The profit split method in Transfer Pricing

The intra-group transactions must be valued according to the arm’s length principle, and that is very known. The problem lies on the selection of the appropriate transfer pricing method for each case. Obviously, the selection of the method depends on the type of transaction and the availability of the information to value the corresponding transaction.

The existing transfer pricing methods are the following:

1. Comparable uncontrolled method;
2. Cost plus method;
3. Resale price method;
4. Transactional profit split method; and
5. Transactional net margin method.

In this case, the transactional profit split method is the subject of this document, considering the importance gained in the last months.

The transactional profit split method allocates the corresponding portion of the total outcome to each related party that carries out transactions together with other parties. The allocation of the results must be performed considering the conditions that third parties would have agreed in similar circunstancies.

In practice, the application of this method is difficult, since taxpayers are unaware about when and how could this method be applied. However, it is an interesting method that, properly used, could align the profits obtain with the value creation, according to the arm’s length principle.

A clear situation to apply the transactional profit split method is when exists unique and valuable contributions of each party or the business of the parties involved in the controlled transactions are highly integrated. In the first case, contributions (for instance functions performed, or assets used or contributed) will be “unique and valuable” in cases where

1. they are not comparable to contributions made by uncontrolled parties in comparable circumstances, and
2. their use in business operations represents a key source of actual or potential economic benefits.

The two factors are often linked: comparables for such contributions are seldom found because they are a key source of economic advantage.

For the implementation of this method, the context of the transaction, including the industry in which it occurs and the factors affecting business performance in that sector, can be particularly relevant to evaluating the contributions of the parties and whether such contributions are unique and valuable. Depending on the facts of the case, other indicators could include a high level of integration in the business operations to which the transactions relate and the shared assumption of economically significant risks by the parties to the transactions

Guidance for the implementation of the Transactional Profit Split Method

According to the document “ Revised Guidance on Profit Splits”, under the transactional profit split method, the relevant profits are to be split between the associated enterprises on 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. In general, the determination of the relevant profits to be split and of the profit splitting factors should:

1. Be consistent with the functional analysis of the controlled transaction under review, and in particular reflect the assumption of economically significant risks by at least one of the parties, and

 

1. Be capable of being measured in a reliable manner.

 

This Guidance also includes that:

If the transactional profit split method is used to set transfer pricing in controlled transactions (ex ante approach), it would be reasonable to expect the life-time of the arrangement and the criteria or profit splitting factors to be agreed in advance of the transaction.

The person using the transactional profit split method (taxpayer or tax administration) should be prepared to explain why it is regarded as the most appropriate method in the circumstances of the case, as well as the way it is implemented, and in particular the criteria or profit splitting factors used to split the relevant profits.

And the determination of the relevant profits to be split and of the profit splitting factors should generally be used consistently over the life-time of the arrangement, including during loss years, unless the rationale for using differing relevant profits or profit splitting factors over time is supported by the facts and circumstances and is documented.

At present

The transactional profit Split method is part of the action 10 of the BEPS project, which invited clarification of the application of transfer pricing methods, in particular the transactional profit split method, in the context of global value chains.

Two drafts have ben launched by the OECD related to the application of this method. The last one is the Revised Guidance on Profit Splits which intends to clarify the application of this method, in particular, by identifying indicators for its use as the most appropriate transfer pricing method, and providing additional guidance on determining the profits to be split. In this sense, the OECD will hold a public consultation related to this guidance, the next 6th November 2017at the OECD Conference Centre, in Paris.

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