Understanding the Profit Split Method (PSM) in Transfer Pricing

This article relates to the following articles:

• Essential Components of Transfer Pricing Documentation
• The Importance of Thorough Economic Analysis in Transfer Pricing

The Profit Split Method in Transfer Pricing is crucial to ensure that transactions between related companies are conducted at arm’s length, meaning at fair market value. This method is particularly useful when highly integrated transactions cannot be evaluated separately.

What is the Profit Split Method (PSM)?

The Profit Split Method (PSM) is one of the five primary transfer pricing methods outlined by the OECD. It is used to allocate profits and losses from controlled transactions between associated enterprises based on the relative value of their contributions. The method ensures that the division of profits approximates what independent enterprises would have agreed upon under similar circumstances.

How the Profit Split Method Works

The PSM works by analyzing the combined profits from intercompany transactions and then splitting these profits based on a formula that reflects the relative value of each entity’s contribution. This contribution can be in terms of functions performed, assets used, and risks each party assumes.

When to Use the Profit Split Method

The PSM is particularly appropriate in the following situations:

• Highly Integrated Operations: When business operations are so integrated, the parties’ contributions cannot be reliably evaluated in isolation.
• Unique and Valuable Contributions: When each party makes unique and valuable contributions to the transaction.
• Shared Risks: When the parties share the assumption of economically significant risks or separately assume closely related risks.

Steps in Applying the Profit Split Method

1. Identification of the Combined Profits: Calculate the total profit generated from the intercompany transactions.
2. Functional Analysis: Evaluate the functions performed, assets employed, and risks each entity bears.
3. Allocation of Profits: Split the combined profits based on the relative contributions of each entity, derived from the functional analysis.

Types of Profit Split Methods

There are two main approaches to applying the Profit Split Method:

1. Contribution Analysis

In this approach, the combined profits from the controlled transactions are allocated between the associated enterprises based on the relative value of their contributions. This method often uses external market data to reflect how independent enterprises would have divided profits in similar circumstances.

2. Residual Analysis

This approach involves a two-step process:

• Step 1: Allocate sufficient profit to each enterprise to provide basic arm’s length compensation for routine contributions. This is usually determined using traditional transactional methods or the Transactional Net Margin Method (TNMM).
• Step 2: Allocate the residual profit (remaining profit after Step 1) based on the relative value of each enterprise’s contributions, particularly focusing on unique and valuable contributions.

Challenges and Considerations

The PSM can be complex to implement due to the need for detailed information on the contributions of each party. It requires:

• Accurate Financial Data: Reliable and auditable financial data to determine the profits to be split.
• Comparable Transactions: External market data to validate the profit split percentages.
• Functional Analysis: A thorough analysis of the functions performed, risks assumed, and assets used by each party.

Examples of Profit Split Method

Example 1: Pharmaceutical Industry Collaboration

A pharmaceutical company and its R&D affiliate collaborate to develop a new drug. The R&D affiliate bears the costs and risks associated with the research and development process. The total investment for bringing the drug to market is $500 million, with the R&D affiliate contributing $375 million (75%). Therefore, the R&D affiliate will receive 75% of the future profits, while the pharmaceutical company will receive 25%.

Initial Scenario:

• Total investment: $500 million
• R&D affiliate contribution: $375 million (75%)
• Pharmaceutical company contribution: $125 million (25%)

Expanded Analysis:

1. Contribution Breakdown:
   • R&D affiliate:
     • Research costs: $250 million
     • Clinical trials: $100 million
     • Regulatory approvals: $25 million
   • Pharmaceutical company:
     • Manufacturing setup: $75 million
     • Initial marketing: $50 million
2. Risk Assessment:
   • R&D affiliate bears higher risks:
     • Failure of drug development
     • Regulatory rejection
     • Potential side effects discovered during trials
   • Pharmaceutical company risks:
     • Market acceptance
     • Competition from similar drugs
3. Profit Split Rationale:
   The 75-25 split is justified not only by the financial contribution but also by the risk allocation. The R&D affiliate’s higher risk exposure supports its larger share of potential profits.
4. Future Adjustments:
   The agreement might include clauses for profit split adjustments based on:
   • Sales milestones (e.g., if annual sales exceed $1 billion, the split shifts to 70-30)
   • Patent life stages (e.g., different splits pre- and post-patent expiration)
   • Geographic expansion (e.g., different splits for domestic vs. international markets)
5. Residual Profit Consideration:
   If using a residual profit split approach:
   • Allocate routine returns first (e.g., 10% return on manufacturing costs for the pharmaceutical company)
   • Split the residual profit based on the 75-25 ratio

