Understanding the Profit Split Method (PSM) in Transfer Pricing

This article relates to the following articles:

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

Identification of the Combined Profits: Calculate the total profit generated from the intercompany transactions.
Functional Analysis: Evaluate the functions performed, assets employed, and risks each entity bears.
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:

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
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
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.
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)
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%.