Category: Annex II to Chapter II – Examples on the Profit Split Method

Chapter II Annex II example 1

Chapter II Annex II example 1

1. Company A is the parent company of an MNE group in the pharmaceutical sector. Company A owns a patent for a new pharmaceutical formulation. Company A designed the clinical trials and performed the research and development functions during the early stages of the development of the product, leading to the granting of the patent. 2. Company A enters into a contract with Company S, a subsidiary of Company A, according to which Company A licenses the patent rights relating to the potential pharmaceutical product to Company S. In accordance with the contract, Company S conducts the subsequent development of the product and performs important enhancement functions. Company S obtains the authorisation from the relevant regulatory body. The development of the product is successful and it is sold in various markets around the world. 3. The accurate delineation of the transaction indicates that the contributions made by both Company A and Company S are unique and valuable to the development of the pharmaceutical product. 4. Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the compensation for the patent rights licensed by Company A to Company S.
Chapter II Annex II example 2

Chapter II Annex II example 2

5. A Co, a member of T Group, is a company incorporated in Country A whose principal activity is the growing and processing of tea. A Co identifies, acquires and cultivates land with extremely good soil for growing tea. A Co has developed extensive know- how in respect of tea-growing, including maximising the desirable qualities of the tea it grows through its cultivation methods. The properties of the soil together with the cultivation methods give A Co’s tea a highly sought after flavour. 6. A Co processes tea by undertaking the following activities: sorting leaf, grading, full or partial fermenting, and blending and packaging for export as per customer order specifications. Blending entails using extensive proprietary know-how to mix the various teas in order to get blends with the unique tastes appreciated by customers of T Group. Tea produced by A Co has won international acclaim for its unique taste and aroma. 7. A Co sells its tea to B Co, its parent company located in Country B. B Co then repackages and brands the teas for sale in the target markets. 8. B Co owns and has, by its own efforts, developed the tradename and trademark which are both unique and valuable. However, the branding features the origin of the tea and the unique blend developed by A Co. B Co has carried out extensive advertising campaigns through electronic media, internet, trade fairs and publications in industry magazines resulting in the product range becoming market leader in a number of geographic markets. Tea sold by T Group commands a premium price. 9. The accurate delineation of the transaction in this particular case determines that both A Co and B Co are making a unique and valuable contribution and the most appropriate transfer pricing method is likely to be the transactional profit split method.
Chapter II Annex II example 3

Chapter II Annex II example 3

10. Company A and Company B are members of an MNE group that sells electronic appliances. For the launch of a new line of products, Company A will be responsible for its design, development and manufacturing whereas Company B will undertake the marketing functions and the global distribution of the goods. 11. In particular, Company A performs the research and development functions and decides on the lines of research and the timelines. For the manufacturing of the new line of products, Company A decides on the levels of production and performs the quality controls. In doing so, Company A uses its valuable know-how and expertise regarding the manufacturing of electronic appliances. 12. Once the products are manufactured, they are sold to Company B, which develops and executes cutting-edge global marketing activities relating to the new line of products. In particular, Company B is responsible for designing the marketing strategy, deciding on the level of marketing expenditure in each country where the products will be released, and validating the impact of the marketing campaigns on a monthly basis. The marketing activities performed by Company B result in a valuable trademark and associated goodwill by which the new line of products is favourably differentiated from competitors’ alternatives in the market. 13. Company B is also responsible for the global distribution of the products. The distribution activities performed by Company B are a key source of economic advantage over competitors. Company B has performed the R&D activities and assumed the risks associated with the development of a sophisticated proprietary algorithm to get feedback from customers on the performance of the products. This information is highly valuable in accurately forecasting demand and managing inventory and distribution logistics so that customers are assured of receiving their orders within 48 hours. 14. The accurate delineation of the transaction indicates that the contributions of Company A and Company B are unique and valuable to the potential success of the new line of products. 15. Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the compensation for the products sold by Company A to Company B as both parties make unique and valuable contributions to the transaction.
Chapter II Annex II example 4

