Residual profit split. (i) Company A, a Country 1 corporation, provides specialized services pertaining to the processing and storage of Level 1 hazardous waste (for purposes of this example, the most dangerous type of waste). Under long-term contracts with private companies and governmental entities in Country 1, Company A performs multiple services, including transportation of Level 1 waste, development of handling and storage protocols, recordkeeping, and supervision of waste-storage facilities owned and maintained by the contracting parties. Company A’s research and development unit has also developed new and unique processes for transport and storage of Level 1 waste that minimize environmental and occupational effects. In addition to this novel technology, Company A has substantial know-how and a long-term record of safe operations in Country 1. (ii) Company A’s subsidiary, Company B, has been in operation continuously for a number of years in Country 2. Company B has successfully completed several projects in Country 2 involving Level 2 and Level 3 waste, including projects with government-owned entities. Company B has a license in Country 2 to handle Level 2 waste (Level 3 does not require a license). Company B has established a reputation for completing these projects in a responsible manner. Company B has cultivated contacts with procurement officers, regulatory and licensing officials, and other government personnel in Country 2. (iii) Country 2 government publishes invitations to bid on a project to handle the country’s burgeoning volume of Level 1 waste, all of which is generated in government-owned facilities. Bidding is limited to companies that are domiciled in Country 2 and that possess a license from the government to handle Level 1 or Level 2 waste. In an effort to submit a winning bid to secure the contract, In an effort to submit a winning bid to secure the contract, Company B points to its Level 2 license and its record of successful completion of projects, and also demonstrates to Country 2 government that it has access to substantial technical expertise pertaining to processing of Level 1 waste. (iv) Company A enters into a long-term technical services agreement with Company B. Under this agreement, Company A agrees to supply to Company B project managers and other technical staff who have detailed knowledge of Company A’s proprietary Level 1 remediation techniques. Company A commits to perform under any long-term contracts entered into by Company B. Company B agrees to compensate Company A based on a markup on Company A’s marginal costs (pro rata compensation and current expenses of Company A personnel). In the bid on the Country 2 contract for Level 1 waste remediation, Company B proposes to use a multi-disciplinary team of specialists from Company A and Company B. Project managers from Company A will direct the team, which will also include employees of Company B and will make use of physical assets and facilities owned by Company B. Only Company A and Company B personnel will perform services under the contract. Country 2 grants Company B a license to handle Level 1 waste. (v) Country 2 grants Company B a five-year, exclusive contract to provide processing services for all Level 1 hazardous waste generated in County 2. Under the contract, Company B is to be paid a fixed price per ton of Level 1 waste that it processes each year. Company B undertakes that all services provided will meet international standards applicable to processing of Level 1 waste. Company B begins performance under the contract. (vi) Analysis of the facts and circumstances indicates that both Company A and Company B make nonroutine contributions to the Level 1 waste processing activity in Country 2. In addition, it is determined that reliable comparables are not available for the services that Company A provides under the long-term contract, in part because those services incorporate specialized knowledge and process intangible property developed by Company A. It is also determined that reliable comparables are not available for the Level 2 license in Country 2, the successful track record, the government contacts with Country 2 officials, and other intangible property that Company B provided. In view of these facts, the Commissioner determines that the residual profit split method for services in paragraph (g) of this section provides the most reliable means of evaluating the arm’s length results for the transaction. In evaluating the appropriate returns to Company A and Company B for their respective contributions, the Commissioner takes into account that the controlled parties incur different risks, because the contract between the controlled parties provides that Company A will be compensated on the basis of marginal costs incurred, plus a markup, whereas the contract between Company B and the government of Country 2 provides that Company B will be compensated on a fixed-price basis per ton of Level 1 waste processed. (vii) In the first stage of the residual profit split, an arm’s length return is determined for routine activities performed by Company B in Country 2, such as transportation, recordkeeping, and administration. In addition, an arm’s length return is determined for routine activities performed by Company A (administrative, human resources, etc.) in connection with providing personnel to Company B. After the arm’s length return for these functions is determined, residual profits may be present. In the second stage of the residual profit split, any residual profit is allocated by reference to the relative value of the nonroutine contributions made by each taxpayer. Company A’s nonroutine contributions include its commitment to perform under the contract and the specialized technical knowledge made available through the project managers under the services agreement with Company B. Company B’s nonroutine contributions include its licenses to handle Level 1 and Level 2 waste in Country 2, its knowledge of and contacts with procurement, regulatory and licensing officials in the government of Country 2, and its record in Country 2 of successfully handling non-Level 1 waste ...

Residual profit split. (i) Company A, a corporation resident in Country X, auctions spare parts by means of an interactive database. Company A maintains a database that lists all spare parts available for auction. Company A developed the software used to run the database. Company A’s database is managed by Company A employees in a data center located in Country X, where storage and manipulation of data also take place. Company A has a wholly-owned subsidiary, Company B, located in Country Y. Company B performs marketing and advertising activities to promote Company A’s interactive database. Company B solicits unrelated companies to auction spare parts on Company A’s database, and solicits customers interested in purchasing spare parts online. Company B owns and maintains a computer server in Country Y, where it receives information on spare parts available for auction. Company B has also designed a specialized communications network that connects its data center to Company A’s data center in Country X. The communications network allows Company B to enter data from uncontrolled companies on Company A’s database located in Country X. Company B’s communications network also allows uncontrolled companies to access Company A’s interactive database and purchase spare parts. Company B bore the risks and cost of developing this specialized communications network. Company B enters into contracts with uncontrolled companies and provides the companies access to Company A’s database through the Company B network. (ii) Analysis of the facts and circumstances indicates that both Company A and Company B possess valuable intangible property that they use to conduct the spare parts auction business. Company A bore the economic risks of developing and maintaining software and the interactive database. Company B bore the economic risks of developing the necessary technology to transmit information from its server to Company A’s data center, and to allow uncontrolled companies to access Company A’s database. Company B helped to enhance the value of Company A’s trademark and to establish a network of customers in Country Y. In addition, there are no market comparables for the transactions between Company A and Company B to reliably evaluate them separately. Given the facts and circumstances, the Commissioner determines that a residual profit split method will provide the most reliable measure of an arm’s length result. (iii) Under the residual profit split method, profits are first allocated based on the routine contributions of each taxpayer. Routine contributions include general sales, marketing or administrative functions performed by Company B for Company A for which it is possible to identify market returns. Any residual profits will be allocated based on the nonroutine contributions of each taxpayer. Since both Company A and Company B provided nonroutine contributions, the residual profits are allocated based on these contributions ...

The principles of this paragraph (g) are illustrated by the following examples: ...

The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The relative value of each controlled taxpayer’s contribution is determined in a manner that reflects the functions performed, risks assumed and resources employed by such controlled taxpayer in the relevant business activity. For application of the profit split method (both the comparable profit split and the residual profit split), see § 1.482-6. The residual profit split method may not be used where only one controlled taxpayer makes significant nonroutine contributions ...

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(1) In general. The provisions of paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section are generally applicable for taxable years beginning after July 31, 2009. (2) Election to apply regulation to earlier taxable years. A person may elect to apply the provisions of paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section to earlier taxable years in accordance with the rules set forth in § 1.482-9(n)(2) ...

Application of Residual Profit Split. (i) XYZ is a U.S. corporation that develops, manufactures and markets a line of products for police use in the United States. XYZ’s research unit developed a bulletproof material for use in protective clothing and headgear (Nulon). XYZ obtains patent protection for the chemical formula for Nulon. Since its introduction in the U.S., Nulon has captured a substantial share of the U.S. market for bulletproof material. (ii) XYZ licensed its European subsidiary, XYZ-Europe, to manufacture and market Nulon in Europe. XYZ-Europe is a well- established company that manufactures and markets XYZ products in Europe. XYZ-Europe has a research unit that adapts XYZ products for the defense market, as well as a well-developed marketing network that employs brand names that it developed. (iii) XYZ-Europe’s research unit alters Nulon to adapt it to military specifications and develops a high-intensity marketing campaign directed at the defense industry in several European countries. Beginning with the 1995 taxable year, XYZ-Europe manufactures and sells Nulon in Europe through its marketing network under one of its brand names. (iv) For the 1995 taxable year, XYZ has no direct expenses associated with the license of Nulon to XYZ-Europe and incurs no expenses related to the marketing of Nulon in Europe. For the 1995 taxable year, XYZ-Europe’s Nulon sales and pre-royalty expenses are $500 million and $300 million, respectively, resulting in net pre-royalty profit of $200 million related to the Nulon business. The operating assets employed in XYZ-Europe’s Nulon business are $200 million. Given the facts and circumstances, the district director determines under the best method rule that a residual profit split will provide the most reliable measure of an arm’s length result. Based on an examination of a sample of European companies performing functions similar to those of XYZ-Europe, the district director determines that an average market return on XYZ-Europe’s operating assets in the Nulon business is 10 percent, resulting in a market return of $20 million (10% × $200 million) for XYZ- Europe’s Nulon business, and a residual profit of $180 million. (v) Since the first stage of the residual profit split allocated profits to XYZ-Europe’s contributions other than those attributable to highly valuable intangible property, it is assumed that the residual profit of $180 million is attributable to the valuable intangibles related to Nulon, i.e., the European brand name for Nulon and the Nulon formula (including XYZ-Europe’s modifications). To estimate the relative values of these intangibles, the district director compares the ratios of the capitalized value of expenditures as of 1995 on Nulon-related research and development and marketing over the 1995 sales related to such expenditures. (vi) Because XYZ’s protective product research and development expenses support the worldwide protective product sales of the XYZ group, it is necessary to allocate such expenses among the worldwide business activities to which they relate. The district director determines that it is reasonable to allocate the value of these expenses based on worldwide protective product sales. Using information on the average useful life of its investments in protective product research and development, the district director capitalizes and amortizes XYZ’s protective product research and development expenses. This analysis indicates that the capitalized research and development expenditures have a value of $0.20 per dollar of global protective product sales in 1995. (vii) XYZ-Europe’s expenditures on Nulon research and development and marketing support only its sales in Europe. Using information on the average useful life of XYZ-Europe’s investments in marketing and research and development, the district director capitalizes and amortizes XYZ-Europe’s expenditures and determines that they have a value in 1995 of $0.40 per dollar of XYZ-Europe’s Nulon sales. (viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in capitalized intangible development expenses for each dollar of XYZ-Europe’s protective product sales for 1995, of which XYZ contributed one-third (or $0.20 per dollar of sales). Accordingly, the district director determines that an arm’s length royalty for the Nulon license for the 1995 taxable year is $60 million, i.e., one-third of XYZ-Europe’s $180 million in residual Nulon profit ...

The provisions of this paragraph (c)(3) are illustrated by the following example ...

Like the methods described in §§ 1.482-3, 1.482-4, 1.482-5, and 1.482-9, the first step of the residual profit split relies exclusively on external market benchmarks. As indicated in § 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, to the extent the allocation of profits in the second step is not based on external market benchmarks, the reliability of the analysis will be decreased in relation to an analysis under a method that relies on market benchmarks. Finally, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the residual profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results ...

The reliability of the results derived from the residual profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered – (1) The reliability of the allocation of costs, income, and assets as described in paragraph (c)(2)(ii)(C)(1) of this section; (2) Accounting consistency as described in paragraph (c)(2)(ii)(C)(2) of this section; (3) The reliability of the data used and the assumptions made in valuing the intangible property contributed by the participants. In particular, if capitalized costs of development are used to estimate the value of intangible property, the reliability of the results is reduced relative to the reliability of other methods that do not require such an estimate, for the following reasons. First, in any given case, the costs of developing the intangible may not be related to its market value. Second, the calculation of the capitalized costs of development may require the allocation of indirect costs between the relevant business activity and the controlled taxpayer’s other activities, which may affect the reliability of the analysis. Finally, the calculation of costs may require assumptions regarding the useful life of the intangible property ...

