Evolution of the profit split method and its use to assess the Arm’s Length principle
The method called Profit Split Method (PSM), including its variant called Residual Profit Split Method (RPSM) it is a method of very little application in general, especially in Latin American countries, a region where relatively few multinationals have their headquarters. This situation complicates its application since usually this method requires information from the whole business group, or at least from the entities involved in the transaction. This is particularly a problem for subsidiaries of a business group that do not have this information. In addition to this limitation, for reasons of simplicity and administrative costs, the use of a method that evaluates one side of the transaction is generally chosen, such as the Transactional Net Margin Method (TNMM), for compliance purposes.
Applying methods based on the split of profits began as a solution to disputes and court cases in which it was not possible to identify comparable transactions to verify the Arm’s Length principle. The 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations included the PSM, and this was justified by the existence of transactions highly integrated together, which could not be assessed separately, when it was not possible to identify ways in which independent companies would divide their profits in their transactions. The 1995 OECD Guidelines defined PSM in the glossary as:
Among the strengths of this method, the 1995 OECD Guidelines highlighted its flexibility in the sense that it takes into account specific, possibly, unique, facts and circumstances of the associated enterprises that are not present in independent enterprises. In addition, the unlikelihood that either party to the controlled transaction will be left with an extreme and improvable profit result, since both parties to the transaction are evaluated. Among the weaknesses highlighted by the 1995 Guidelines is that the external market data considered in valuing the contributions each associated enterprise make to the controlled transaction will be less closely connected to the transactions than in the case of other available methods. They also highlight the difficulty in its implementation.
The update of the OECD Guidelines in 2010 had an impact in relation to PSM. In this update, the guidelines also highlight among the main strengths of PSM that it offers a solution for highly integrated transactions. It is also considered the most appropriate method when both parties involved in the transaction make unique and valuable contributions.
As part of the Action 10: Other high-risk transactions of the BEPS Action Plan, which considers “clarify the application of transfer pricing methods of, in particular profit splits, in the context of global value chains,” the OECD worked to carry out an update regarding PSM and some documents were issued (2014, 2016 and 2017) as draft, which were commented. However, for the update of the OECD Guidelines in 2017, no consensus was reached, so this task remained pending.
Finally, in mid-2018, rRevised Guidance on the Application of the Transactional Profit Split Method were issued which ratify as its main strengths that it provides a solution in the event that the participants in the transaction provide unique and valuable contributions, as well as in cases of highly integrated activities.
This guidance update the definition of PSM, considering it:
This guidance also highlight among the strengths of the PSM that it offers flexibility by taking into account specific, possibly, unique, facts and circumstances, that may not be present in independent enterprises. Furthermore, all relevant parties to the transaction are directly evaluated as part of the pricing of the transaction, i.e. the contribution of each part of the transaction are particularly identified and their relative value measured in order to determine the arm’s length compensation for each of the parties in relation to the transaction.
Regarding contributions, the guidelines stress that they will be unique and valuable in cases where:
With respect to its implementation, which continues to be one of the weaknesses of this method, the guide mentions that at first glance the PSM may appear readily accessible to both taxpayers and the tax administrations because it tends to rely less on information from independent enterprises. However, associated enterprises and the tax administration alike may have difficulty accessing the detailed information required to apply this method reliably.
The revised guidance for the implementation of PSM have included some aspects concerning the accurate delimitation of the transaction. In this regard, they mention that regardless of the method of transfer prices to be used, the accurate delimitation of the transaction requires a two-sided analysis (or a multi-sided analysis of contributions, if there are more than two parties) of the transaction. Despite the above, the guidelines highlight that a accurate delimitation of the transaction is important to determine if the PSM is potentially applicable.
In cases where a accurate delimitation of the transaction determines that one of the two sides of the transaction performs only simple functions, does not assume economically significant risks in relation to the transaction and does not make any contribution which is unique and valuable, the PSM would typically not be the most appropriate method. In addition, the lack of comparable transactions alone should not lead to the conclusion that the PSM is the most appropriate method. Under certain circumstances, the use of comparable transactions sufficiently similar, though not identical, to that tested transaction could shed more reliable results than the inappropriate application of PSM.
Regarding the risk, the guidance state that the PSM is the most appropriate method when, according to the accurate delimitation of the transaction, the various economically significant risks in relation to the transaction are separately assumed by the parties, but those risks are so closely inter-related or correlated that the playing out of the risks of each party cannot reliably be isolated. The economic significance of these risks should be analyzed in relation to the actual or anticipated relevant profits or gains of the controlled transaction.
Among the changes in the international transfer-pricing regime, driven by the BEPS action plan, the PSM has been a source of discussion. Some consider that it should be more used since it is aligned with the transparency and vision of the transaction from both sides, although to date, as mentioned, its application tends to be considered appropriate only in the presence of unique and valuable intangibles, and high level of integration of the operation. However, it remains an important method, worth the effort of being implemented when it can be confirmed as the best method to evaluate the transaction.
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