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Thursday, July 25, 2024

The Profit Split Method is Appropriate for Transactions with High Integration-1

The Profit Split Method (PSM) stands as one of the five transfer pricing methods delineated in the guidelines provided by the Organisation for Economic Cooperation and Development (OECD). The detailed insights into PSM can be found in the transfer pricing guidance (CTGTP1) issued by the Federal Tax Authority.

According to the OECD’s guidelines, PSM is described as a “transactional profit method” that identifies the combined profit to be split for associated enterprises engaged in a controlled transaction. This involves splitting profits based on an economically valid basis, approximating the division of profits as anticipated in an arm’s length agreement.

The method necessitates the identification and division of combined profits among associated enterprises, utilizing comparables or considering functions, risks, and assets when comparables are unavailable. The OECD guidelines outline two significant approaches for profit splitting: contribution analysis and residual analysis.

Contribution Analysis: Allocating Profits Based on Comparable Data

In contribution analysis, total transaction profits are divided among associated enterprises using comparable data. When comparable data is not available, profits are allocated based on risk, functions, and assets. Each party receives a share based on its contribution value, determined by factors such as services provided, development expenses, and invested capital.

Residual Analysis: Dividing Profits in Two Stages: Profit Split

Residual analysis involves the division of total profits from the transaction into two stages. Initially, profits are allocated to each party based on routine functions. The second stage involves dividing residual profits using allocation keys such as assets, costs, sales, headcounts, and time spent. This method is suitable for highly integrated operations where interdependent functions cannot be performed in isolation, and where the functions, costs, and roles of each party are clearly defined.

An example is presented to illustrate the application of PSM in a scenario involving a UK beverage company (UKB) and its UAE subsidiary Dudlee Ltd, engaged in the production and sale of an energy drink (EZEE). Profits are initially divided based on non-routine functions and then allocated in the second stage based on R&D costs.

Challenges and Considerations in Applying PSM: Profit Split

While PSM is a complex approach suitable for highly integrated and interdependent transactions, it is not the primary choice due to certain challenges. These challenges include obtaining information from foreign affiliates, difficulty in measuring combined revenue and costs, and identifying appropriate operating expenses and allocating costs between transactions and other activities of associated enterprises when applied to operating profit.

In conclusion, the Profit Split Method offers a nuanced approach to transfer pricing, particularly in intricate transactions where each party makes unique and valuable contributions. It provides a two-sided method for the allocation of costs to each function and the assessment of each party’s contribution. However, its complexity and challenges make it a secondary choice in transfer pricing strategies.

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