The first step of the residual profit split relies on market benchmarks of profitability. Thus, the comparability considerations that are relevant for the first step of the residual profit split are those that are relevant for the methods that are used to determine market returns for the routine contributions. The second step of the residual profit split, however, may not rely so directly on market benchmarks. Thus, the reliability of the results under this method is reduced to the extent that the allocation of profits in the second step does not rely on market benchmarks ...

Whether results derived from this method are the most reliable measure of the arm’s length result is determined using the factors described under the best method rule in § 1.482-1(c). Thus, comparability and the quality of data and assumptions must be considered in determining whether this method provides the most reliable measure of an arm’s length result. The application of these factors to the residual profit split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this section ...

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In many cases, nonroutine contributions of a taxpayer to the relevant business activity may be contributions of intangible property. For purposes of paragraph (c)(3)(i)(B)(1) of this section, the relative value of nonroutine intangible property contributed by taxpayers may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the relative value of nonroutine intangible property contributions may be estimated by the capitalized cost of developing the intangible property and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible property. Finally, if the intangible property development expenditures of the parties are relatively constant over time and the useful life of the intangible property contributed by all parties is approximately the same, the amount of actual expenditures in recent years may be used to estimate the relative value of nonroutine intangible property contributions ...

The allocation of income to the controlled taxpayer’s routine contributions will not reflect profits attributable to each controlled taxpayer’s contributions to the relevant business activity that are not routine (nonroutine contributions). A nonroutine contribution is a contribution that is not accounted for as a routine contribution. Thus, in cases where such nonroutine contributions are present, there normally will be an unallocated residual profit after the allocation of income described in paragraph (c)(3)(i)(A) of this section. Under this second step, the residual profit generally should be divided among the controlled taxpayers based upon the relative value of their nonroutine contributions to the relevant business activity. The relative value of the nonroutine contributions of each taxpayer should be measured in a manner that most reliably reflects each nonroutine contribution made to the controlled transaction and each controlled taxpayer’s role in the nonroutine contributions. If the nonroutine contribution by one of the controlled taxpayers is also used in other business activities (such as transactions with other controlled taxpayers), an appropriate allocation of the value of the nonroutine contribution must be made among all the business activities in which it is used ...

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The first step allocates operating income to each party to the controlled transactions to provide a market return for its routine contributions to the relevant business activity. Routine contributions are contributions of the same or a similar kind to those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. Routine contributions ordinarily include contributions of tangible property, services and intangible property that are generally owned by uncontrolled taxpayers engaged in similar activities. A functional analysis is required to identify these contributions according to the functions performed, risks assumed, and resources employed by each of the controlled taxpayers. Market returns for the routine contributions should be determined by reference to the returns achieved by uncontrolled taxpayers engaged in similar activities, consistent with the methods described in §§ 1.482-3, 1.482-4, 1.482-5 and 1.482-9 ...

Under this method, the combined operating profit or loss from the relevant business activity is allocated between the controlled taxpayers following the two-step process set forth in paragraphs (c)(3)(i)(A) and (B) of this section ...

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Like the methods described in §§ 1.482-3, 1.482-4, 1.482-5, and 1.482-9, the comparable profit split relies exclusively on external market benchmarks. As indicated in § 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the comparable profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results ...

The reliability of the results derived from the comparable profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered – (1) The reliability of the allocation of costs, income, and assets between the relevant business activity and the participants’ other activities will affect the accuracy of the determination of combined operating profit and its allocation among the participants. If it is not possible to allocate costs, income, and assets directly based on factual relationships, a reasonable allocation formula may be used. To the extent direct allocations are not made, the reliability of the results derived from the application of this method is reduced relative to the results of a method that requires fewer allocations of costs, income, and assets. Similarly, the reliability of the results derived from the application of this method is affected by the extent to which it is possible to apply the method to the parties’ financial data that is related solely to the controlled transactions. For example, if the relevant business activity is the assembly of components purchased from both controlled and uncontrolled suppliers, it may not be possible to apply the method solely to financial data related to the controlled transactions. In such a case, the reliability of the results derived from the application of this method will be reduced. (2) The degree of consistency between the controlled and uncontrolled taxpayers in accounting practices that materially affect the items that determine the amount and allocation of operating profit affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect operating profit, the ability to make reliable adjustments for such differences would affect the reliability of the results. Further, accounting consistency among the participants in the controlled transaction is required to ensure that the items determining the amount and allocation of operating profit are measured on a consistent basis ...

If there are differences between the controlled and uncontrolled taxpayers that would materially affect the division of operating profit, adjustments must be made according to the provisions of § 1.482-1(d)(2) ...

The degree of comparability between the controlled and uncontrolled taxpayers is determined by applying the comparability provisions of § 1.482-1(d). The comparable profit split compares the division of operating profits among the controlled taxpayers to the division of operating profits among uncontrolled taxpayers engaged in similar activities under similar circumstances. Although all of the factors described in § 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on the considerations described under the comparable profits method in § 1.482-5(c)(2) or § 1.482-9(f)(2)(iii) because this method is based on a comparison of the operating profit of the controlled and uncontrolled taxpayers. In addition, because the contractual terms of the relationship among the participants in the relevant business activity will be a principal determinant of the allocation of functions and risks among them, comparability under this method also depends particularly on the degree of similarity of the contractual terms of the controlled and uncontrolled taxpayers. Finally, the comparable profit split may not be used if the combined operating profit (as a percentage of the combined assets) of the uncontrolled comparables varies significantly from that earned by the controlled taxpayers ...

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Whether results derived from application of this method are the most reliable measure of the arm’s length result is determined using the factors described under the best method rule in § 1.482-1(c) ...

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A comparable profit split is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, each uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity ...

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The allocation of profit or loss under the profit split method must be made in accordance with one of the following allocation methods – (i) The comparable profit split, described in paragraph (c)(2) of this section; or (ii) The residual profit split, described in paragraph (c)(3) of this section ...

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The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of § 1.482-1(d)(3). Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity. The profit allocated to any particular member of a controlled group is not necessarily limited to the total operating profit of the group from the relevant business activity. For example, in a given year, one member of the group may earn a profit while another member incurs a loss. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally, or in any other arbitrary proportion. The specific method of allocation must be determined under paragraph (c) of this section ...

The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity) ...

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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) ...

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 ...

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 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 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 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 (initial returns for manufacturing transactions) 23 Residual profit before Expenditure in relation to the unique and valuable intangible to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible     132 Residual profit allocated to A: 132 * 30/70 56.57 Residual profit allocated to B: 132 * 40/70 75.43 Total profits allocated to A: 6 (initial return) + 56.57 (residual) – 30 (expenditure in relation to the unique and valuable intangible)   32.57 Total profits allocated to B: 17 (initial return) + 75.43 (residual) – 40 (expenditure in relation to the unique and valuable intangible)   52.43 Total 85 i.e. A and B are allocated the same profits as in the case where the relevant profit to be split is determined as the operating profit after expenditure in relation to the unique and valuable intangible, see case a) above 79. This example illustrates the fact that, when the profit splitting factor used to split the residual profit relies on a category of expenses incurred during the period, it is irrelevant whether the residual profit to be split is determined before the expenses are deducted by each party, or whether the residual profit to be split is determined after the expenses are deducted. The outcome can however be different in the case where the splitting factor is based on the accumulated expenditure of the prior as well as current ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

In appropriate circumstances, transfer pricing methods or valuation techniques not dependent on the identification of reliable comparable uncontrolled transactions may also be utilised to determine arm’s length conditions for the sale of goods or the provision of services where intangibles are used in connection with the transaction. The alternative selected should reflect the nature of the goods or services provided and the contribution of intangibles and other relevant factors to the creation of value ...

In applying a profit split method in a case involving the use of intangibles, care should be taken to identify the intangibles in question, to evaluate the manner in which those intangibles contribute to the creation of value, and to evaluate other income producing functions performed, risks assumed and assets used. Vague assertions of the existence and use of unspecified intangibles will not support a reliable application of a profit split method ...

Section C in Part III of Chapter II contains guidance to be considered in applying transactional profit split methods. That guidance is fully applicable to matters involving the use of intangibles in connection with the sale of goods or the provision of services in controlled transactions ...

In some circumstances where reliable uncontrolled transactions cannot be identified, transactional profit split methods may be utilised to determine an arm’s length allocation of profits for the sale of goods or the provision of services involving the use of intangibles. One circumstance in which the use of transactional profit split methods may be appropriate is where both parties to the transaction make unique and valuable contributions to the transaction ...

Where limited rights in fully developed intangibles are transferred in a licence or similar transaction, and reliable comparable uncontrolled transactions cannot be identified, a transactional profit split method can often be utilised to evaluate the respective contributions of the parties to earning the relevant income. The profit contribution of the rights in intangibles made available by the licensor or other transferor would, in such a circumstance, be one of the factors contributing to the earning of income following the transfer. However, other factors would also need to be considered. In particular, functions performed and risks assumed by the licensee/ transferee should specifically be taken into account in such an analysis. Other intangibles used by the licensor/transferor and by the licensee/transferee in their respective businesses should similarly be considered, as well as other relevant factors. Careful attention should be given in such an analysis to the limitations imposed by the terms of the transfer on the use of the intangibles by the licensee/transferee and on the rights of the licensee/transferee to use the intangibles for purposes of ongoing research and development. Further, assessing contributions of the licensee to enhancements in the value of licensed intangibles may be important. The allocation of income in such an analysis would depend on the findings of the functional analysis, including an analysis of the relevant risks assumed. It should not be assumed that all of the residual profit after functional returns would necessarily be allocated to the licensor/transferor in a profit split analysis related to a licensing arrangement ...

Caution should be exercised in applying profit split approaches to determine estimates of the contributions of the parties to the creation of income in years following the transfer, or an arm’s length allocation of future income, with respect to partially developed intangibles. The contribution or value of work undertaken prior to the transfer may bear no relationship to the cost of that work. For example, a chemical compound with potentially blockbuster pharmaceutical indications might be developed in the laboratory at relatively little cost. In addition, a variety of difficult to evaluate factors would need to be taken into account in such a profit split analysis. These would include the relative riskiness and value of research contributions before and after the transfer, the relative risk and its effect on value, for other development activities carried out before and after the transfer, the appropriate amortisation rate for various contributions to the intangible value, assumptions regarding the time at which any potential new products might be introduced, and the value of contributions other than intangibles to the ultimate generation of profit. Income and cash flow projections in such situations can sometimes be especially speculative. These factors can combine to call the reliability of such an application of a profit split analysis into question. See Section D.4 on hard-to-value intangibles ...

It is also sometimes suggested that a profit split analysis can be applied to transfers of partially developed intangibles. In such an analysis, the relative value of contributions to the development of intangibles before and after a transfer of the intangibles in question is sometimes examined. Such an approach may include an attempt to amortise the transferor’s contribution to the partially developed intangible over the asserted useful life of that contribution, assuming no further development. Such approaches are generally based on projections of cash flows and benefits expected to arise at some future date following the transfer and the assumed successful completion of further development activities ...

Transactional profit split methods may have application in connection with the sale of full rights in intangibles. As with other applications of the transactional profit split method, a full functional analysis that considers the functions performed, risks assumed and assets used by each of the parties is an essential element of the analysis. Where a transactional profit split analysis is based on projected revenues and expenses, the concerns with the accuracy of such projections described in Section D.2.6.4.1 should be taken into account ...