Chapter II Annex II example 4

16. The facts in this example are the same as in Example 3, except that the marketing activities performed by Company B are more limited and do not significantly enhance the goodwill or reputation associated with the trademark. Company B has a mechanism whereby customer feedback on the products it sells is relayed to Company A, but this is a relatively simple process, and does not constitute a unique and valuable contribution. In sum, its distribution activities are not a particular source of competitive advantage in its industry. In particular, the potential success of the new line of products is largely dependent on its technical specifications, its design, and the price at which the products are sold to final customers. 17. The functional analysis concludes that Company A assumes the risks associated with the design, development and manufacturing of the product and Company B assumes the risks relating to marketing and distribution. 18. Marketing and distribution risks assumed by Company B may impact on the ultimate profitability of Company A. However, the functional analysis determines that the risks assumed by Company B are not economically significant for the business operations and that Company B does not make any unique and valuable contributions in relation to the controlled transaction. 19. Under these circumstances, the transactional profit split method may not be the most appropriate method as it is likely that the arm’s length compensation for the contribution of Company B can be reliably benchmarked by reference to comparable uncontrolled transactions and the application of a one-sided transfer pricing method or methods.
Chapter II Annex II example 5

Chapter II Annex II example 5

20. WebCo is a member of an MNE group that develops IT solutions for business customers. Recently, WebCo designed the architecture of a web crawler to collect pricing data from internet sites. WebCo has written the code of the program so it is able to systematically scan web pages in a more efficient and faster way than any other similar search engines available in the market. 21. At this stage, WebCo licenses the program to ScaleCo, a company in the same MNE group. ScaleCo is responsible for scaling-up the web crawler and for deciding the crawling strategy. ScaleCo is a specialist in designing add-ons for the web crawler and in customising the product to address gaps in the market. Without these contributions, the system would not be able to meet potential customers’ needs. 22. Under the terms of the licence, WebCo will continue developing the underlying base technology and ScaleCo will use these developments to scale up the web crawler. 23. The functional analysis concludes that the economically significant risk in relation to the transaction is the development risk, i.e. the risk that the web crawler being developed is unsuccessful.. In accordance with the risk analysis framework described in Section D.1.2.1 of Chapter I of these Guidelines, it is determined that WebCo and ScaleCo assume the development risk of the software. 24. The accurate delineation of the transaction indicates that WebCo’s and ScaleCo’s contributions are unique and valuable to the creation and potential success of the web crawler. 25. Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the arm’s length compensation for the licence between WebCo and ScaleCo.
Chapter II Annex II example 6

Chapter II Annex II example 6

26. ASSET Co is the parent company of an MNE group that provides asset management services to unrelated parties. It has two subsidiaries, Company A in Country A and Company B, in Country B. 27. FUND Co is an independent asset management company that offers collective investment vehicles to retail investors in Country A and Country B. The investment vehicles commercialised by FUND Co are mirror funds that contain equity holdings from both Country A and Country B. 28. FUND Co hires ASSET Co to provide portfolio management services for the funds. FUND Co pays ASSET Co a fee based on the combined assets under management of the funds sold to retail investors in Country A and Country B. 29. ASSET Co enters into a contract with Company A and Company B such that both companies will provide the portfolio management services. Company A employs portfolio managers who specialise in Country A equity and Company B employs portfolio managers who specialise in Country B equity. ASSET Co acts as a nominee for Companies A and B. It does not perform any functions in relation to the FUND Co contract, nor has it contributed any assets or assumed any risks. 30. An investment management committee composed of equal numbers of portfolio managers from Company A and Company B decides on the funds’ investment management. This committee meets regularly and determines the composition of the funds. The composition of the funds between equities of countries A and B will vary according to the decisions of the committee. 31. The functional analysis concludes that the economically significant risk in relation to the transaction relates to retail investors withdrawing their deposits from the FUND Co mirror funds, in particular as a result of poor performance. In accordance with the risk analysis framework described in Section D.1.2.1 of Chapter I of these Guidelines, it is determined that Company A and Company B share the assumption of risks related to the performance of the funds and perform the portfolio management services in a highly integrated fashion. 32. While Company A and Company B provide valuable services, an active arm’s length market for portfolio management services indicates that these services are not unique. Comparables for such portfolio management services (i.e. the services performed by Company A and B together) may be available, but would provide no information on how to split the arm’s length fee between Company A and Company B. 33. Under these circumstances, the transactional profit split method is found to be the most appropriate method for determining the compensation for Company A and Company B as their operations are highly integrated and interdependent such that it is not possible to use a one-sided method to determine an arm’s length outcome for either of their respective contributions. The arm’s length fee received by ASSET Co from FUND Co will form the revenue portion of the relevant profits to be split between Company A and Company B. The arm’s length compensation to ASSET Co will be zero.
Chapter II Annex II example 7

