purpose of identifying the activities and entities within the chain that are likely to be earned above‐normal rents, reflecting sustainable competitive advantage.[6] Although, a value chain analysis is not, in and of itself, a method for applying transactional profit split but a tool to help delineate the transaction; determine the level of integration (to ascertain the level at which profits or revenues should be split); and determine the economically relevant contributions (factors used to split the profits). There are several types of profit shift method that can be used to determine the arm’s length pricing of intangibles transfer involving associated multinational entities.
[1] § 1.482–6
[2] “Base Erosion and Profit Shifting (BEPS) Action 8 – 10, Revised Guidance on Profit Splits. (2016).” OECD.org – OECD.
[3] Id. at p. 4.
[4] Id. at p. 9.
[5] Id. at p. 4.
[6] Eden, Lorraine. “Comments on the OECD’s BEPS Public Discussion Draft BEPS Actions 8‐10, “Revised Guidance on Profit Splits”.” OECD.org – OECD. p. 267