In some circumstances, a transactional profit split method can be utilised to determine the arm’s length conditions for a transfer of intangibles or rights in intangibles where it is not possible to identify reliable comparable uncontrolled transactions for such transfers. Section C of Chapter II contains guidance to be considered in applying transactional profit split methods. That guidance is fully applicable to matters involving the transfer of intangibles or rights in intangibles. In evaluating the reliability of transactional profit split methods, however, the availability of reliable and adequate data regarding the relevant profits to be split, appropriately allocable expenses, and the reliability of factors used to divide the relevant income should be fully considered ...

A transactional profit split method might in appropriate circumstances be considered without comparable data, e.g. where the absence of comparable data is due to the presence of unique and valuable intangibles contributed by each party to the transaction (see paragraph 2.119). However, even in cases where comparable data are scarce and imperfect, the selection of the most appropriate transfer pricing method should be consistent with the functional analysis of the parties, see paragraph 2.2 ...

Where the most appropriate transfer pricing method in the circumstances of the case, determined following the guidance in paragraphs 2.1- 2.12, is a transactional profit split, financial information on all the parties to the transaction, domestic and foreign, is needed. Given the two-sided nature of this method, the application of a transactional profit split necessitates particularly detailed information on the foreign associated enterprise party to the transaction. This includes information on the five comparability factors in order to appropriately characterise the relationship between the parties and demonstrate the appropriateness of the transactional profit split method, as well as financial information (the determination of the relevant profits to be split and the splitting of the profits both rely on financial information pertaining to all the parties to the transaction, including the foreign associated enterprise). Accordingly, where the most appropriate transfer pricing method in the circumstances of the case is a transactional profit split, it would be reasonable to expect that taxpayers be ready to provide tax administrations with the necessary information on the foreign associated enterprise party to the transaction, including the financial data necessary to calculate the profit split. See Chapter V ...

Asset-based or capital-based profit splitting factors can be used where there is a strong correlation between tangible assets or intangibles, or capital employed and creation of value in the context of the controlled transaction. In order for a profit splitting factor to be meaningful, it should be applied consistently to all the parties to the transaction. See paragraph 2.104 for a discussion of comparability issues in relation to asset valuation in the context of the transactional net margin method, which is also valid in the context of the transactional profit split method. Example 15 in Annex II to this chapter illustrates the principles of this section ...

Internal data are essential to assess the values of the respective contributions of the parties to the controlled transaction. The determination of such values should rely on a functional analysis that takes into account all the economically significant functions, assets and risks contributed by the parties to the controlled transaction. In those cases where the profit is split on the basis of an evaluation of the relative importance of the functions, assets and risks to the value added to the controlled transaction, such evaluation should be supported by reliable objective data in order to limit arbitrariness. Particular attention should be given to the identification of the relevant contributions of unique and valuable intangibles and the assumption of economically significant risks and the importance, relevance and measurement of the factors which gave rise to these ...

Internal data may also be helpful where the profit splitting factor is based on a cost accounting system, e.g. employee costs related to some aspects of the transaction, or time spent by a certain group of employees on certain tasks, etc ...

Similarly, where cost-based profit splitting factors are used that are based on data extracted from the taxpayers’ profit and loss accounts, it may be necessary to draw up transactional accounts that identify those expenses that are related to the controlled transaction at hand and those that should be excluded from the determination of the profit splitting factor. The type of expenditure that is taken into account (e.g. salaries, depreciation, etc.) as well as the criteria used to determine whether a given expense is related to the transaction at hand or is rather related to other transactions of the taxpayer (e.g. to other lines of products not subject to this profit split determination) should be applied consistently to all the parties to the transaction ...

For instance, where an asset-based profit splitting factor is used, it may be based on data extracted from the balance sheets of the parties to the transaction. It will often be the case that not all the assets of the taxpayers relate to the transaction at hand and that accordingly some analytical work is needed for the taxpayer to draw up a “transactional” balance sheet that will be used for the application of the transactional profit split method. In addition, certain assets, such as self-developed intangibles, may not be reflected on the balance sheet at all, and accordingly must be separately evaluated. In this regard, valuation techniques, such as those based on the discounted value of projected future income streams or cash flows derived from the exploitation of the intangible may be useful. See Section D.2.6.3 of Chapter VI of these guidelines. See also paragraph 2.104 for a discussion of valuation of assets in the context of the transactional net margin method where the net profit is weighted to assets, which is also relevant to the valuation of assets in the context of a transactional profit split where an asset- based profit splitting factor is used ...

Where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the relevant profits, consideration should be given to internal data, which may provide a reliable means of establishing or testing the arm’s length nature of the division of profits. The types of such internal data that are relevant will depend on the facts and circumstances of the case and should satisfy the conditions outlined in this section and in particular in paragraphs 2.147–2.148 and 2.166. They will frequently be extracted from the taxpayers’ cost accounting or financial accounting ...

In addition to the Local File, which should contain a detailed functional analysis of the taxpayer and its relevant associated enterprises, the MNE group’s Master File might be a useful source of information relevant to the determination of appropriate profit splitting factors. As is set out in Annex I to Chapter V, the Master File should include information on the important drivers of business profit, the principal contributions to value creation by entities within the group, and key group intangibles. However, it should be borne in mind that the Master File is intended only to provide a high-level overview of an MNE group, and not granular or detailed information as to all of the group’s transactions ...

Other profit splitting factors that could be appropriate in the circumstances of a given case include incremental sales, or employee compensation (relating to the individuals involved in the key functions that generate value to the transaction, for example in relation to the global trading of financial instruments). In other situations it is possible that headcount or time spent by a certain group of similarly skilled employees with similar responsibilities could be used if there is a strong and relatively consistent correlation between this and the creation of value represented by the relevant profits. The guidance in this section should not be considered as an exhaustive list of potential profit splitting factors. Other profit splitting factors may be acceptable provided they result in arm’s length outcomes for all relevant parties ...

Profit splitting factors based on assets or capital (e.g. operating assets, fixed assets (e.g. production assets, retail assets, IT assets), intangibles), or costs (e.g. relative spending and/or investment in key areas such as research and development, engineering, marketing) may be used where these capture the relative contributions of the parties to the profits being split and they can be measured reliably. Note that while costs may be a poor measure of the value of intangibles contributed (see paragraph 6.142), the relative costs incurred by parties may provide a reasonable proxy for the relative value of those contributions where such contributions are similar in nature (see paragraphs 8.27-8.28) ...

Depending on the facts and circumstances of the case, the factor can be a figure (e.g. a 30%-70% split based on evidence of a similar split achieved between independent parties in comparable transactions), or a variable (e.g. relative value of participant’s marketing contributions or other possible factors as discussed below) which could be calculated on the basis of a single profit splitting factor or a weighting of multiple factors ...

As noted above, arm’s length parties can be assumed to split profits on the basis of their relative contributions to the creation of those profits. The division of the relevant profits under the transactional profit split method is generally achieved using one or more profit splitting factors. The functional analysis and an analysis of the context in which the transactions take place (e.g. the industry and environment) are essential to the process of determining the relevant factors to use in splitting profits, including determining the weighting of applicable profit splitting factors, in cases where more than one factor is used. The determination of appropriate profit splitting factor(s) should reflect the key contributions to value in relation to the transaction. Examples 15 and in Annex II to Chapter II of these Guidelines illustrate the principles of this section ...

However, it can be difficult to find reliable comparables data that can be used in this manner. Nevertheless, external market data can be relevant in the profit split analysis to assess the value of contributions that each associated enterprise makes to the transactions. In effect, the assumption is that independent parties would have split relevant profits in proportion to the value of their respective contributions to the generation of profit in the transaction. Thus, where there is no more direct evidence of how independent parties in comparable circumstances would have split the profit in comparable transactions, the allocation of profits may be based on the relative contributions of the parties, as measured by their functions, assets used and risks assumed ...

One possible approach is to split the relevant profits based on the division of profits that actually is observed in comparable uncontrolled transactions. Examples of possible sources of information on uncontrolled transactions that might usefully assist the determination of criteria to split the profits, depending on the facts and circumstances of the case, include joint-venture arrangements between independent parties under which profits are shared, such as development projects in the oil and gas industry; pharmaceutical collaborations, co-marketing or co-promotion agreements; arrangements between independent music record labels and music artists; uncontrolled arrangements in the financial services sector, etc ...

Profits should be split on an economically valid basis that reflects the relative contributions of the parties to the transaction and thus approximates the division of profits that would have obtained at arm’s length. The relevance of comparable uncontrolled transactions or internal data (see Section C.5.2) and the criteria used to achieve an arm’s length division of the profits depend on the facts and circumstances of the case. It is therefore not desirable to establish a prescriptive list of criteria or profit splitting factors. See paragraphs 2.146-2.148 for general guidance on the consistency of the determination of the splitting factors. In addition, the criteria or splitting factors used to split the profit should be: independent of transfer pricing policy formulation, i.e. they should be based on objective data (e.g. sales to independent parties), not on data relating to the remuneration of controlled transactions (e.g. sales to associated enterprises), verifiable, and supported by comparables data, internal data, or both ...

Example 14 in Annex II to Chapter II illustrates the principles of this section ...

For example, two associated enterprises, each with its own manufacturing specialisation and unique and valuable intangibles, agree to contribute the intangibles to produce innovative, complex products. The accurate delineation of the transaction determines that the enterprises in this example share the assumption of risks associated with the success or otherwise of the products in the marketplace. However, they do not share the assumption of risks associated with their selling and other expenses, which are largely unintegrated. Using a profit split based on combined operating profits after all expenses of both parties would have the potential result of sharing the consequences of risks that are assumed by only one of the parties. In such cases, a splitting of gross profits may be more appropriate and reliable since this level of profits captures the outcomes of market and production activities that the parties share together with the assumption of associated risks. Similarly, in the case of associated enterprises that engage in highly integrated worldwide trading operations, if the accurate delineation of the actual transaction determines that the shared assumption of risks and level of integration does not extend to operating costs, it may be appropriate to split the gross profits from each trading activity, and then deduct from the resulting share of the overall gross profits allocated to each enterprise its own operating expenses incurred ...

That is, the measure of profits to be split will depend on the accurate delineation of the transaction. For instance, if the accurate delineation of the transaction determines that the parties share the assumption of not only market risk, which affects the volume of sales and prices charged, but also risks associated with producing or otherwise acquiring goods and services, which affect the level of gross profit, it would be most appropriate to use gross profits as the basis of the split. In such a scenario, the parties may have integrated or joint functions and assets relating to the production or acquisition of goods and services. If the accurate delineation of the transaction determines that the parties share the assumption of, in addition to market and production risks, a further range of risks that affect the level of operating expenses that may include investment in intangibles, it would be most appropriate to use operating profits as the basis of the split. In this scenario, the parties may have integrated or joint functions relating to the entire value chain ...

Most commonly, the relevant profits to be split under the transactional profit split method are operating profits. Applying the transactional profit split method in this manner ensures that both income and expenses of the MNE are attributed to the relevant associated enterprise on a consistent basis. However, depending on the accurate delineation of the transaction, it may be appropriate to split a different measure of profits such as gross profits, and then deduct the expenses incurred by or attributable to each relevant enterprise (excluding expenses already taken into account). In such cases, care must be taken to ensure that the expenses incurred by or attributable to each enterprise are consistent with the accurate delineation of the trans- action, particularly the activities and risks undertaken by each party, and that the allocation of profits is likewise consistent with the contributions of the parties ...

In any application of a transactional profit split, care should be exercised to ensure that the method is applied without hindsight. See paragraph 3.74. That is, irrespective of whether a transactional profit split of anticipated or actual profits is used, unless there are major unforeseen developments which would have resulted in a renegotiation of the agreement had it occurred between independent parties, the basis upon which those profits are to be split between the associated enterprises, including the profit splitting factors, the way in which relevant profits are calculated, and any adjustments or contingencies, must be determined on the basis of information known or reasonably foreseeable by the parties at the time the transactions were entered into. This is so notwithstanding the fact that in many cases, the actual calculations can necessarily only be performed some time afterwards, where, for example they apply profit splitting factors determined at the outset to the actual profits. Additionally, it should be remembered that the starting point in the accurate delineation of any transaction will generally be the written contracts which may reflect the intention of the parties at the time the contract was concluded. See paragraph 1.42 ...