This expanded example demonstrates the complexity of factors considered in a pharmaceutical PSM scenario, including varied contributions, risk allocation, and potential future adjustments.

Example 2: Brand and Local Affiliate

A manufacturer owns a brand and sells products to an affiliate in another country. The affiliate has invested in building the customer base and developing the market. Suppose the parent company spent $15 million on advertising, and the affiliate spent $10 million. The parent company has invested 60% of the total advertising costs, while the affiliate has invested 40%. Thus, the parent company will receive 60% of the profits, and the affiliate will receive 40%.

Initial Scenario:

• Parent company (brand owner) advertising investment: $15 million (60%)
• Local affiliate marketing investment: $10 million (40%)

Expanded Analysis:

1. Detailed Contribution Breakdown:
   • Parent company:
     • Global brand advertising: $10 million
     • Product development: $3 million
     • Market research: $2 million
   • Local affiliate:
     • Local advertising campaigns: $6 million
     • Customer relationship management: $2 million
     • Market adaptation costs: $2 million
2. Intangible Assets Consideration:
   • Parent company:
     • Brand value
     • Product patents
     • Global marketing strategies
   • Local affiliate:
     • Local customer base
     • Market-specific knowledge
     • Distribution network
3. Functional Analysis:
   • Parent company:
     • Strategic brand management
     • Product innovation
     • Global supply chain management
   • Local affiliate:
     • Local sales and distribution
     • Customer service
     • Inventory management
4. Profit Split Rationale:
   The 60-40 split reflects not just the advertising spend, but also the relative value of intangible assets and functions performed by each entity.
5. Dynamic Profit Split Approach:
   Consider a tiered profit split based on performance:
   • Base profit up to $10 million: 60-40 split
   • Profit between $10-20 million: 55-45 split
   • Profit above $20 million: 50-50 split
     This approach incentivizes the local affiliate to grow the market while recognizing the parent company’s brand value.
6. Comparability Analysis:
   Research similar arrangements in the industry to validate the profit split percentages. For instance, if comparable independent distributors typically earn a 30% share of profits, the affiliate’s 40% allocation might be justified by its additional market-building activities.
7. Periodic Review:
   Include provisions for annual or biennial reviews of the profit split arrangement, considering:
   • Changes in market conditions
   • Evolving contributions of each party
   • Shifts in the relative value of intangible assets

This expanded example illustrates the nuanced considerations in a brand-affiliate PSM scenario, including the valuation of intangible contributions, functional analysis, and the potential for dynamic profit split arrangements.

Why Consult Experts?

Given the complexities of applying the Profit Split Method, consulting experts like Tax Risk Management (TRM) is highly beneficial. TRM’s team can offer:

• Expertise: Extensive knowledge of transfer pricing regulations and best practices.
• Accuracy: Ensuring precise functional analysis and profit allocation.
• Compliance: Helping maintain compliance with international and local tax laws.
• Documentation: Provide thorough documentation to support the chosen method and allocations.

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References

1. United Nations Practical Manual on Transfer Pricing for Developing Countries
2. European Commission Directorate-General Taxation and Customs Union Report on the Application of the Profit Split Method within the EU
3. Valentiam Group, “The Profit Split Method (PSM) With Examples.”
4. EY, “Worldwide Transfer Pricing Reference Guide 2022-23.”
5. OECD, “Revised Guidance on the Application of the Transactional Profit Split Method.”