Profit-Split Method - Academy of Tax Law

The Profit-Split Method (PSM) is a critical tool in transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish.

The PSM ensures compliance with the arm’s length principle, requiring that profits are divided in a way that independent entities would agree upon under comparable circumstances. This method is outlined in Chapter II of the OECD Transfer Pricing GuidelinesThe OECD Transfer Pricing Guidelines serve as a critical framework for multinational enterprises (MNEs) and tax administrations worldwide. They provide detailed principles for the pricing of intra-group transactions to ensure that profits are allocated fairly across jurisdictions, based on the arm’s length principle. In essence, these Guidelines are instrumental in preventing tax base erosion and profit shifting by MNEs. The... and supported by BEPSBEPS stands for "Base Erosion and Profit Shifting". BEPS refers to tax avoidance strategies used by multinational enterprises (MNEs) to exploit gaps and mismatches in the international tax system. By shifting profits from high-tax jurisdictions to low- or no-tax locations, MNEs reduce their overall tax burden, even if little to no economic activity occurs in the low-tax jurisdictions. These practices erode... Actions 8-10. Its application is most effective when parties contribute significantly to the generation of profits through intangibles, unique assets, or significant risks.

Core Principles of the Profit-Split Method:

Arm’s Length Principle: The PSM ensures compliance with the arm’s length principle, requiring profit allocation as independent enterprises would have agreed under comparable circumstances.
Combined Profits: The method focuses on the total profits generated by the controlled transaction rather than individual pricing elements.
Relative Contribution: Profits are divided based on each entity’s relative contribution, determined through a detailed functional, asset, and risk analysis.

When is the Profit-Split Method Applied?

Integrated Transactions: When parties contribute closely to integrated operations, making it challenging to delineate individual contributions.
Unique Intangibles: When each party owns or contributes unique and valuable intangible assetsIntangible Assets are non-physical assets that have value due to the rights or advantages they confer on a business. Unlike tangible assets like machinery or buildings, intangible assets cannot be seen or touched but often hold significant worth. Common examples include intellectual property (IP) such as patents, trademarks, copyrights, goodwill, and brand recognition. Intangible assets are crucial for driving long-term..., such as intellectual propertyIntellectual Property (IP) refers to creations of the mind, including inventions, literary and artistic works, symbols, names, images, and designs used in commerce. It grants creators exclusive legal rights to use and exploit their work, ensuring protection against unauthorised use or reproduction. These rights are critical in fostering innovation and creativity while providing economic value to individuals and organisations. IP..., that drive profits.
Absence of Comparables: When it is difficult or impossible to find reliable external comparables for traditional methods, such as the Comparable Uncontrolled Price (CUP) methodThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed... or Transactional Net Margin Method (TNMM)The Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to....

Allocation Approaches:

Contribution Analysis: Profits are split based on the direct contributions of each party to the value creation.
Residual Analysis:
- Step 1: Allocate routine profits to each party based on standard returns for their routine activities (e.g., manufacturing, distribution).
- Step 2: Allocate the residual profits to reflect the relative contributions of unique and valuable intangibles or exceptional risks undertaken.

Key Features of the Profit-Split Method:

Flexibility: Adapts to complex and integrated operations, including joint ventures, global value chains, and R&D collaborations.
Transparency: Provides clarity in profit allocation by focusing on value contributions rather than transactional pricing.
Alignment with Value Creation: Ensures that profits align with where value is created, supporting compliance with global tax regulationsTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public..., such as the OECD Transfer Pricing GuidelinesThe OECD Transfer Pricing Guidelines serve as a critical framework for multinational enterprises (MNEs) and tax administrations worldwide. They provide detailed principles for the pricing of intra-group transactions to ensure that profits are allocated fairly across jurisdictions, based on the arm’s length principle. In essence, these Guidelines are instrumental in preventing tax base erosion and profit shifting by MNEs. The... and BEPSBEPS stands for "Base Erosion and Profit Shifting". BEPS refers to tax avoidance strategies used by multinational enterprises (MNEs) to exploit gaps and mismatches in the international tax system. By shifting profits from high-tax jurisdictions to low- or no-tax locations, MNEs reduce their overall tax burden, even if little to no economic activity occurs in the low-tax jurisdictions. These practices erode... Actions 8-10.

Limitations:

Subjectivity: Determining the relative contributions can be subjective, especially when intangibles or risks are involved.
Data Intensity: Requires robust documentation, detailed functional analysisFunctional analysis is the cornerstone of transfer pricing and international tax compliance, ensuring that intercompany transactions adhere to the arm’s length principle. It evaluates the roles, contributions, and risk profiles of entities within a multinational enterprise (MNE) to determine how profits and costs should be allocated. This process ensures that related-party transactions reflect the pricing that independent enterprises would establish..., and reliable data to justify allocations.
Complex Implementation: Applying PSM requires a deep understanding of business operations, financial data, and intangibles.