Alternatively, if the transactional profit split is found to be the most appropriate method (e.g. because each party to the transaction makes unique and valuable contributions) but one of the parties does not share in the assumption of the economically significant risks which might play out after entering into the transaction, a split of anticipated profits would be more appropriate. See scenario 1 of Example 13 in Annex II to Chapter II of this guidance ...

Where the transactional profit split method is found to be the most appropriate, the splitting of actual profits, i.e. profits which have been affected by the playing out of economically significant risks, would only be appropriate where the accurate delineation of the transaction shows that the parties either share the assumption of the same economically significant risks associated with the business opportunity or separately assume closely related, economically significant risks associated with the business opportunity and consequently should share in the resulting profits or losses. These kinds of risk assumption may occur in scenarios where the business operations are highly integrated and/or each party makes unique and valuable contributions ...

The determination of the profits to be split, including whether those profits are actual profits or anticipated profits, or some combination thereof, should be aligned with the accurately delineated transaction. Example 13 in Annex II to Chapter II illustrates the principles of this section ...

However, except in circumstances where the total activities of each of the parties are the subject of the profit split, the financial data will need to be segregated and allocations made in accordance with the accurately delineated transaction(s) so that the profits relating to the combined contributions made by the parties are identified. For example, a product supplier in a profit split with an associated enterprise engaged in European marketing and distribution would need to identify the profits arising from its production of goods for the European market, and exclude the profits arising from the production of goods for other markets. The exercise may be relatively simple if the same goods are supplied to all markets, but will be more complex if different goods with different production costs or with different embedded technology, for example, are supplied to different markets. Similarly, if the associated enterprise engaged in European marketing and distribution buys products from other sources, it will need to segregate its financial data in a way that reflects the revenues, costs, and profits relating to the goods purchased from the associated product supplier in the profit split. Experience suggests that this initial stage in performing a profit split can in some circumstances be extremely complex, and the method of identifying the profits relevant to the transaction and any assumptions made in doing so need to be documented ...

Financial accounting may provide the starting point for determining the profit to be split in the absence of harmonised tax accounting standards. The use of other financial data (e.g. cost accounting) should be permitted where such accounts exist, are reliable, auditable and sufficiently transactional. In this context, product-line income statements or divisional accounts may prove to be the most useful accounting records ...

The relevant profits to be split under the transactional profit split method are those of the associated enterprises arising as a result of the controlled transactions under review. It is essential to identify the level of aggregation, see paragraphs 3.9-3.12. In determining the relevant profits, it is therefore essential to first identify and accurately delineate the transactions to be covered by the transactional profit split method, and from this identify the relevant income and expense amounts for each party in relation to those transactions. See Section C.4.2, below. Example 12 in Annex II to Chapter II of these Guidelines illustrates the principles of this section ...

Example 11 in Annex II to Chapter II illustrates the application of a residual analysis under a transactional profit split method ...

Where the contributions of the parties are such that some can be reliably valued by reference to a one-sided method and benchmarked using comparables, while others cannot, the application of a residual analysis may be appropriate. A residual analysis divides the relevant profits from the controlled transactions under examination into two categories. In the first category are profits attributable to contributions which can be reliably benchmarked: typically less complex contributions for which reliable comparables can be found. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of the residual profit among the parties will be based on the relative value of the second category of contributions of the parties in the same way as in the application of the contribution analysis outlined above and in accordance with the guidance as described in Section C.5 ...

It can be difficult to determine the relative value of the contribution that each of the associated enterprises makes to the relevant profits, and the approach will depend on the facts and circumstances of each case. The determination might be made by comparing the nature and degree of each party’s contribution of differing types (for example, provision of services, development expenses incurred, assets used or contributed, capital invested) and assigning a percentage based upon the relative comparison and external market data. See Section C.5 for a discussion of how to split the relevant profits ...

Under a contribution analysis, the relevant profits, which are the total profits from the controlled transactions under examination, are divided between the associated enterprises in order to arrive at a reasonable approximation of the division that independent enterprises would have achieved from engaging in comparable transactions. This division can be supported by comparables data where available. In the absence thereof, it should be based on the relative value of the contributions by each of the associated enterprises participating in the controlled transactions, determined using information internal to the MNE group, as a proxy for the division that independent enterprises would have achieved (see Section C.5.2). In cases where the relative value of the contributions can be measured, it may not be necessary to estimate the actual market value of each party’s contributions ...

There are a number of approaches to the application of the transactional profit split method, depending on the characteristics of the controlled transactions, and the information available. As has been described above, the method seeks to split the relevant profits from controlled transactions on an economically valid basis, in order to approximate the results that would have been achieved between independent enterprises in comparable circumstances. This may be done by considering the relative contributions of each party (a “contribution analysis”). Where the transactional profit split method is the most appropriate method but at least one party also makes some less complex contributions which are capable of being benchmarked by reference to comparable, uncontrolled transactions, a two-stage “residual analysis” may be appropriate ...

In addition, If the transactional profit split method is used to set transfer pricing in controlled transactions at the outset, it would be reasonable to expect the life-time of the arrangement and the criteria or profit splitting factors to be agreed in advance of the transaction, The person using the transactional profit split method (taxpayer or tax administration) should be prepared to explain why it is regarded as the most appropriate method in the circumstances of the case, as well as the way it is implemented, and in particular the criteria or profit splitting factors used to split the relevant profits, and The determination of the relevant profits to be split and of the profit splitting factors should generally be used consistently over the life-time of the arrangement, including during loss years, unless the rationale for using differing relevant profits or profit splitting factors over time is supported by the facts and circumstances and is documented ...

Under the transactional profit split method, the relevant profits are to be split between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. In general, the determination of the relevant profits to be split and of the profit splitting factors should be: consistent with the functional analysis of the controlled trans- action under review, and in particular reflect the assumption of the economically significant risks by the parties, and capable of being measured in a reliable manner ...

These Guidelines do not seek to provide an exhaustive catalogue of ways in which the transactional profit split method may be applied. Application of the method will depend on the facts and circumstances of the case and the information available, but the overriding objective should be to approximate as closely as possible the split of profits that would have been realised had the parties been independent enterprises ...

This section has described certain characteristics of the transactional profit split method and provided a number of potential indicators as to when it may be found to be the most appropriate method, as well as a number of factors which may point in the opposite direction. The guidance in this regard does not seek to be comprehensive, nor is it prescriptive. The presence or absence of one or more of the indicators described in this section will not necessarily lead to the conclusion that the transactional profit split will (or will not) be the most appropriate method in a particular case. Each case needs to be analysed on its own facts, and it will be important to consider the relative merits and shortcomings of available transfer pricing methods ...

While the transactional profit split method can be applied in cases where there are no uncontrolled comparables, information from transactions between independent parties may still be relevant to the application of the method, for example to guide the splitting of relevant profits (see Section C.3.1.1), or where a residual analysis approach is used (see Section C.3.1.2) ...

In general, it will tend to be the case that the presence of factors indicating that a transactional profit split is the most appropriate method will correspond to an absence of factors indicating that an alternative transfer pricing method – one which relies entirely on comparables – is the most appropriate method, determined in accordance with paragraph 2.2 of these Guidelines. Put another way, if information on reliable comparable uncontrolled transactions is available to price the transaction in its entirety, it is less likely that the transactional profit split method will be the most appropriate method. However, a lack of comparables alone is insufficient to warrant the use of a transactional profit split. See paragraph 2.128 ...

If each party shares the assumption of economically significant risks or separately assumes inter-related, economically significant risks, and a transactional profit split is considered to be the most appropriate method, it is likely that a split of actual profits, rather than anticipated profits, will be warranted since those actual profits, i.e. the actual relevant profits to be split, will reflect the playing out of the risks of each party. Conversely, a profit split of anticipated profits will tend to concentrate the playing out of economically significant risks on one party. That is, the transfer pricing outcome – a sharing of actual or anticipated profits – should align with the accurate delineation of the transaction. See Section C.4.1 below on splits of actual and anticipated profits ...

The relevance of this factor as an indicator for the transactional profit split method will depend in large measure on the extent to which the risks concerned are economically significant such that a share of relevant profits would be warranted for each party. The economic significance of the risks should be analysed in relation to their importance to the actual or anticipated relevant profits from the controlled transaction(s), rather than in respect of their importance to any one of the associated enterprises whose business operations may extend beyond those covered by the relevant profits ...

A transactional profit split may also be found to be the most appropriate method where, according to the accurately delineated transaction, the various economically significant risks in relation to the transaction are separately assumed by the parties, but those risks are so closely inter-related and/or correlated that the playing out of the risks of each party cannot reliably be isolated. See Example 10 in Annex II to Chapter II ...

A transactional profit split may be found to be the most appropriate method where, according to the accurately delineated transaction, each party to the controlled transaction shares the assumption of one or more of the economically significant risks in relation to that transaction (see paragraph 1.95) ...

Where the contributions are highly inter-related or inter-dependent upon each other, the evaluation of the respective contributions of the parties may need to be done holistically. That is, a high degree of integration may also affect whether contributions by the enterprises are considered to be unique and valuable. For instance, a unique contribution by one party may have a significantly greater value when considered in combination with the particular unique contribution of the other party. Paragraphs 6.93-6.94 discuss this issue in relation to the combination of intangibles. See also Example 9 in Annex II to Chapter II ...

Where a party contributes to the control of economically significant risk, but that risk is assumed by the other party to the transaction, this may, in some cases, demonstrate that it is appropriate for the first party to share in the potential upside and downside associated with that risk, commensurate with its contribution to control. See paragraph 1.105. However, the mere fact that an entity performs control functions in relation to a risk will not necessarily lead to the conclusion that the transactional profit split is the most appropriate method in the case ...

Where business operations are highly integrated, the extent to which the parties share the assumption of the same economically significant risks or separately assume closely related economically significant risks will be relevant to the determination of the most appropriate method and, if a transactional profit split is considered the most appropriate method, how it should be applied; in particular whether a split of actual profits or of anticipated profits should be used. See Section C.4.1 ...

Another example may be where the integration between the parties takes the form of a high degree of inter-dependency. For instance, profit split approaches may be used by independent enterprises engaged in long-term arrangements where each party has made a significant contribution (e.g. of an asset) whose value depends on the counterparty to the arrangement. In these kinds of cases, where each party makes such a contribution, and is dependent on the other party (or where the value of the contribution(s) of one party depends to a significant degree on the contribution(s) of the other party), some form of flexible pricing that takes into account, and varies with, the outcome of the risks assumed by each party arising from its dependence on the other party may be observed ...

In some cases the parties may perform functions jointly, use assets jointly and/or share assumption of risks to such an extent that it is impossible to evaluate their respective contributions in isolation from those of others. As an example, the transactional profit split method can be applied to the global trading of financial instruments by associated enterprises. See in Part III, Section C of the Report on the Attribution of Profits to Permanent Establishments. See Report on the Attribution of Profits to Permanent Establishments (OECD, 2010) ...

Although most MNE groups are integrated to some extent, a particularly high degree of integration in certain business operations is an indicator for the consideration of the transactional profit split method. A high degree of integration means that the way in which one party to the transaction performs functions, uses assets and assumes risks is interlinked with, and cannot reliably be evaluated in isolation from, the way in which another party to the transaction performs functions, uses assets and assumes risks. In contrast, many instances of integration within an MNE result in situations in which the contribution of at least one party to the transaction can in fact be reliably evaluated by reference to comparable uncontrolled transactions. For example, where complementary but discrete activities are undertaken by the entities, it may be the case that it is possible to find reliable comparables since the functions, assets and risks involved in each discrete stage may be comparable to those in uncontrolled arrangements. This needs to be borne in mind in considering which transfer pricing method is the most appropriate in a particular case. Examples , and in Annex II to Chapter II illustrate the principles of this section ...

