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Borys Ulanenko
CEO of ArmsLength AI
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The profit split method is a transfer pricing method that divides the combined profits (or losses) from controlled transactions between associated enterprises based on the relative value of each party's contributions. Unlike one-sided methods like TNMM, profit split evaluates both parties to the transaction.
Profit split method definition: A transactional profit method that identifies the combined profit to be split from controlled transactions and then divides that profit between the associated enterprises based upon an economically valid basis that approximates the division that would have been anticipated between independent enterprises. See .
The profit split method (also called the transactional profit split method) is one of the five OECD-approved transfer pricing methods described in OECD Guidelines Chapter II. It's unique because it's a two-sided method—evaluating the contributions of both parties rather than just testing one party.
The method works by:
The OECD doesn't establish a strict hierarchy of methods. Instead, the most appropriate method should be selected based on facts and circumstances (). However, profit split is often considered when:
Profit split is not a "method of last resort." Per , it may be the most appropriate method when both parties contribute valuable intangibles or perform unique functions.
Profit split is appropriate in specific circumstances where one-sided methods would be unreliable. The OECD provides guidance in on when profit split is most appropriate.
Profit split is generally not appropriate when:
Profit split requires detailed data on combined profits, allocation keys, and each party's contributions. If this data isn't available or reliable, one-sided methods may be more practical. See .
The profit split method can be applied using two main approaches: contribution analysis and residual analysis. Each serves different situations.
Contribution analysis divides the combined profits based on the relative value of each party's contributions to the transaction. It's a direct approach that allocates all profits at once.
| Allocation Key | Best For | Example |
|---|---|---|
| Relative costs | Similar functions with different scales | R&D costs as proxy for innovation contribution |
| Headcount/FTEs | Labor-intensive operations | Number of engineers on joint project |
| Assets employed | Capital-intensive operations | Value of manufacturing assets |
| Relative value of functions | Different but complementary contributions | Weighted scoring of FAR analysis |
Scenario: USCo and EUCo jointly develop and market software. USCo handles development; EUCo handles marketing and sales. Combined profit is €10 million.
Analysis:
Allocation (cost-based key):
This simple cost-based approach assumes costs are a reasonable proxy for value contributed. In practice, more sophisticated keys may be needed if costs don't reflect relative value.
Residual analysis (or residual profit split) is a two-step approach that first allocates routine returns, then splits the remaining profits based on unique contributions.
Step 1: Allocate routine returns
Step 2: Split residual profits
Residual analysis is useful when:
Scenario: ParentCo develops patented technology; SubCo manufactures using that technology. Combined profit is €20 million.
Step 1: Routine returns
Step 2: Residual profit split
Allocation of residual:
Total allocation:
| Factor | Contribution Analysis | Residual Analysis |
|---|---|---|
| Both parties have unique contributions only | ✓ Preferred | May overcomplicate |
| Both parties have routine + unique contributions | Possible but complex | ✓ Preferred |
| Reliable benchmarks for routine functions exist | Not required | ✓ Required |
| Data availability | Requires contribution data | Requires routine benchmarks + contribution data |
| Complexity | Simpler | More complex but often more precise |
The OECD doesn't prescribe one approach over another. Select the approach that provides the most reliable result given the specific facts and available data. See .
Scenario: JapanCo (manufacturer) and USCo (distributor) jointly develop and sell premium electronics. Both contribute valuable intangibles—JapanCo has patented technology; USCo has developed unique customer relationships and brand recognition in the US market.
Why profit split? Both parties make unique and valuable contributions. Testing USCo as a "routine distributor" would ignore its marketing intangibles. Testing JapanCo as a "routine manufacturer" would ignore its technology.
Approach: Residual analysis
Scenario: PharmaCo and BiotechCo jointly develop a new drug. PharmaCo contributes existing IP and clinical trial expertise; BiotechCo contributes novel discovery platform and research scientists.
Why profit split? Classic joint development scenario. Each party contributes unique and valuable intangibles to create combined value.
Approach: Contribution analysis based on:
Scenario: A commodities trading group with entities in Singapore (trading), Switzerland (risk management), and London (client relationships) operates as highly integrated business.
Why profit split? No single entity performs the complete function—value creation requires all three locations working together.
Approach: Contribution analysis based on:
Profit split requires extensive data that may not be readily available:
Allocation keys involve judgment. Tax authorities may challenge:
Profit split is accepted by most jurisdictions but requires robust documentation. Tax authorities may:
Given its complexity, profit split requires thorough documentation. Your transfer pricing documentation should include:
The profit split method divides the combined profits from intercompany transactions between related parties based on how much each contributed to creating that profit. It's like splitting restaurant profits between a chef and a manager—each gets a share based on what they brought to the business.
Profit split is most appropriate when both parties make unique and valuable contributions that can't be evaluated separately. Common scenarios include: joint development of intangibles, highly integrated operations, or when neither party is clearly "routine." If one party just performs simple functions, TNMM is usually more appropriate.
Contribution analysis divides all profits at once based on relative contributions. Residual analysis first gives each party a "routine return" for their basic functions, then splits the remaining (residual) profit based on unique contributions. Residual is more common when parties perform both routine and unique functions.
Allocation keys should reflect the relative value each party contributes. Common keys include: R&D costs (for technology contributions), marketing spend (for brand contributions), asset values (for capital-intensive operations), or headcount (for labor-intensive operations). The key should be economically justified and documented.
Not necessarily. Profit split is appropriate in specific circumstances and requires robust documentation. Tax authorities may challenge allocation keys or argue that simpler methods would be more reliable. The best method is the one that provides the most reliable arm's length result given your facts.
Yes. If combined profits are negative (losses), profit split divides those losses. If one party's routine return exceeds combined profits in residual analysis, allocations can become complex. Document how losses are handled in your transfer pricing policy.
For pure contribution analysis, no—you're directly assessing contributions. For residual analysis, yes—you need comparables to benchmark routine returns. In all cases, you may use comparables to validate that your split produces arm's length outcomes.
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