Chapter II Annex II example 7

34. Company L, a resident of Country L, and Company M, a resident of Country M, are part of an MNE group, LM Corporation. Companies L and M offer international trade facilitation, freight forwarding and customs broking services to unrelated customers. Together, Companies L and M, provide customers with services including receipt of goods in the exporting country, customs clearance in the exporting country, containerisation, organising shipment of the container, delivery of containers to and from the ship, de-containerisation, customs clearance in the importing country, and delivering the goods to their destination. Customers may be importers or exporters and Companies L and M facilitate imports and exports from both countries. Customers typically pay for these services based on a combination of the volume and weight of the goods. 35. The accurate delineation of the transaction determines that Companies L and M perform the same trade facilitation, freight forwarding and customs broking services jointly in a highly integrated manner. Companies L and M are highly dependent on each other for the successful completion of each transaction with a customer. Companies L and M also perform similar marketing and customer relationship functions, depending on the location of the customer. Companies L and M jointly use an integrated goods-tracking IT system. The system was initially purchased jointly by Companies L and M from an unrelated supplier. Companies L and M each make incremental improvements to the system where possible. LM Corporation’s value proposition to its customers lies in its competitive pricing, which is made possible by its efficiency and economies of scale and scope, and its seamless integration across international boundaries. 36. Companies L and M jointly perform the same key value-adding functions and jointly use and contribute to the MNE group’s most important assets. Although arm’s length pricing for their joint activities is readily available, their operations are highly integrated and interdependent such that it is not possible to use a one-sided method to determine an arm’s length outcome for either of their respective contributions. In this case, therefore, it is likely that a transactional profit split will be the most appropriate method of determining the arm’s length compensation due to Companies L and M. 37. If Companies L and M also share the assumption of the economically significant risks associated with the transactions, a profit split of actual profits is likely to be appropriate.
Chapter II Annex II example 8

Chapter II Annex II example 8

38. Company A is the parent company of M Group, an MNE group engaged in the manufacturing and distribution of electronic devices. Company A has the exclusive right to sell the devices in all territories. 39. Company A decides to subcontract the manufacturing of the electronic devices to Company B, another member of M Group. Under the terms of the contract, Company B will follow the directions of Company A to produce the devices. Company B will source and supply the materials necessary to produce the different parts of the final products. A key component in the manufacturing process is sourced from Company A. Company B sells the finished goods to Company A, which in turn will market and distribute the product to unrelated customers. 40. To perform the manufacturing activities, Company B has invested in machinery and tooling that is specifically adapted to the production of the electronic devices sold by M Group. Company B has no other customer than Company A so its entire output is acquired by Company A. 41. The accurately delineated transaction shows that Company B does not make any unique and valuable contributions in relation to the controlled transactions and the business of M Group. Furthermore, the risks assumed by Company B are not economically significant for the business operations of the group. While the operations of Company B are integrated to some degree with those of Company A and are dependent upon Company A, arm’s length compensation for the contributions of Company B can be reliably benchmarked by reference to comparable uncontrolled transactions and the application of a one-sided transfer pricing method or methods. Under these circumstances, the transactional profit split method is unlikely to be the most appropriate method.