As set out in paragraphs 6.148 to 6.149 and 6.152, in some cases, the transactional profit split method may be the most appropriate method for a transfer of fully developed intangibles (including rights in intangibles) where it is not possible to identify reliable comparable uncontrolled transactions. The transactional profit split method may also be appropriate for transfers of partially developed intangibles. Example 5 in Annex II to Chapter II provides an illustration. See paragraphs 6.150 to 6.151. Where the intangibles transferred are hard-to-value intangibles, the provisions of Section D.4 of Chapter VI should be considered ...

Where each party to the transaction legally owns unique and valuable intangibles that are relevant to the transaction, it will also be necessary to consider whether, under the accurate delineation of the transaction, they each assume the economically significant risks relating to those intangibles, e.g. risks related to development, obsolescence, infringement, product liability and exploitation (see paragraphs 6.65 to 6.68) ...

Contributions (for instance functions performed, or assets used or contributed) will be “unique and valuable” in cases where (i) they are not comparable to contributions made by uncontrolled parties in comparable circumstances, and (ii) they represent a key source of actual or potential economic benefits in the business operations. The two factors are often linked: comparables for such contributions are seldom found because they are a key source of economic advantage. It may be the case that in these situations, the risks associated with the respective unique and valuable contributions cannot be controlled by the other party or parties. This may impact the assumption of risk under the accurate delineation of the actual transaction. For example, the developer and manufacturer of a key component of a product together with the developer and manufacturer of another key component that together with the first component, form the ready-to-sell product, may both make unique and valuable contributions in terms of functions and intangibles that represent a key source of economic benefits. (See also paragraphs 6.50 to 6.58 and 6.133.) In practice, neither of them may be able to control the development risk in relation to the product as a whole, but instead they together control the development risks and share in the relevant profits resulting from their contributions. The principles of this section are illustrated by Examples 1, 2, 3 and 4 in Annex II to Chapter II of these Guidelines ...

It may also be relevant to consider industry practices. For instance, if information is available that independent parties do commonly use profit splitting approaches in similar situations, careful consideration should be given to whether the transactional profit split method may be the most appropriate method for the controlled transactions. Such industry practices may be a pointer to the fact that each party makes unique and valuable contributions, and/or that the parties are highly inter-dependent upon each other. Conversely, if independent parties engaged in comparable transactions are found to make use of other pricing methods, this should also be taken into account in determining the most appropriate transfer pricing method ...

A lack of closely comparable, uncontrolled transactions which would otherwise be used to benchmark an arm’s length return for the party performing the less complex functions should not per se lead to a conclusion that the transactional profit split is the most appropriate method. Depending on the facts of the case, an appropriate method using uncontrolled transactions that are sufficiently comparable, but not identical to the controlled transaction is likely to be more reliable than an inappropriate use of the transactional profit split method. See paragraphs 3.38-3.39 for a discussion of limitations in available comparables. See also Section C.2.3 ...

At the other end of the spectrum, where the accurate delineation of the transaction determines that one party to the transaction performs only simple functions, does not assume economically significant risks in relation to the transaction and does not otherwise make any contribution which is unique and valuable, a transactional profit split method typically would not be appropriate since a share of profits (which may be impacted by the playing out of the economically significant risks) would be unlikely to represent an arm’s length outcome for such contributions or risk assumption ...

The existence of unique and valuable contributions by each party to the controlled transaction is perhaps the clearest indicator that a transactional profit split may be appropriate. The context of the transaction, including the industry in which it occurs and the factors affecting business performance in that sector can be particularly relevant to evaluating the contributions of the parties and whether such contributions are unique and valuable. Depending on the facts of the case, other indicators that the transactional profit split may be the most appropriate method could include a high level of integration in the business operations to which the transactions relate and /or the shared assumption of economically significant risks (or the separate assumption of closely related economically significant risks) by the parties to the trans- actions. It is important to note that the indicators are not mutually exclusive and on the contrary may often be found together in a single case ...

The accurate delineation of the actual transaction will be important in determining whether a transactional profit split is potentially applicable. This process should have regard to the commercial and financial relations between the associated enterprises, including an analysis of what each party to the transaction does, and the context in which the controlled transactions take place. That is, the accurate delineation of a transaction requires a two- sided analysis (or a multi-sided analysis of the contributions of more than two associated enterprises, where necessary) irrespective of which transfer pricing method is ultimately found to be the most appropriate. (See Section D.1, and in particularly Section D.1.2 of Chapter I of these Guidelines.) ...

It is sometimes argued that a transactional profit split method is rarely used among independent enterprises, and thus its application in controlled transactions should be similarly rare. Where such a method is determined to be the most appropriate, this should not be a factor since transfer pricing methods are not necessarily intended to replicate arm’s length behaviour, but rather to serve as a means of establishing and/or verifying arm’s length outcomes for controlled transactions. That said, where there is evidence that independent parties in comparable transactions apply a profit split method among themselves, such evidence should be considered in determining whether a transactional profit split method is the most appropriate method for the controlled transactions. See paragraph 2.129 ...

A weakness of the transactional profit split method relates to difficulties in its application. On first review, the transactional profit split method may appear readily accessible to both taxpayers and tax administrations because it tends to rely less on information about independent enterprises. However, associated enterprises and tax administrations alike may have difficulty accessing the detailed information required to apply a transactional profit split method reliably. It may be difficult to measure the relevant revenue and costs for all the associated enterprises participating in the controlled transactions, which could require stating books and records on a common basis and making adjustments in accounting practices and currencies. Further, when the transactional profit split method is applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises’ other activities. Identifying the appropriate profit splitting factors can also be challenging. Given the necessity of applying judgement in determining each of the parameters for the application of the transactional profit split method, it will be particularly important to document how the method has been applied, including the determination of the relevant profits to be split, and how the profit splitting factors were arrived at. See Sections C.4 and C.5 ...

A further strength of the transactional profit split method is that all relevant parties to the transaction are directly evaluated as part of the pricing of the transaction, that is, the contributions of each party to the transaction are specifically identified and their relative values measured in order to determine an arm’s length compensation for each party in relation to the transaction ...

Another strength of the transactional profit split method is that it can offer flexibility by taking into account specific, possibly unique, facts and circumstances of the associated enterprises that may not be present in independent enterprises. Moreover, where there is a high degree of uncertainty for each of the parties in relation to a transaction, for example in transactions involving the shared assumption of economically significant risks by all parties (or the separate assumption of closely related economically significant risks), the flexibility of the transactional profit split method can allow for the determination of arm’s length profits for each party that vary with the actual outcomes of the risks associated with the transaction ...

The transactional profit split method can also provide a solution for highly integrated operations in cases for which a one-sided method would not be appropriate. See Section C.2.2.2, below ...

The main strength of the transactional profit split method is that it can offer a solution for cases where both parties to a transaction make unique and valuable contributions (e.g. contribute unique and valuable intangibles) to the transaction. In such a case independent parties might effectively price the transaction in proportion to their respective contributions, making a two-sided method more appropriate. Furthermore, since those contributions are unique and valuable there will be no reliable comparables information which could be used to price the entirety of the transaction in a more reliable way, through the application of another method. In such cases, the allocation of profits under the transactional profit split method may be based on the contributions made by the associated enterprises, by reference to the relative values of their respective functions, assets and risks. See Section C.2.2 below on the nature of the transaction ...

While there is no requirement in these Guidelines to undertake exhaustive analysis or testing of every method in each case, the selection of the most appropriate method should take into account the relative appropriateness and reliability of the selected method as compared to other methods which could be used ...

The arm’s length principle has also been found to work effectively in the vast majority of cases. For example, there are many cases involving the purchase and sale of commodities and the lending of money where an arm’s length price may readily be found in a comparable transaction undertaken by comparable independent enterprises under comparable circumstances. There are also many cases where a relevant comparison of transactions can be made at the level of financial indicators such as mark-up on costs, gross margin, or net profit indicators. Nevertheless, there are some significant cases in which the arm’s length principle is difficult and complicated to apply, for example, in MNE groups dealing in the integrated production of highly specialised goods, in unique intangibles, and/or in the provision of specialised services. Solutions exist to deal with such difficult cases, including the use of the transactional profit split method described in Chapter II, Part III of these Guidelines in those situations where it is the most appropriate method in the circumstances of the case ...

Ensco Gerudi provided offshore drilling services to the petroleum industry in Malaysia, including leasing drilling rigs, to oil and gas operators in Malaysia. In order to provide these services, the Ensco entered into a Master Charter Agreement dated 21.9.2006 (amended on 17.8.2011) (“Master Charter Agreement”) with Ensco Labuan Limited (“ELL”), a third-party contractor, to lease drilling rigs from ELL. Ensco then rents out the drilling rigs to its own customers. As part of the Master Charter Agreement, Ensco agreed to pay ELL a percentage of the applicable day rate that Ensco earns from its drilling contracts with its customers for the drilling rigs. By way of a letter dated 12.10.2018, the tax authorities initiated its audit for FY 2015 to 2017. The tax authorities issued its first audit findings letter on 23.10.2019 where it took the position that the pricing of the leasing transactions between the Applicant and ELL are not at arm’s length pursuant to s 140A of the Income Tax Act 1967 (“ITA”). The tax authorities proposed that the profit earned by ELL should remain with the Ensco by reducing the cost of the leasing asset by 20% or equivalent to the margin obtained by ELL. Ensco disputed the tax assessment and brought the case to court for an appeals review. Decision of the High Court The High Court granted orders in terms of Ensco’s application allowing an appeal. Excerpts “It has been said that additional assessment is rooted in fairness and that there is a duty on the part of the Respondent [tax authorities] being an important public authority to give its reasons more so, when the issues pertaining to transfer pricing are complex matters and can never be straightforward. As the Applicant [Ensco] has submitted and this Court agrees, that at the very least, the most basic Transfer Pricing Report by the Respondent will be able to shed some light on the Applicant on this issue because without some basis, how would the Applicant be able to adequately defend itself before the Special Commissioners of Income Tax. The Applicant’s [Ensco] basis and justifications for the pricing of the leasing transactions is definitely in stark contrast to the Respondent’s failure to provide its own Transfer Pricing Report to the Applicant. In the present matter, exceptional circumstances of the case have been established at the leave stage which is a starting point in judicial review cases. Illegality, unlawful treatment, error of law and failure to adhere to legal principles established by the Courts tantamount to an excess of jurisdiction and all of which this Court finds have been demonstrated by the Applicant. ensco gerudi v kphdn ...

