by Guy Sanschagrin and Doug Schwerdt, WTP Advisors

Our second article in a series on the profit split method (“PSM”), “The Profit-Split Method: A Comparison of U.S. and OECD Guidance,” was published in Tax Notes International on April 24, 2023. We describe what multinational enterprises (MNEs) must understand to navigate the differences and similarities between the U.S. Treasury’s transfer pricing regulations (“U.S. Regs”) and the Organisation for Economic Co-operation and Development’s Transfer Pricing Guidelines (“OECD Guidelines”). Tax authorities interested in claiming their fair share of the taxable profit generated by an MNE’s value chain follow the transfer pricing rules of their country. Many countries closely align their transfer pricing rules with the OECD Guidelines. However, the PSM evaluates the arm’s length allocation of operating profit like a pie, and the OECD and the U.S. provide different perspectives on how to cut it. This blog post provides an overview of the article.

First, we note there are two distinct types of Profit-Split Methods:

1. Comparable Profit-Split Method: This PSM requires finding comparable profit-splitting arrangements between unrelated parties, which contribute to relevant business activities that closely resemble those of the controlled parties. Finding comparable arrangements is difficult due to the lack of reliable data that details the division of profits among unrelated parties. Therefore, the comparable PSM is seldom utilized.
2. Residual Profit-Split Method: This PSM allocates combined profit or loss via a two-step process. The first step determines routine returns to functions and the second step allocates residual combined profit or loss based on the relative value of each party’s nonroutine contributions.

When to Use the Profit Split Method

The OECD Guidelines suggest using the profit-split method when contributions made by two or more parties to a transaction are unique and valuable. The U.S. Regs agree, emphasizing using the residual profit-split method when multiple parties in a value chain make nonroutine contributions, often in the form of intangible property, perform high-value functions, or are exposed to entrepreneurial risks. Additionally, the OECD Guidelines highlight the advantages of applying the PSM when one or more parties are highly integrated, share the assumption of economically significant risks, or separately assume closely related risks. Many U.S. transfer pricing court cases involve the application of a version of the PSM.

Determining Combined Profit

U.S. Regs require using the combined operating profit derived from the most narrowly identifiable business activity related to the controlled transaction. In determining combined profit, the OECD Guidelines discuss the difficulties in measuring relevant revenue and costs, emphasizing the need for adjustments in accounting practices and currencies.

Splitting Gross or Operating Profit

The OECD Guidelines provide a framework for splitting profits at the gross or operating level. The choice depends on the nature of the shared risks and the level of integration between the parties involved. For example, it may be more reliable and appropriate to split based on gross profit when the parties share market risk (i.e., generally, when revenue is subject to changes in sales volume and prices) and production risk (i.e., when there are integrated or joint functions and assets relating to the cost of sales). However, the U.S. Regs focus on splitting the combined operating profit and do not mention splitting gross profit.

Actual or Anticipated Profit

The OECD Guidelines distinguish between actual or anticipated profit splitting. Parties split actual profit when they share economically significant risks or separately assume closely related risks. Alternatively, suppose one of the parties does not share in the assumption of the economically significant risks that might play out after entering into the transaction. In that case, the OECD Guidelines assert that a split of anticipated profit would be appropriate. However, the U.S. Regs refer to actual profit and do not discuss profit splits based purely on anticipated profit – so it is uncertain whether the IRS would accept a PSM approach based on anticipated profit.

Conclusion

Understanding the nuances of the profit-split method per the U.S., OECD Guidelines and other relevant tax authorities is important for MNEs with integrated global value chains. By considering the criteria for each approach, taxpayers can better implement the profit-split method in their transfer pricing analyses, reducing the risk of proposed adjustments by tax authorities and potential double taxation (or more) on their global profit.
Our first article in this PSM series, “Introducing the Profit Split Method – To Apply or Not to Apply, This is a BEPS Question,” ran on March 27, 2023, in Tax Notes.

If you have any questions about the article or would like more information, please contact the authors: Guy Sanschagrin, CPA/ABV, Principal in Charge of Transfer Pricing and Valuation Services, WTP Services, WTP Advisors, guy.sanschagrin@wtpadvisors.com / (866) 298-7829 ext. 702 and Doug Schwerdt, Transfer Pricing Sr. Manager, WTP Advisors, doug.schwerdt@wtpadvisors.com / (866) 298-7829 ext. 715.

We thank Kash Mansori, Ph.D. in Economics from Princeton University and Managing Director at WTP Advisors, for his contributions.

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