In conclusion, the Profit-Split Method is a vital tool in transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., ensuring fair and equitable profit allocation for controlled transactions that cannot be reliably analysed using traditional methods. By focusing on combined profits and contributions, the method supports compliance with international tax standards while addressing the complexities of global business operations.

Practical Examples of the Profit-Split Method

Example 1: Pharmaceutical Industry Collaboration

Scenario:
Two related companies, Company A (based in Switzerland) and Company B (based in the US), work together to develop, produce, and sell a breakthrough cancer drug.

Company A specialises in research and development (R&D) and has created a patented formula for the drug.
Company B handles large-scale manufacturing, marketing, and global distribution.

Application of the Profit-Split Method:

Calculate Combined Profits:
The first step is to determine the total profits from the sales of the drug worldwide, aggregating all revenues and deducting total costs. Assume the total profits amount to $500 million annually.
Allocate Routine Profits:
- Company A receives a return for its R&D activities, reflecting routine returns typical in the pharmaceutical industry.
  Example: A benchmark analysisA Comparability Analysis is an essential framework in Transfer Pricing used to evaluate whether the conditions of a transaction between related entities (such as subsidiaries of the same multinational enterprise) are consistent with the arm’s length principle. The arm’s length principle requires that intercompany transactions reflect terms that independent entities would negotiate under comparable circumstances, ensuring that multinational corporations (MNEs)... shows that routine R&D returns average 10% of costs. If Company A incurs $100 million in R&D costs annually, it receives $10 million as its routine return.
- Company B receives a routine return for its manufacturing and distribution functions. For instance, if its routine costs are $300 million, with a benchmarkBenchmarking, within the context of transfer pricing, refers to the process of analysing and comparing financial and economic data from independent companies to establish a fair and arm’s length price for controlled transactions. It is typically conducted using databases that provide details about comparable companies and transactions. The objective is to determine whether the terms and conditions of intercompany transactions... return of 8%, it earns $24 million in routine profits.
Split Residual Profits:
After allocating routine profits ($10M + $24M = $34M), the residual profits ($500M – $34M = $466M) are split based on each company’s contribution to the creation of unique value:
- Company A (owner of the patented formula) is assigned 70% of the residual profits.
- Company B (leveraging expertise in global distribution) is allocated 30%.
- Final Allocation:
  - Company A: $10M (routine) + $326.2M (residual) = $336.2M
  - Company B: $24M (routine) + $139.8M (residual) = $163.8M

This ensures that profits are allocated according to the relative contributions of both entities, reflecting the arm’s length principle.

Example 2: Technology Joint Venture

Scenario:
Company X (US-based) and Company Y (India-based) form a joint venture to develop and market a new AI-based software platform.

Company X contributes proprietary algorithms and designs, representing the core technology driving the platform.
Company Y manages development teams, oversees coding and testing, and uses its marketing network to drive adoption in emerging markets.

Application of the Profit-Split Method:

Determine Combined Profits:
The joint venture generates annual profits of $200 million from software sales and licensing agreements.
Allocate Routine Profits:
Each company is compensated for routine activities, such as administrative support, project management, and basic coding services.
- Assume Company Y incurs $20 million in routine costs annually with a 10% industry-standard return. It earns $2 million in routine profits.
- Company X incurs $15 million in basic support costs with an 8% return. It earns $1.2 million.
Split Residual Profits:
The remaining $196.8 million is split based on the unique value contributions of both companies:
- A functional analysisFunctional analysis is the cornerstone of transfer pricing and international tax compliance, ensuring that intercompany transactions adhere to the arm’s length principle. It evaluates the roles, contributions, and risk profiles of entities within a multinational enterprise (MNE) to determine how profits and costs should be allocated. This process ensures that related-party transactions reflect the pricing that independent enterprises would establish... determines that Company X’s algorithms contribute 60% of the residual value, while Company Y’s marketing expertise and operational scale contribute 40%.
- Residual Allocation:
  - Company X: 60% of $196.8M = $118.08M
  - Company Y: 40% of $196.8M = $78.72M
Final Profit Distribution:
- Company X: $1.2M (routine) + $118.08M (residual) = $119.28M
- Company Y: $2M (routine) + $78.72M (residual) = $80.72M

This ensures fair allocation of profits, recognising the value of Company X’s intangibles and Company Y’s market contributions.

Example 3: Automotive Manufacturing Supply Chain

Scenario:
A global automaker, Company Z, operates subsidiaries in Germany and Japan that collaborate to develop and manufacture components for electric vehicles (EVs).