In 2017 the European Commission concluded that Luxembourg granted undue tax benefits to Amazon of around €250 million.  Following an in-depth investigation the Commission concluded that a tax ruling issued by Luxembourg in 2003, and prolonged in 2011, lowered the tax paid by Amazon in Luxembourg without any valid justification. The tax ruling enabled Amazon to shift the vast majority of its profits from an Amazon group company that is subject to tax in Luxembourg (Amazon EU) to a company which is not subject to tax (Amazon Europe Holding Technologies). In particular, the tax ruling endorsed the payment of a royalty from Amazon EU to Amazon Europe Holding Technologies, which significantly reduced Amazon EU’s taxable profits. This decision was brought before the European Court of Justice by Luxembourg and Amazon. Judgement of the EU Court  The European General Court found that Luxembourg’s tax treatment of Amazon was not illegal under EU State aid rules. According to a press release ” The General Court notes, first of all, the settled case-law according to which, in examining tax measures in the light of the EU rules on State aid, the very existence of an advantage may be established only when compared with ‘normal’ taxation, with the result that, in order to determine whether there is a tax advantage, the position of the recipient as a result of the application of the measure at issue must be compared with his or her position in the absence of the measure at issue and under the normal rules of taxation. In that respect, the General Court observes that the pricing of intra-group transactions carried out by an integrated company in that group is not determined under market conditions. However, where national tax law does not make a distinction between integrated undertakings and standalone undertakings for the purposes of their liability to corporate income tax, it may be considered that that law is intended to tax the profit arising from the economic activity of such an integrated undertaking as though it had arisen from transactions carried out at market prices. In those circumstances, when examining a fiscal measure granted to such an integrated company, the Commission may compare the tax burden of that undertaking resulting from the application of that fiscal measure with the tax burden resulting from the application of the normal rules of taxation under national law of an undertaking, placed in a comparable factual situation, carrying on its activities under market conditions. In addition, the General Court points out that, in examining the method of calculating an integrated company’s taxable income endorsed by a tax ruling, the Commission can find an advantage only if it demonstrates that the methodological errors which, in its view, affect the transfer pricing do not allow a reliable approximation of an arm’s length outcome to be reached, but rather lead to a reduction in the taxable profit of the company concerned compared with the tax burden resulting from the application of normal taxation rules. In the light of those principles, the General Court then examines the merits of the Commission’s analysis in support of its finding that, by endorsing a transfer pricing method that did not allow a reliable approximation of an arm’s length outcome to be reached, the tax ruling at issue granted an advantage to LuxOpCo.  In that context, the General Court holds, in the first place, that the primary finding of an advantage is based on an analysis which is incorrect in several respects. Thus, first, in so far as the Commission relied on its own functional analysis of LuxSCS in order to assert, in essence, that contrary to what was taken into account in granting the tax ruling at issue, that company was merely a passive holder of the intangible assets in question, the General Court considers that analysis to be incorrect. In particular, according to the General Court, the Commission did not take due account of the functions performed by LuxSCS for the purposes of exploiting the intangible assets in question or the risks borne by that company in that context.  Nor did it demonstrate that it was easier to find undertakings comparable to LuxSCS than undertakings comparable to LuxOpCo, or that choosing LuxSCS as the tested entity would have made it possible to obtain more reliable comparison data. Consequently, contrary to its findings in the contested decision, the Commission did not, according to the General Court, establish that the Luxembourg tax authorities had incorrectly chosen LuxOpCo as the ‘tested party’ in order to determine the amount of the royalty. Secondly, the General Court holds that, even if the ‘arm’s length’ royalty should have been calculated using LuxSCS as the ‘tested party’ in the application of the TNMM, the Commission did not establish the existence of an advantage since it was also unfounded in asserting that LuxSCS’s remuneration could be calculated on the basis of the mere passing on of the development costs of the intangible assets borne in relation to the Buy-In agreements and the cost sharing agreement without in any way taking into account the subsequent increase in value of those intangible assets. Thirdly, the General Court considers that the Commission also erred in evaluating the remuneration that LuxSCS could expect, in the light of the arm’s length principle, for the functions linked to maintaining its ownership of the intangible assets at issue. Contrary to what appears from the contested decision, such functions cannot be treated in the same way as the supply of ‘low value adding’ services, with the result that the Commission’s application of a mark-up most often observed in relation to intra-group supplies of a ‘low value adding’ services is not appropriate in the present case. In view of all the foregoing considerations, the General Court concludes that the elements put forward by the Commission in support of its primary finding are not capable of establishing that LuxOpCo’s tax burden was artificially reduced as a result of an overpricing of the royalty. In the second place, after examining the ...

A fully fledged Norwegian distributor in the H group was restructured and converted into a Limited risk distributor. The tax authorities issued an assessment where the income of the Norwegian distributor was adjusted to the median in a benchmark study prepared by the tax authorities, based on the “Transactional Net Margin Method” (TNMM method). Decision of the Tax Board In a majority decision, the Tax Board determined that the case should be send back to the tax administration for further processing. Excerpt “…The majority agrees with the tax office that deficits over time may give reason to investigate whether the intra-group prices are set on market terms. However, the case is not sufficiently informed for the tribunal to take a final position on this. In order to determine whether the income has been reduced as a result of incorrect pricing of intra-group transactions and debits, it is necessary to analyze the agreed prices and contract terms. A comparability analysis will be needed, cf. OECD TPG Chapter III, including especially OECD TPG Section 3.4. to be able to determine whether the intra-group prices have been at arm’s length. When analysing the controlled transactions and identifying possible comparable uncontrolled transactions, reference must be made to the comparability factors as instructed in OECD TPG section 1.36. A functional analysis must be performed to identify which party to the contractual relationship is to form the basis for the choice of pricing method in accordance with OECD TPG clause 3.4, step 3, as well as a market analysis to identify how this may affect the price in the controlled transactions. See OECD TPG Section 3.7, step 2. In the majority’s view, the tax office is closest to making the necessary analyzes and assessments of the above matters. The majority therefore believes that the decision should be revoked and sent back to the tax office for possible new processing, cf. the Tax Administration Act § 13-7 (3).” Click here for translation Spørsmål om inntekten til selskapet er ...

A Dutch company, Zinc Smelter B.V., transferred part of it’s business to a Swiss group company in 2010. In dispute was whether the payment for the transferred activities had been set at arm’s length, and whether the cost-plus remuneration applied to the Dutch company after the business restructuring constituted an arm’s length remuneration for the remaining activities in the company. The case had previously been presented before the lower court where a decision had been issued in October 2017. After hearings in the Court of Appeal, Zinc Smelter B.V. and the Dutch tax authorities reached a settlement which was laid down in the decision. According to the agreement the profit split method was the correct method for determining the arm’s length remuneration of the Dutch company after the restructuring. Click here for translation ECLI_NL_GHSHE_2020_968 ...

“Metal Plating Corp” is engaged in manufacturing and selling plating chemicals and had entered into a series of controlled transactions with foreign group companies granting licenses to use intangibles (know-how related to technology and sales) – and provided technical support services by sending over technical experts. The company had used a CUP method to price these transactions based on “internal comparables”. The tax authorities found that the amount of the consideration paid to “Metal Plating Corp” for the licenses and services had not been at arm’s length and issued an assessment where the residual profit split method was applied to determine the taxable profit for the fiscal years FY 2007-2012. “Metal Plating Corp” on its side held that it was inappropriate to use a residual profit split method and that there were errors in the calculations performed by the tax authorities. Judgement of the Court The Court dismissed the appeal of “Metal Plating Corp” and affirmed the assessment made by the Japanese tax authority. On the company’s use of the CUP method the Court concluded that there were significant differences between the controlled transactions and the selected “comparable” transactions in terms of licences, services and the circumstances under which the transactions were took place. Therefore the CUP method was not the most appropriate method to price the controlled transactions. The Court recognised that “Metal Plating Corp” had intangible assets created by its research and development activities. The Court also recognised that the subsidiaries had created intangible assets by penetrating regional markets and cultivating and maintaining customer relationships. The Court found the transactions should be aggregated and that the price should be determined for the full packaged deal – not separately for each transaction. Click here for English Translation Click here for other translation JAP TOKYO 089550_hanrei ...

Orange Business Norway AS, a subsidiary of the French Orange Telecom Group, had been issued a tax assessment for FY 2006-2008. According to the Norwegian tax authorities, Orange Business Norway had determined the remuneration by applying a Profit Split Method in a way that closely resembled Global formulary apportionment. The tax authorities also found that a Profit Split approach was not suitable for the case and instead determined the income of Orange Business Norway based on the Transactional Net Margin Method. The Court of Appeal concluded that the tax authorities had not proven that the income of Orange Business Norway had been reduced due to common interests with other group companies, cf. SKL § 13-1 (1) and the OECD transfer pricing guidelines. Like the district court, the Court of Appeal concluded that the profit split method (PSM) had not been incorrectly applied by the company. Furthermore, the internal pricing determined by the company was sufficiently substantiated by the functional analyzes. The tax authorities had not proven a reduction in income due to common interest. The comparability analysis provided, where the operating margin had been compared to nine allegedly comparable companies, could not be given weight due to significant differences in the nature of the business, size, etc. Click here for translation Norway vs Orange Borgarting lagmannsrett 2020 ...

On 8 April 2019 the UN subcommittee issued it’s first discussion draft on the future updates to the UN Practical-Manual-on-Transfer-Pricing on Financial transactions, BEPS consistency and Risk Assessment and Audit practices. Attachment A: the proposed new Chapter B on Financial Transactions. The draft discusses the importance of corporate financing decisions within multinational groups and how those decisions could lead to tax base The Chapter discusses interaction with rules and measures against base erosion; common types of intra- group financial transactions and of group financing departments; the process of actual delineation and relevant characteristics of financial transactions; the process and system of credit rating; potential transfer pricing methods, including the use of simplification measures/safe harbours; different types of intra group loans and relevant characteristics; determining the arm’s length nature of intra-group loans; different types of intra group financial guarantees and relevant characteristics; determining the arm’s length nature of intra-group financial guarantees; and available methods. The chapter also discusses cash pooling practices and captive insurance, without getting into further detail on the delineation and arm’s length pricing of those specific transactions. Different types of intra-group loans are mentioned, and the draft identifies four steps to determine the arm’s length nature of intra-group loans: (i) analyse economically relevant characteristics; (ii) accurately delineate the entire transaction undertaken as well as (iii) selection and (iv) application, of the most appropriate transfer pricing method. The Subcommittee has not yet discussed any of the examples in shaded text and comments are therefore not invited for discussion at this Session of the Committee. Attachment B: Revision to the guidance contained in the Manual on the transactional profit-split method (Chapter 3.3.) with the main focus being on seeking consistency of this guidance with the work done in the context of the Inclusive Framework on BEPS, while providing more practical examples. The draft includes the existing text side-by-side with the proposed revisions for better understanding. The draft is ready for Committee consideration, with one exception. Shaded text, such as on the use of “hindsight”, will need further Subcommittee discussion before a draft is ready for Committee consideration and comments are therefore not invited for discussion at this Session of the Committee. Attachment C: A progress draft of the work on sections C.2. Establishing Transfer Pricing Capability in Developing Countries (previously C.5.); C.4. Risk Assessment (Previously part of C.3.) and C.5. Transfer Pricing Audits. The purpose is mainly to streamline the sequences of presentation and to eliminate overlaps in the current 2019-Update-UN-Practical-Manual-on-Transfer-Pricing-1 ...

A new version of the UN Practical Manual on Transfer Pricing for Developing Countries is due by 2021. According to the mandate the new manual will make further improvements in usability and practical relevance, updates and improvements to existing text, including on Country Practices (Part D) and will have new content, in particular, on financial transactions; profit splits, centralized procurement functions and comparability issues. A draft paper was published 8 April 2019 containing further guidance on: • Financial Transactions (Attachment A); • Profit Splits (Attachment B); and • Establishing Transfer Pricing Capability, Risk Assessment and Transfer Pricing Audits (Attachment C). 2019 Update-UN-Practical-Manual-on-Transfer-Pricing ...

A new version of the UN Practical Manual on Transfer Pricing for Developing Countries is due by 2021. According to the mandate the new manual will make further improvements in usability and practical relevance, updates and improvements to existing text, including on Country Practices (Part D) and will have new content, in particular, on financial transactions; profit splits, centralized procurement functions and comparability issues. A draft paper was published 8 April 2019 containing further guidance on: • Financial Transactions (Attachment A); • Profit Splits (Attachment B); and • Establishing Transfer Pricing Capability, Risk Assessment and Transfer Pricing Audits (Attachment C). 2019 Update-UN-Practical-Manual-on-Transfer-Pricing ...

