In the above example, the CUP method cannot be used due to the uniqueness of the final product. For the sake of simplicity, assume that there is insufficient data and information to apply the cost plus method, while the resale price method is inappropriate as the product has undergone substantial transformation at Y. The profit split method is adopted using the residual approach.

1. Residual analysis of the group profit

Calculation of total profit

The mark-ups derived from external data will be used to calculate basic returns to X and Y.

1. Basic return to X = 30% of (COGS + Other operating expenses) = 30% x (35+15) = 15
2. The calculation of basic return to Y has to take into account the fact that the COGS for the comparable independent companies have included the purchase price for the semi-finished product. Since this is the transfer price for Y, the basic return for Y will be a function of the transfer price i.e.
   
   = 20% of [(COGS – purchase price) + other operating expenses + arm's length transfer price]
   = 20% [(135 –100) + 10 + TP]
   = 20% (35 + 10 + TP)
   
   b. Residual profit split:
   
   Calculation of residual profit
   
   Residual profit = Net profit – [(Return to X) + (Return to Y)]
   = 170 – [15 + (9 + 0.2TP)]
   = 146 – 0.2TP
   
   Assume that in this case R&D is a reliable indicator of X and Y's relative contribution of an intangible asset, the residual profit may be split based on the relative R&D expenditure as follows:
   
   

   	X	Y
   R&D	20	15
   Total R&D	35	35
   R&D expenditure ratio	57%	43%

Calculation of residual profit split

For X = 57% of (146 – 0.2TP) = 83.22 – 0.114TP

For Y = 43% of (146 – 0.2TP) = 62.78 – 0.086TP

Net profit for X

Net profit for Y

Adjustment for transfer price between X and Y:

Sales price of X (Assume X makes no profit)

= 100 – 30 = 70

Adjusted sales price (i.e. TP)

= 70 + Adjusted net profit for X

= 70 + 98.22 – 0.114TP

= 168.22 – 0.114TP

TP = 168.22/1.114 = 151

Adjusted net profit:

(iii) Contribution analysis approach

1. The second approach under the Transactional Profit Method is the contribution analysis approach. Under this approach, combined profits would be divided between associated persons based on the relative value of functions (i.e. contribution) performed by each of the associated persons participating in a controlled transaction. To determine the relative value of contribution, it may be necessary to focus on the nature and degree of each party's contribution of differing types (e.g. provision of services, capital invested) and assign a percentage based on the relative comparison and external market data
   
   Unlike the residual approach, basic returns are not allocated to each party to the transaction before the profit split is made. Generally, the profit to be combined and divided is the operating profit. Where allocation of expenses to controlled transactions is impossible, a split of gross profits may be considered, after which expenses attributable to the relevant enterprises will be deducted accordingly.
   
   However, it is difficult to determine the relative value of contribution that each of the participants makes to the controlled transactions, and the approach will often depend on the facts and circumstances of each case. Thus, the approach requires careful judgment and the criteria should always include what adds value to the transaction and how economically important were the functions carried out by each party in earning the profits
2. The division of combined profits under the transactional profit split method is achievable by the use of allocation keys. The choice of allocation keys by which profits are split largely depends on the facts and circumstances that surround a case. An allocation key can be in the form of a figure (e.g. a percentage) or a variable (e.g. specific expenses). Some of the more common types of allocation keys are:
   
   
   • Asset-based: useful where the controlled transaction demonstrates strong correlation between assets and the creation of value;
   • Cost-based: where there is clear indication of correlation between cost and value created;
   • Time spent by employees performing intragroup services;
   • Units produced or sold;
   • Number of employees;
   • Space used.