Chapter II Annex II example 9

42. ACo, resident in Country A, and BCo, resident in Country B, are members of AB Inc, an MNE Group. ACo owns worldwide patents on Compound A and BCo owns worldwide patents on Enzyme B. Compound A and Enzyme B are both unique. ACo and BCo have each developed their respective compound or enzyme by their own efforts, for different purposes, but each found that they were not able to be used as they had originally intended. As a result, neither Compound A nor Enzyme B has significant value at this time. 43. However, engineers from ACo and BCo working together subsequently determine that the combination of Compound A and Enzyme B creates a unique and valuable drug which is very effective in treating a specific disease and is likely to be highly valuable. 44. ACo and BCo enter into a contract according to which ACo grants BCo the right to use Compound A. BCo will combine both components to develop the new drug and will market it. 45. Under these circumstances, the high level of integration and inter-dependency between the contributions of ACo and BCo affects the value of those contributions such that each contribution is unique and valuable when considered in combination with the other. As a result, the transactional profit split method is found to be the most appropriate method for determining the compensation at which the rights to use Compound A are transferred by ACo to BCo.

Chapter II Annex II example 10

46. Company A designs, develops and produces a line of high technology industrial products. A new generation of the product line incorporates a key component developed and created by Company B, an associated enterprise of Company A. This key component is highly innovative, incorporating unique and valuable intangibles. This innovation represents the key point of difference in the new generation of products. The success of the new generation of products is heavily dependent upon the performance of the key component made by Company B. The key component is specifically tailored for the new generation of products and cannot be used in any other products. 47. The key component was developed entirely by Company B. The accurate delineation of the transaction determines that Company B performs all the control functions and assumed all the risks in relation to the development of the component, with no involvement by Company A. 48. The accurate delineation of the transaction also finds that Company A performs all the control functions and assumed all the risks in relation to the overall production and sale of the new generation of products. Company A cannot control (and thus does not assume) the risks relating to the performance of the key component. 49. In this example, it is determined that while Company A and Company B each assumes separate economically significant risks, those risks are highly inter-dependent. As a result, it is determined that the transactional profit split method is the most appropriate method. 50. If it is also found that the most appropriate way of applying the transactional profit split method in this case is by splitting revenues or gross profits from Company A’s sales of the new generation product, each party would bear the consequences of the playing out of risks relating to their own operating costs.
Chapter II Annex II example 11

Chapter II Annex II example 11

51.  The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A; is transferred to associated company B which designs and manufactures the rest of the product; and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions, assets and risks of Company C are being appropriately rewarded by the transfer price of the finished product sold from B to C. 52.  The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. See paragraph 2.15 of the Guidelines. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, which is found to be a unique and valuable contribution by company A, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the unique and valuable intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its unique and valuable intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective unique and valuable intangibles can be determined. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. 53.  The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. See paragraph 2.145 of the Guidelines. This means that each company’s unique and valuable contribution may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, giving a combined R&D expenditure of 25, the residual could be split 15/25 for A and 10/25 for B. 54.  Some figures may assist in following the example: a)  Profit & Loss of A and B Fig. b)   Determine routine profit on manufacturing by A and B, and calculate total residual profit 55.  It is established, for both jurisdictions, that third-party comparable manufacturers without unique and valuable intangibles earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).2 A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the relevant net profit of 10 the combined manufacturing profit of 3.5. (This 10% return does not technically correspond to a cost plus mark-up in its strictest sense because it yields net profit rather than gross profit. But neither does the 10% return correspond to a TNMM margin in its strictest sense, since the cost base does not include operating expenses. The net return on manufacturing costs is being used as a convenient and practical first stage of the profit split method, because it simplifies the determination of the amount of residual net profit attributable to the unique and valuable intangibles contributed by A and B.) c)   Allocate residual profit 56.      The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective unique and valuable contributions that have resulted in a technologically advanced product. Since in this case it is determined that the relative share of total R&D costs incurred by A and B in relation to the product is a reliable proxy for the value of their respective unique and valuable contributions, the residual can be split between A and B on that basis. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6 d)  Recalculate Profits 57.      A’s net profits would thus become 1.5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 = 4.6. The revised P & L for tax purposes would appear as: Fig. Note 58.      The example is intended to exemplify in a simple manner the mechanisms of a residual profit split and should not be interpreted as providing general guidance as to how the arm’s length principle should apply in identifying arm’s length comparables and determining an appropriate split. It is important that the principles that it seeks to illustrate are applied in each case taking into account the specific facts and circumstances of the case. In particular, it should be noted that the allocation of the residual profit may need considerable refinement in practice in order to identify and quantify the appropriate basis for the split. Where R&D expenditure is used, differences in the types of R&D conducted may need to be taken into account, e.g. because different types of R&D may have different levels of risk associated with them, which would lead to different levels of expected returns at