The profit split method (PSM) is one of the five transfer pricing methods in Chapter II of the OECD Transfer Pricing Guidelines. These methods can be used to establish whether the conditions imposed on the commercial or financial relations between associated enterprises are consistent with the arm’s length principle. The OECD guidelines of 1995 referred to the PSM as a method of “last resort”, to be used when other methods could not be reliably applied (para. 3.50). Yet, since the revision of the OECD Guidelines in 2010, the PSM is considered a pricing method to be applied in an equally reliable manner as the other methods in accordance with the “most appropriate method” criterion. Due to the increased integration of multinational enterprises and the globalization of national economies and markets, the clarification of the PSM was one of the priorities identified in the action plan against Base Erosion and Profit Shifting (BEPS). Indeed, in order to develop rules that can prevent BEPS resulting from engaging in transactions which would not, or would only very rarely, occur between third parties, Action 10 called for clarification of the application of transfer pricing methods, in particular of the transactional profit split method, in the context of global value chains. In June 2018 the OECD published a Report containing Revised Guidelines on the application of PSM that clarifies and significantly expands the Guidelines on when a profit split may be the most appropriate method. The Guidelines also note that the basic premise that the transactional profit split method is applicable where it is found to be the most appropriate method is unchanged. In addition, the programme of work 2015-2019 of the Joint Transfer Pricing Forum (JTPF) referred to the PSM as one of the topics on which the JTPF should provide output in order to address the problems in the practical application of the PSM. A particular reference is made to the high degree of subjectivity encountered when stakeholders determine how to share the profit. As pointed out in the OECD Guidelines, the main advantage of the PSM is that it can offer solutions in cases where all relevant parties make unique and valuable contributions and/or there is a high degree of integration. In such cases, it is frequent that the reliable information on comparables is insufficient for applying another transfer pricing method although as pointed out by the OECD, lack of external comparable per se should not lead to default use of PSM (para 2.128 and 2.143 of the OECD Guidelines). Secondly, when parties share the assumption of economically significant risks or assume closely related risks, its flexibility allows the determination of an arm’s length profit for the parties according to the actual assumption of the risks. The analysis of the economically relevant characteristics of the transaction and in particular, the functional analysis, supported by the information in the MNE group’s transfer pricing documentation, should reveal: (i) how value is generated by the group as a whole; (ii) the interdependencies between the functions performed by the associated enterprises; and (iii) the contribution that each of the associated enterprises makes to that value creation. In particular, the analysis of risks and the determination of which group entities take the key decisions related to control over risk as well as which of these entities have the financial capacity to assume the risk should help identify the most appropriate way of splitting the relevant profit from the transaction under review. report_on_the_application_of_the_profit_split_method_within_the_eu_en ...

A GmbH (“Sport Data GmbH”) was founded in 2006 as a wholly-owned subsidiary of A Holding AG, which had been founded shortly before and had its registered office in Switzerland. A AG, Switzerland was also founded as a sister company of A GmbH. A AG is A GmbH´s only customer. The business of A GmbH is the development and support of software for A AG, the maintenance of hardware, the training of employees and the forwarding of information. A AG, Switzerland sells the information provided by A GmbH. For these services A GmbH receives a remuneration from A AG determined as actual costs plus a profit surcharge of 5 %. The tax authorities noted that A AG did not initially have any active business activities. Against this background, the tax office had doubts about the arm’s length nature of the transfer prices. The tax authorities concluded, there were also no “simple services” by A GmbH for which, according to international accounting principles (services of a routine nature), procedures with profit mark-ups in the range of 5% to 15% could be considered. A high quality service should not be compensated by a 5% mark-up, especially if the service is performed using self-created intangible assets. In such cases, the profit split method should instead be applied. An assessment of estimated additional profits was issued. Judgement of the Court The court decided that the remuneration should be based on the cost plus method, but that the margin should be changed from 5 % to 10 % due to the advanced functions performed by A GmbH. Excerpts: “The contacts with the international sports organisers such as the IFA and the customers (companies) are again (only) with A AG, Switzerland. This picture also shows the overall profit situation of the group of companies in comparison: In the first year in dispute, the 5% mark-up applied by the Bf. amounted to 276,214.58 euros, while the share of the company’s profit applied by the tax office (in the context of the BVE) was “only” 195,120 euros. In the following year, the ratio changed in such a way that the surcharge of the complainant amounted to approximately 150,000 euros, while the part assessed by the tax office amounted to approximately 270,000 euros, and in the third year, with the same accounting of the complainant, even approximately 840,000 euros, and in the following years much more. While the performance of the complainant thus remained relatively constant (in the first year longer periods were affected due to a different business year), A AG, Switzerland was able to increase its business results enormously through efficient marketing on the basis of the good functioning of the EDP and/or the training of the employees working worldwide. Even if the business idea and the IT implementation of the same originated with the complainant, the economic success of the group of companies is not least due to the marketing activities of A AG, Switzerland, under the motto “even the best product must first find a buyer”. In this situation, the appropriateness can only be checked using the standard cost+ method.” “As far as a profit mark-up of 5% is charged for this routine activity, a higher profit mark-up must be applied for the services of the complainant in comparison. Determining the amount of the appropriate mark-up within the range of 5 – 15% is naturally associated with uncertainties. One indication in the case of a complaint can be the mark-up rates for IT programming of between 4.78% and 13.95% determined in the transfer pricing study by PwC. Another indication is the assessment of the complainant herself, who had to concede at the hearing that the 5% mark-up may be too low. In a detailed discussion, she was unable to offer any substantive arguments against a 10% mark-up rate. Considering that the defendant’s activities after the development and sale of the software “A Live System”, which is not in dispute here, consist of very different services, a mixed mark-up rate of 10% seems appropriate:” Click here for English translation Click here for other translation BFG 22112018, RV-2100386-2017 ...

June 2018 the OECD released revised guidance on the profit split method. The new guidance will be incorporated into the OECD Transfer Pricing Guidelines, replacing the previous text on the transactional profit split method in Chapter II. The revised guidance retains the basic premise that the profit split method should be applied where it is found to be the most appropriate method to the case at hand, but it significantly expands the guidance available to help determine when that may be the case. It also contains more guidance on how to apply the method, as well as numerous examples. revised-guidance-on-the-application-of-the-transactional-profit-split-method-beps-action-10 ...

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) ...

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 ...

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 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 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 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 (initial returns for manufacturing transactions) 23 Residual profit before Expenditure in relation to the unique and valuable intangible to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible     132 Residual profit allocated to A: 132 * 30/70 56.57 Residual profit allocated to B: 132 * 40/70 75.43 Total profits allocated to A: 6 (initial return) + 56.57 (residual) – 30 (expenditure in relation to the unique and valuable intangible)   32.57 Total profits allocated to B: 17 (initial return) + 75.43 (residual) – 40 (expenditure in relation to the unique and valuable intangible)   52.43 Total 85 i.e. A and B are allocated the same profits as in the case where the relevant profit to be split is determined as the operating profit after expenditure in relation to the unique and valuable intangible, see case a) above 79. This example illustrates the fact that, when the profit splitting factor used to split the residual profit relies on a category of expenses incurred during the period, it is irrelevant whether the residual profit to be split is determined before the expenses are deducted by each party, or whether the residual profit to be split is determined after the expenses are deducted. The outcome can however be different in the case where the splitting factor is based on the accumulated expenditure of the prior as well as current ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

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 ...

In some cases, a significant issue for the reliability of cost-based splitting factors is the determination of the relevant period of time from which the elements of determination of the profit splitting factor(s) (e.g. assets, costs, or others) should be taken into account. A difficulty arises because there can be a lag between the time when expenses are incurred and the time when value is created, and it is sometimes difficult to decide which period’s expenses should be used. For example, in the case of a cost-based factor, using the expenditure on a single-year basis may be suitable for some cases, while in some other cases it may be more suitable to use accumulated expenditure (net of depreciation or amortisation, where appropriate in the circumstances) incurred in the previous as well as the current years. Depending on the facts and circumstances of the case, this determination may have a significant effect on the allocation of profits amongst the parties. As noted at section C.5.1 above, the selection of the profit splitting factor should be appropriate to the particular circumstances of the case and provide a reliable approximation of the division of profits that would have been agreed between independent parties. The principles of this section are illustrated by Example 16 in Annex II to Chapter II of this guidance ...

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 ...

In identifying and applying appropriate cost-based profit splitting factors a number of issues may need to be considered. One is that there may be differences between the parties in the timing of expenditure. For example, research and development costs that are relevant to the value of a party’s contributions may have been incurred several years in the past, whereas the expenditure for another party may be current. As a result, it may be necessary to bring historic costs to current values (as discussed further below) in addition to the risk weighting described in paragraph 2.181. The relevant costs may be part of a larger cost pool that needs to be analysed and allocated to the contributions made to the profit split transaction. For example, marketing costs may be incurred and recorded across several product lines, whereas only one product line is the subject of the profit split transaction. Where location savings retained by member(s) of the MNE group are a significant contributor to profits, and such costs are included in the profits to be split, then the manner in which independent parties would allocate retained location savings would need to be reflected in the profit split, taking into account the guidance in section D.6 of Chapter I. Cost-based profit splitting factors can be very sensitive to differences and changes in accounting classification of costs. It is therefore necessary to clearly identify in advance what costs will be taken into account in the determination of the profit splitting factor and to determine the factor consistently among the parties ...

A profit splitting factor based on expenses may be appropriate where it is possible to identify a strong correlation between relative expenses incurred and relative value contributed. For example, marketing expenses may be an appropriate factor for distributors-marketers if advertising generates unique and valuable marketing intangibles, e.g. in consumer goods where the value of marketing intangibles is affected by advertising. Research and development expenses may be suitable for manufacturers if they relate to the development of unique and valuable intangibles such as patents. However, if, for instance, each party contributes different valuable intangibles, then it is not appropriate to use a cost- based factor unless cost is a reliable measure of the relative value of those intangibles or costs can be risk-weighted to achieve a reliable measure of relative value. Even where each party contributes the same kind of intangibles, risk-weighting will be an appropriate consideration. For example, where the risk of failure at an early stage of development is several times higher than the risk of failure at a later stage or in the development of incremental improvements to an already proven concept, then the costs incurred in that early stage will have a higher risk weighting than the costs incurred at a later stage or on incremental improvements. Employee remuneration may be relevant in situations where functions relating to the skills and experience of staff are the primary factor in generating the relevant profits ...

Where one or more of the parties to a transaction for which the transactional profit split method is found to be the most appropriate makes a contribution in the form of intangibles, difficult issues can arise in relation both to their identification and to their valuation. Guidance on the identification and valuation of intangibles is found at Chapter VI of these Guidelines. See also the examples in the Annex to Chapter VI “Examples to illustrate the guidance on intangibles.” ...

Asset-based or capital-based profit splitting factors can be used where there is a strong correlation between tangible assets or intangibles, or capital employed and creation of value in the context of the controlled transaction. In order for a profit splitting factor to be meaningful, it should be applied consistently to all the parties to the transaction. See paragraph 2.104 for a discussion of comparability issues in relation to asset valuation in the context of the transactional net margin method, which is also valid in the context of the transactional profit split method. Example 15 in Annex II to this chapter illustrates the principles of this section ...

Internal data are essential to assess the values of the respective contributions of the parties to the controlled transaction. The determination of such values should rely on a functional analysis that takes into account all the economically significant functions, assets and risks contributed by the parties to the controlled transaction. In those cases where the profit is split on the basis of an evaluation of the relative importance of the functions, assets and risks to the value added to the controlled transaction, such evaluation should be supported by reliable objective data in order to limit arbitrariness. Particular attention should be given to the identification of the relevant contributions of unique and valuable intangibles and the assumption of economically significant risks and the importance, relevance and measurement of the factors which gave rise to these ...

Internal data may also be helpful where the profit splitting factor is based on a cost accounting system, e.g. employee costs related to some aspects of the transaction, or time spent by a certain group of employees on certain tasks, etc ...

