Approaches to applying the profit split method to transfer pricing
The application of the profit split method (PSM) has been updated in the Revised Guidance on the Application of the Transactional Profit Split Method resulting from Action 10: Other High-Risk Transactions of the BEPS Action Plan, which provides for “clarification of the application of transfer pricing methods, in particular the profit split method.
These guidelines corroborate that the approaches for their application consider the relative contributions of each party, when applying the approach called “contribution analysis” and when some of the parties involved make contributions that are less complex, for which they can identify comparable transactions or companies, the analysis can be carried out in two steps, this approach being called “residual analysis”. In this sense, the guidelines define the contribution analysis as:
“An analysis used in the PSM under which the relevant profits from a controlled transaction are divided between associated enterprises based upon the relative value of the contributions made by each of the associated enterprises participating in those transactions, supplemented where possible by external market data that indicate how independent enterprises would have divided profits in similar circumstances.”
“an analysis used in the PSM which divides the relevant profits from the controlled transaction under examination into two categories. In the first category are profits attributable to contributions for which can be reliably benchmarked. Ordinarily this initial remuneration would be determined by applying one of the traditional transactional methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of any residual profit (or loss) remaining after allocating for the profits attributable to the first category of contributions would be based on the analysis of the relative value of the second category of contributions by the parties, supplemented where possible by external market data that indicate how independent enterprises would have divided profits in similar circumstances.”
With respect to the determination of the profits to be split, the guidance mentions that the relevant profits to be split under PSM are those of the associated enterprises arising as a result of the controlled transaction under review, which in turn are essential to first identify and accurately delineate the transactions. It emphasizes that a common basis of accounting practices and currency should be used before combining them. Also, that financial accounting provides a starting point for determining the profits to be split and that financial data, such as cost accounting data, should be permitted when they exist, are reliable, auditable and sufficiently transactional (including Income Statements by business line or by division).
The Revised Guidance for the application of the PSM explains that the most common profits to be split are the operating profits, although depending on the accurate delineation of the transaction, other profit measures may be considered such as gross profit. The latter would usually be considered in those cases in which the parties share the assumption of market risks (prices and sales volumes) and those of production, acquisition of goods or services as the case may be, these aspects affecting the results only at the gross profit level.
With respect to the division of profits, the guidance mentions that this split must be made on an economically valid basis that reflects the relative contributions of the parties to the transaction and thus approximates the division of profits that would have obtained under the Arm’s Length principle. Also, that the criteria or splitting factors used to split the profit should:
The guidance also mentions regarding the profit splitting factors that the functional analysis and an analysis of the context in which the transaction take place (industry and environment) are essential to the process of determining the relevant factors to be used in splitting profits, including determining the weighting of such factors in cases where more than one factor is used. Also, that such factors can be a fixed value or figure (e.g. 70%-30%) or a variable that can be calculated based on one or multiple factors (weighted) and that they can be based on assets (or capital) or costs. Other factors such as incremental sales, employee compensation, number of employees and time are also mentioned.
On the reliance on data from the taxpayer’s own operations, the guidance mentions that, where comparable uncontrolled transactions are lacking to support the division of relevant profits, internal data of the taxpayer should be considered, which may be a reliable means of establishing or testing the arm’s length nature of the division of profits. Also, that such data are frequently extracted from the taxpayer’s cost or financial accounting, e.g., asset-based benefit splitting factor data could be extracted from the balance sheet, while in the case of cost-based benefit splitting factors, the data could be extracted from the profit and loss statement.
Some examples provided by the guidance for asset-based benefit splitting factors are primarily tangible and intangible assets and capital employed that contribute to value creation in the context of the controlled transaction, while cost-based benefit splitting factors highlight marketing expenses, research and development expenses, employee compensation, location savings.
For practical purposes, in addition to the most recent developments compiled in this guidance, the greatest challenges are the identification/segregation of the profits attributable to the transaction and the selection of the factors to be used to split those profits or benefits. These aspects are key for the proper application of the method and will require a deep knowledge of the taxpayer’s business, of the transaction and its application in a creative way when defining the profit splitting factors, if the PSM is to be applied in the way that most accurately approximates to the results obtained by independent enterprises in comparable transactions.
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