Chapter II Annex II example 12

59. Company A, resident in Country A, Company B, resident in Country B, and Company C, resident in Country C, are members of an MNE group. Companies A and B undertake the design and manufacturing of products and their activities in this regard are highly integrated. Additionally, Company A and Company B are responsible for the marketing and distribution of the products to unrelated customers in Country A and in Country B, respectively. Company C is responsible for the benchmarkable marketing and distribution of products purchased from Company A and Company B to unrelated customers in Country C. 60. Company A and Company B enter into an agreement to buy and sell pieces, moulds and components to manufacture the different models of the products. These transactions may also relate to semi-finished products to effectively meet customers’ demands in a timely fashion. As a result of their broad experience in the sector, Company A and Company B have each developed unique and valuable know-how and other intangibles in their respective design and manufacturing processes. In contrast, the accurate delineation of the transaction shows that Company C does not make any unique and valuable contribution. Instead, Company C performs benchmarkable marketing and distribution functions. 61. Design and manufacturing are identified as the key value drivers for the MNE group and the functional analysis shows the economically significant risks are the strategic and operational risks relating to the design and manufacturing functions. Company A and Company B are engaged in a complex web of intragroup transactions where the performance of each company heavily depends on the capacity of the other to provide the different components and other inputs. The manufacturing and design activities of Company A and Company B are highly interdependent and the entities both perform relevant control functions in relation to the economically significant risks. In accordance with the risk analysis framework described in Section D.1.2.1 of Chapter I of these Guidelines, it is determined that Company A and Company B share the assumption of the risks relating to design and manufacturing. Both Companies A and B make unique and valuable contributions to the manufacturing and design processes. 62. Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the compensation for Companies A and B in relation to their intra-group transactions. However, a one-sided transfer pricing method such as a resale price method or a TNMM is likely to be the most appropriate to determine an arm’s length return for Company C. 63. In applying the transactional profit split method, the sales of products in Countries A, B and C should be taken into account in determining the relevant profits to be split. In the case of Country C, this will be calculated by reference to the sales revenue of Company C, less the arm’s length return to Company C (as established above) for its contributions. 64. Under a residual approach to the transactional profit split method, the first step of the process would be to determine an arm’s length return for the less complex, benchmarkable contributions of each of the parties (i.e. Companies A and B). These amounts are then deducted from the pool of relevant profits to identify the residual profits to be split. Under the second step of the residual analysis, the residual profits would then be split between Company A and Company B on the basis of their relative contributions to those residual profits.

Chapter II Annex II example 13

65. Company A, resident in Country A, is the parent company of Retail Group, an MNE group engaged in the retail fashion industry. Over the years, Company A has developed know-how and has enhanced the value of the trademark and associated goodwill of its business through intensive marketing activities. In this case, the intangibles developed and owned by Company A do not qualify as hard-to-value intangibles. 66. To expand the business into the Country B market, Company A enters into an agreement with Company B, a member of Retail Group resident in Country B. Under this agreement, Company A grants to Company B the rights to utilise the know-how and to use the trademarks for the purpose of fashion retailing in Country B. Company B has extensive experience in retail fashion distribution and has a strong track record in building brand recognition and loyalty in Country B through its in-house team which develops and implements innovative marketing strategies and activities. 67. The accurate delineation of the transaction indicates that the contributions of both companies are unique and valuable to the Retail Group’s business in Country B. 68. In the scenarios presented below, the transactional profit split is found to be the most appropriate method for determining the compensation for the rights granted by Company A to Company B on the basis that both parties to the transaction are making unique and valuable contributions. Scenario 1 69. The accurately delineated transaction shows that Company A does not share in the assumption of any of the economically significant risks associated with the marketing and exploitation activities of Company B related to the licensed intangibles. 70. Under these circumstances, the application of the transactional profit split should be based on the profits anticipated to be generated by Company B from commercialising the products over an appropriate period (e.g. using a discounted cash flow valuation technique as described in Chapter VI, Sections D.2.6.3 and D.2.6.4 of these Guidelines). 71. The relative value of the contributions made by Company A and Company B will be used to determine a split of the anticipated profits of Company B resulting from the combined contributions of the enterprises. The payment for the transaction may take a variety of forms, including a lump sum payment to Company A or a sales-based royalty. Scenario 2 72. In this scenario the accurately delineated transaction shows that: • Company A and Company B agree to a split of the actual profits from the sale of the products by Company B • Company A and Company B will jointly perform the marketing and distribution activities related to the trademarked products and • Both Company A and Company B assume risks associated with the success or otherwise of the marketing and commercialisation of the products by Company B 73. Under these circumstances, the transactional profit split method applies to the actual profits achieved from the sales of the products and the relative value of the contributions made by Company A and Company B will be used to determine the split of those profits.