The German subsidiary is responsible for designing and engineering innovative EV batteries.
The Japanese subsidiary oversees production, quality control, and global logistics.

Application of the Profit-Split Method:

Combine Profits:
The total profit generated from the sale of EVs globally is $1 billion annually.
Allocate Routine Profits:
- The Japanese subsidiary receives routine profits for its manufacturing functions, based on industry benchmarks for such activities. Assume manufacturing costs total $400 million, with an industry standard return of 8%. The Japanese subsidiary earns $32 million.
- The German subsidiary receives routine profits for its R&D management functions. If R&D costs are $200 million, with a standard return of 10%, it earns $20 million.
Split Residual Profits:
Residual profits amount to $948 million ($1 billion – $52 million in routine returns). These profits are split based on the relative value contributions:
- German subsidiary (innovative battery design): 65% of residual profits = $616.2 million.
- Japanese subsidiary (manufacturing and logistics expertise): 35% of residual profits = $331.8 million.
Final Allocation:
- German subsidiary: $20M (routine) + $616.2M (residual) = $636.2M
- Japanese subsidiary: $32M (routine) + $331.8M (residual) = $363.8M

This approach reflects the value of the German subsidiary’s innovation and the Japanese subsidiary’s production and distribution activities.

Judgments/Cases Where the Profit-Split Method Played a Role

1. Coca-Cola Co. v. Commissioner (2020)

Jurisdiction: United States Tax Court
Overview:
The case revolved around Coca-Cola’s transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... arrangements for its foreign subsidiaries engaged in manufacturing and distributing concentrate products. The IRS contended that the company’s allocation of profits did not align with the arm’s length principle, asserting that Coca-Cola’s use of the Comparable Profits Method (CPM) undervalued the contributions of the foreign subsidiaries.

Role of the Profit-Split Method:
The IRS argued that the Profit-Split Method was more appropriate due to the shared value created by Coca-Cola’s brand intangibles and the foreign subsidiaries’ significant contributions to marketing and distribution.

The IRS proposed reallocation of profits, considering the foreign subsidiaries’ substantial role in generating Coca-Cola’s global profits.
The court rejected Coca-Cola’s reliance on CPM, though it did not fully endorse the IRS’s PSM application.

Outcome:
The Tax Court ruled in favour of the IRS, leading to a significant tax adjustment of $3.3 billion. This case underscores the importance of accurately applying the PSM in scenarios involving shared intangibles and integrated operations.

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2. GlaxoSmithKline (2006)

Jurisdiction: United States Tax Court
Overview:
This landmark case involved a transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... dispute between GlaxoSmithKline (GSK) and the IRS over the allocation of profits from the sale of blockbuster drugs such as Zantac. GSK’s U.S. entity claimed that most profits should be attributed to its UK parent due to its ownership of the patents and trademarks.

Role of the Profit-Split Method:
The IRS challenged GSK’s transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... arrangement, arguing that the U.S. subsidiary’s marketing activities played a critical role in driving sales. The IRS proposed using the Profit-Split Method to allocate profits between the UK parent (for intellectual propertyIntellectual Property (IP) refers to creations of the mind, including inventions, literary and artistic works, symbols, names, images, and designs used in commerce. It grants creators exclusive legal rights to use and exploit their work, ensuring protection against unauthorised use or reproduction. These rights are critical in fostering innovation and creativity while providing economic value to individuals and organisations. IP... contributions) and the U.S. subsidiary (for marketing and distribution contributions).

The PSM was considered appropriate due to the integrated nature of the transactions and the unique intangibles contributed by both entities.

Outcome:
GSK eventually settled with the IRS for $3.4 billion, one of the largest tax settlements in U.S. history. The case highlighted the application of PSM in disputes involving high-value intangibles and marketing intangibles.

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3. Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (2017)

Jurisdiction: Federal Court of Australia
Overview:
This case involved Chevron Australia’s use of an intra-group financing arrangement. The Australian Taxation Office (ATO) challenged the company’s transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., arguing that interest rates on loans from its U.S. parent were not at arm’s length.

Role of the Profit-Split Method:
While the case primarily focused on financing arrangements, the ATO highlighted that profits derived from Chevron’s Australian operations should reflect contributions from both the local subsidiary and the parent company.

The ATO proposed the Profit-Split Method as a suitable alternative, suggesting that profits be allocated based on the integrated nature of Chevron’s global financing operations.

Outcome:
The Federal Court ruled in favour of the ATO, disallowing the deductions claimed by Chevron for excessive interest payments. Although the court ultimately did not apply the PSM, the case reinforced its relevance in scenarios involving global value chains and shared risks.

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