- The transactional profit split method provides an alternative solution for cases where no comparable transactions between independent parties can be identified. This would normally happen when transactions are highly integrated that they cannot be evaluated separately. Profit split method is based on the concept that the combined profits earned in a controlled transaction should be equitably divided between associated persons involved in the transaction according to the functions performed. To arrive at an arm's length price, the value of the contributions that each associated person makes to the transaction is assessed based on how independent persons would split the profits among them under similar circumstances
Two approaches for estimating the division of profits (projected or actual) are described in the following paragraphs. These approaches are neither exhaustive nor mutually exclusive:
- Residual profit split approach
This approach is the most appropriate method in cases where both parties to a transaction contribute significant unique intangibles. There are two stages of profit division under this approach. First, the combined profit is apportioned according to basic returns assigned to each party to the transaction. These returns are based on the basic, non-unique, functions that each party performs, and are determined by reference to market returns obtained by independent parties in similar transactions. This basic return would generally not account for the return that would be generated by any unique and valuable assets owned by the participants. The next stage involves the allocation of the remaining residual profit/loss, also with reference to how independent parties in similar circumstances would have divided such residuals.
The following example demonstrates the application of the residual profit split approach
- Residual profit split approach
3.5 Transactional Profit Method
Transactional profit methods examine profits that arise from controlled transactions among associated persons. The profit methods that satisfy the arm's length principle are those that are consistent with the transactional profit split method or the transactional net margin method (TNMM) as described in these Guidelines.
3.5.1 Transactional Profit Split Method
Example 7
X, Y and Z are companies located in different countries. Company X designs and manufactures the major components of a high quality electrical product which it sells to its subsidiary. From these components, Y further develops and manufactures them into the final product which it exports to Z, an independent distributor.
X | Y | |
Sales | 100 | 300 |
Purchases | 15 | 100 |
Manufacturing cost | 20 | 35 |
Gross profit | 65 | 165 |
R&D | 20 | 15 |
Other operating expenses | 15 | 10 |
Net profit | 30 | 140 |
The trading accounts of X and Y is as follows:
The final product in the transaction happens to be a unique product for which there is no comparable. However, research indicates that there are several companies that carry out similar functions to that of X and Y involving similar semi-finished and final products, of a much lower quality. The average net mark- ups for these independent companies involved in transactions similar to X and Y is 30% and 20% respectively.
Application of Residual Profit Split Approach
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.
- Residual analysis of the group profit
Calculation of total profit
Total Sales of transaction | 300 |
Cost of goods sold (X) | 35 |
Cost of goods sold (Y) [excluding purchases from X] | 35 |
Gross profit | 230 |
R&D | 35 |
Other operating expenses | 25 |
Net profit | 170 |
The mark-ups derived from external data will be used to calculate basic returns to X and Y.
- Basic return to X = 30% of (COGS + Other operating expenses) = 30% x (35+15) = 15
- 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
Basic return to X | = 15 |
Residual return to X | = 83.22 – 0.114TP Total |
net profit for X | = 15 + 83.22 – 0.114TP |
= 98.22 – 0.114TP |
Net profit for Y
Basic return to Y | = 9 + 0.2TP |
Residual return to Y | = 62.78 – 0.086TP |
net profit for Y | = (9 + 0.2TP) + (62.78 – 0.086TP) |
= 71.78 + 0.114TP |
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:
X | Y | |
Sales | 100 | 300 |
Arm's length adjustment | 51 | |
Adjusted sales | 151 | |
Purchases | (15) | 100 |
Adjustment | 51 | |
Adjusted purchases | 151 | |
Manufacturing cost | (20) | (35) |
Adjusted gross profit | 116 | 114 |
R&D | 20 | 15 |
Other operating expenses | 15 | 10 |
Adjusted net profit | 81 | 89 |
(iii) Contribution analysis approach
- 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 - 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.