Chapter II Annex II example 14

74. Below are some illustrations of the effect of choosing a measure of profits to determine the relevant profits to be split when applying a transactional profit split Scenario 1 74. Assume A and B are two associated enterprises situated in two different tax jurisdictions. Both manufacture the same widgets and incur expenditure that results in the creation of a unique and valuable intangible which they can mutually use. For the purpose of this example, it is assumed that the nature of this particular unique and valuable intangible is such that the value of A and B’s respective unique and valuable contributions in the year in question is proportional to A and B’s relative expenditure on the intangible in that year. (It should be noted that this assumption will not always be true in ) Assume A and B exclusively sell products to third parties. Assume that it is determined that the most appropriate method to be used is a residual profit split method; that the manufacturing activities of A and B are less complex, non-unique transactions that should be allocated an initial return of 10% of the Cost of Goods Sold; and that the residual profit should be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible. The following figures are for illustration only: A B Combined A + B Sales 100 300 400 Cost Of Goods Sold 60 170 230 Gross Profit 40 130 170 Overhead expenses 3 6 9 Other operating expenses 2 4 6 Expenditure in relation to the unique and valuable intangible 30 40 70 Operating Profit 5 80 85 Step one: determining the initial return for the non-unique manufacturing transactions (Cost of Goods Sold + 10% in this example) A 60 + (60 * 10 %) = 66 à Initial return for the manufacturing transactions of A = 6 B 170 + (170 * 10 %) = 187 à Initial return for the manufacturing transactions of B = 17 Total profit allocated through initial returns (6+17) = 23   Step two: determining the residual profit to be split a) In case it is determined as the operating profit: Combined Operating Profit 85 Profit already allocated (initial returns for manufacturing transactions) 23 Residual profit to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible 62 Residual profit allocated to A: 62 * 30/70 26.57 Residual profit allocated to B: 62 * 40/70 35.43 Total profits allocated to A: 6 (initial return) + 26.57 (residual) 32.57 Total profits allocated to B: 17 (initial return) + 35.43 (residual) 52.43 Total 85 b) In case it is determined as the operating profit before overhead expenses (assuming it is determined that the overhead expenses of A and B do not relate to the transaction examined and should be excluded from the determination of the relevant profits to be split):   A B Combined A + B Sales 100 300 400 Cost Of Goods Sold 60 170 230 Gross Profit 40 130 170 Other operating expenses 2 4 6 Expenditure in relation to the unique and valuable intangible 30 40 70 Operating Profit before overhead expenses 8 86 94 Overhead expenses 3 6 9 Operating Profit 5 80 85   Combined Operating Profit before overhead expenses 94 Profit already allocated (initial returns for manufacturing transactions) 23 Residual profit before overhead expenses to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible   71 Residual profit allocated to A: 71 * 30/70 30.43 Residual profit allocated to B: 71 * 40/70 40.57 Total profits allocated to A: 6 (initial return) + 30.43 (residual) – 3 (overhead expenses) 33.43 Total profits allocated to B: 17 (initial return) + 40.57 (residual) – 6 (overhead expenses) 51.57 Total 85 76. As shown in the above example, excluding some specific items from the determination of the relevant profits to be split implies that each party remains responsible for its own expenses in relation to it. As a consequence, the decision whether or not to exclude some specific items must be consistent with the accurate delineation of the Scenario 2 77. As another example, in some cases it may be appropriate to back out a category of expenses to the extent that the profit splitting factor(s) used in the residual profit split analysis relies on those expenses. For example, in cases where relative expenditure contributing to the development of a unique and valuable intangible is determined to be the most appropriate profit splitting factor, residual profits can be based on operating profits before that expenditure. After determining the split of residual profits, each associated enterprise then subtracts its own expenditure. This can be illustrated as follows. Assume the facts are the same as in Scenario 1 to this example at paragraph 2.74 above and assume the overhead expenses are not excluded from the determination of the residual profit to be split. Step one: determining the basic return for the manufacturing activities (Cost of Goods Sold + 10% in this examplel 78. Same as at Scenario 1, Step 1 Step two: determining the residual profit to be split a) In case it is determined as the operating profit after expenditure in relation to the unique and valuable intangible: Same as at Scenario 1, Step 2, case a) b) In case it is determined as the operating profit before expenditure in relation to the unique and valuable intangible:   A B Combined A + B Sales 100 300 400 Cost Of Goods Sold 60 170 230 Gross Profit 40 130 170 Overhead expenses 3 6 9 Other operating expenses 2 4 6 Operating profit before expenditure in relation to the unique and valuable intangible   35   120   155 Expenditure in relation to the unique and valuable intangible 30 40 70 Operating Profit 5 80 85 Relevant Operating Profit before Expenditure in relation to the unique and valuable intangible   155 Profit already allocated

Chapter II Annex II example 15

80. Company A, resident in Country A, and Company B, resident in Country B, are members of an MNE group. Both companies undertake the design and manufacturing of products and their activities in this regard are highly integrated. Additionally, Company A and Company B are responsible for the marketing and distribution of the products to unrelated customers in Country A and in Country B, respectively. 81. Company A and Company B enter into an agreement to buy and sell pieces, moulds and different components to manufacture various different models of products. These transactions may also relate to semi-finished products to effectively meet customers’ demands in a timely fashion. As a result of their broad experience in the sector, Company A and Company B have each developed unique and valuable know-how and other intangibles in their respective design and manufacturing processes. 82. The functional analysis shows the economically significant risks are the strategic and operational risks in relation to the design and manufacturing functions and that Company A and Company B are engaged in a complex web of intragroup transactions where the performance of each company heavily depends on the capacity of the other to provide the different components and other inputs. The manufacturing and design activities of Company A and Company B are highly interdependent and the entities both perform relevant control functions in relation to the economically significant risks. In accordance with the risk analysis framework described in Section D.1.2.1 of Chapter I of these Guidelines, it is determined that Company A and Company B share the assumption of the risks relating to design and manufacturing. Both Companies A and B make unique and valuable contributions to the design and manufacturing processes. 83. Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the compensation for Companies A and B in relation to their intra-group transactions 84. In the absence of comparable uncontrolled transactions or direct evidence of how independent parties would have split the profits in comparable circumstances, the profit split can be applied based on the relative value of the contributions of Company A and Company B. In particular, an asset-based splitting factor may be appropriate, provided that the functional analysis concludes that there is a strong correlation between the assets of Company A and Company B and the creation of value in the context of their controlled transactions.

Chapter II Annex II example 16

85. Company A, Company B and Company C, members of the same MNE group, jointly agree to share the “greenfield” development of a new product. In this regard, none of the entities brings existing contributions of value such as pre-existing intangibles to the project. Each associated enterprise will be responsible for developing and manufacturing one of the three key components of the product. 86. In this case, assume that the transactional profit split is found to be the most appropriate method for determining the profits of the three companies from the sale of the new product. The functional analysis concludes that the relative contributions of the parties may be measured by reference to the relative expenses incurred by each company in the development of the components as there is a direct correlation between these relative expenses and the relative value contributed by each company. Accordingly, the relevant profits (losses) in relation to the sales of the new product can be split based on the relative development costs incurred by each of the parties. 87. In this example, the splitting of profits based on relative development costs will yield results similar to those which would have resulted under an analogous cost contribution arrangement, since parties performing activities with similar economic characteristics should receive similar expected returns, irrespective of whether the contractual arrangement in a particular case is termed as a CCA or not (see paragraph 8.4).