Similarly, where cost-based profit splitting factors are used that are based on data extracted from the taxpayers’ profit and loss accounts, it may be necessary to draw up transactional accounts that identify those expenses that are related to the controlled transaction at hand and those that should be excluded from the determination of the profit splitting factor. The type of expenditure that is taken into account (e.g. salaries, depreciation, etc.) as well as the criteria used to determine whether a given expense is related to the transaction at hand or is rather related to other transactions of the taxpayer (e.g. to other lines of products not subject to this profit split determination) should be applied consistently to all the parties to the transaction ...

For instance, where an asset-based profit splitting factor is used, it may be based on data extracted from the balance sheets of the parties to the transaction. It will often be the case that not all the assets of the taxpayers relate to the transaction at hand and that accordingly some analytical work is needed for the taxpayer to draw up a “transactional” balance sheet that will be used for the application of the transactional profit split method. In addition, certain assets, such as self-developed intangibles, may not be reflected on the balance sheet at all, and accordingly must be separately evaluated. In this regard, valuation techniques, such as those based on the discounted value of projected future income streams or cash flows derived from the exploitation of the intangible may be useful. See Section D.2.6.3 of Chapter VI of these guidelines. See also paragraph 2.104 for a discussion of valuation of assets in the context of the transactional net margin method where the net profit is weighted to assets, which is also relevant to the valuation of assets in the context of a transactional profit split where an asset-based profit splitting factor is used ...

Where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the relevant profits, consideration should be given to internal data, which may provide a reliable means of establishing or testing the arm’s length nature of the division of profits. The types of such internal data that are relevant will depend on the facts and circumstances of the case and should satisfy the conditions outlined in this section and in particular at paragraphs 2.147-2.148 and 2.166. They will frequently be extracted from the taxpayers’ cost accounting or financial accounting ...

In addition to the Local File, which should contain a detailed functional analysis of the taxpayer and its relevant associated enterprises, the MNE group’s Master File might be a useful source of information relevant to the determination of appropriate profit splitting factors. As is set out in Annex I to Chapter V, the Master File should include information on the important drivers of business profit, the principal contributions to value creation by entities within the group, and key group intangibles. However, it should be borne in mind that the Master File is intended only to provide a high-level overview of an MNE group, and not granular or detailed information as to all of the group’s transactions ...

Other profit splitting factors that could be appropriate in the circumstances of a given case include incremental sales, or employee compensation (relating to the individuals involved in the key functions that generate value to the transaction, for example in relation to the global trading of financial instruments). In other situations it is possible that headcount or time spent by a certain group of similarly skilled employees with similar responsibilities could be used if there is a strong and relatively consistent correlation between this and the creation of value represented by the relevant profits. The guidance in this section should not be considered as an exhaustive list of potential profit splitting factors. Other profit splitting factors may be acceptable provided they result in arm’s length outcomes for all relevant parties ...

Profit splitting factors based on assets or capital (e.g. operating assets, fixed assets (e.g. production assets, retail assets, IT assets), intangibles), or costs (e.g. relative spending and/or investment in key areas such as research and development, engineering, marketing) may be used where these capture the relative contributions of the parties to the profits being split and they can be measured reliably. Note that while costs may be a poor measure of the value of intangibles contributed (see paragraph 6.142), the relative costs incurred by parties may provide a reasonable proxy for the relative value of those contributions where such contributions are similar in nature (see paragraphs 8.27-8.28) ...

Depending on the facts and circumstances of the case, the factor can be a figure (e.g. a 30%-70% split based on evidence of a similar split achieved between independent parties in comparable transactions), or a variable (e.g. relative value of participant’s marketing contributions or other possible factors as discussed below) which could be calculated on the basis of a single profit splitting factor or a weighting of multiple factors ...

As noted above, arm’s length parties can be assumed to split profits on the basis of their relative contributions to the creation of those profits. The division of the relevant profits under the transactional profit split method is generally achieved using one or more profit splitting factors. The functional analysis and an analysis of the context in which the transactions take place (e.g. the industry and environment) are essential to the process of determining the relevant factors to use in splitting profits, including determining the weighting of applicable profit splitting factors, in cases where more than one factor is used. The determination of appropriate profit splitting factor(s) should reflect the key contributions to value in relation to the transaction. Examples 15 and 16 in Annex II to Chapter II of these Guidelines illustrate the principles of this section ...

However, it can be difficult to find reliable comparables data that can be used in this manner. Nevertheless, external market data can be relevant in the profit split analysis to assess the value of contributions that each associated enterprise makes to the transactions. In effect, the assumption is that independent parties would have split relevant profits in proportion to the value of their respective contributions to the generation of profit in the transaction. Thus, where there is no more direct evidence of how independent parties in comparable circumstances would have split the profit in comparable transactions, the allocation of profits may be based on the relative contributions of the parties, as measured by their functions, assets used and risks assumed ...

One possible approach is to split the relevant profits based on the division of profits that actually is observed in comparable uncontrolled transactions. Examples of possible sources of information on uncontrolled transactions that might usefully assist the determination of criteria to split the profits, depending on the facts and circumstances of the case, include joint-venture arrangements between independent parties under which profits are shared, such as development projects in the oil and gas industry; pharmaceutical collaborations, co-marketing or co-promotion agreements; arrangements between independent music record labels and music artists; uncontrolled arrangements in the financial services sector, etc ...

Profits should be split on an economically valid basis that reflects the relative contributions of the parties to the transaction and thus approximates the division of profits that would have obtained at arm’s length. The relevance of comparable uncontrolled transactions or internal data (see section C.5.2) and the criteria used to achieve an arm’s length division of the profits depend on the facts and circumstances of the case. It is therefore not desirable to establish a prescriptive list of criteria or profit splitting factors. See paragraphs 2.146-2.148 for general guidance on the consistency of the determination of the splitting factors. In addition, the criteria or splitting factors used to split the profit should: Be independent of transfer pricing policy formulation, i.e. they should be based on objective data (e.g. sales to independent parties), not on data relating to the remuneration of controlled transactions (e.g. sales to associated enterprises), Be verifiable, and Be supported by comparables data, internal data, or both ...

Example 14 in Annex II to Chapter II illustrates the principles of this section ...

For example, two associated enterprises, each with its own manufacturing specialisation and unique and valuable intangibles, agree to contribute the intangibles to produce innovative, complex products. The accurate delineation of the transaction determines that the enterprises in this example share the assumption of risks associated with the success or otherwise of the products in the marketplace. However, they do not share the assumption of risks associated with their selling and other expenses, which are largely unintegrated. Using a profit split based on combined operating profits after all expenses of both parties would have the potential result of sharing the consequences of risks that are assumed by only one of the parties. In such cases, a splitting of gross profits may be more appropriate and reliable since this level of profits captures the outcomes of market and production activities that the parties share together with the assumption of associated risks. Similarly, in the case of associated enterprises that engage in highly integrated worldwide trading operations, if the accurate delineation of the actual transaction determines that the shared assumption of risks and level of integration does not extend to operating costs, it may be appropriate to split the gross profits from each trading activity, and then deduct from the resulting share of the overall gross profits allocated to each enterprise its own operating expenses incurred ...

That is, the measure of profits to be split will depend on the accurate delineation of the transaction. For instance, if the accurate delineation of the transaction determines that the parties share the assumption of not only market risk, which affects the volume of sales and prices charged, but also risks associated with producing or otherwise acquiring goods and services, which affect the level of gross profit, it would be most appropriate to use gross profits as the basis of the split. In such a scenario, the parties may have integrated or joint functions and assets relating to the production or acquisition of goods and services. If the accurate delineation of the transaction determines that the parties share the assumption of, in addition to market and production risks, a further range of risks that affect the level of operating expenses that may include investment in intangibles, it would be most appropriate to use operating profits as the basis of the split. In this scenario, the parties may have integrated or joint functions relating to the entire value chain ...

Most commonly, the relevant profits to be split under the transactional profit split method are operating profits. Applying the transactional profit split method in this manner ensures that both income and expenses of the MNE are attributed to the relevant associated enterprise on a consistent basis. However, depending on the accurate delineation of the transaction, it may be appropriate to split a different measure of profits such as gross profits, and then deduct the expenses incurred by or attributable to each relevant enterprise (excluding expenses already taken into account). In such cases, care must be taken to ensure that the expenses incurred by or attributable to each enterprise are consistent with the accurate delineation of the transaction, particularly the activities and risks undertaken by each party, and that the allocation of profits is likewise consistent with the contributions of the parties ...

In any application of a transactional profit split, care should be exercised to ensure that the method is applied without hindsight. See paragraph 3.74. That is, irrespective of whether a transactional profit split of anticipated or actual profits is used, unless there are major unforeseen developments which would have resulted in a renegotiation of the agreement had it occurred between independent parties, the basis upon which those profits are to be split between the associated enterprises, including the profit splitting factors, the way in which relevant profits are calculated, and any adjustments or contingencies, must be determined on the basis of information known or reasonably foreseeable by the parties at the time the transactions were entered into. This is so notwithstanding the fact that in many cases, the actual calculations can necessarily only be performed some time afterwards, where, for example they apply profit splitting factors determined at the outset to the actual profits. Additionally, it should be remembered that the starting point in the accurate delineation of any transaction will generally be the written contracts which may reflect the intention of the parties at the time the contract was concluded. See paragraph 1.42 ...

Alternatively, if the transactional profit split is found to be the most appropriate method (e.g. because each party to the transaction makes unique and valuable contributions) but one of the parties does not share in the assumption of the economically significant risks which might play out after entering into the transaction, a split of anticipated profits would be more appropriate. See scenario 1 of Example 13 in Annex II to Chapter II of this guidance ...

Where the transactional profit split method is found to be the most appropriate, the splitting of actual profits, i.e. profits which have been affected by the playing out of economically significant risks, would only be appropriate where the accurate delineation of the transaction shows that the parties either share the assumption of the same economically significant risks associated with the business opportunity or separately assume closely related, economically significant risks associated with the business opportunity and consequently should share in the resulting profits or losses. These kinds of risk assumption may occur in scenarios where the business operations are highly integrated and/or each party makes unique and valuable contributions ...

The determination of the profits to be split, including whether those profits are actual profits or anticipated profits, or some combination thereof, should be aligned with the accurately delineated transaction. Example 13 in Annex II to Chapter II illustrates the principles of this section ...

However, except in circumstances where the total activities of each of the parties are the subject of the profit split, the financial data will need to be segregated and allocations made in accordance with the accurately delineated transaction(s) so that the profits relating to the combined contributions made by the parties are identified. For example, a product supplier in a profit split with an associated enterprise engaged in European marketing and distribution would need to identify the profits arising from its production of goods for the European market, and exclude the profits arising from the production of goods for other markets. The exercise may be relatively simple if the same goods are supplied to all markets, but will be more complex if different goods with different production costs or with different embedded technology, for example, are supplied to different markets. Similarly, if the associated enterprise engaged in European marketing and distribution buys products from other sources, it will need to segregate its financial data in a way that reflects the revenues, costs, and profits relating to the goods purchased from the associated product supplier in the profit split. Experience suggests that this initial stage in performing a profit split can in some circumstances be extremely complex, and the method of identifying the profits relevant to the transaction and any assumptions made in doing so need to be documented ...

Financial accounting may provide the starting point for determining the profit to be split in the absence of harmonised tax accounting standards. The use of other financial data (e.g. cost accounting) should be permitted where such accounts exist, are reliable, auditable and sufficiently transactional. In this context, product-line income statements or divisional accounts may prove to be the most useful accounting records ...

The relevant profits to be split under the transactional profit split method are those of the associated enterprises arising as a result of the controlled transactions under review. It is essential to identify the level of aggregation, see paragraphs 3.9-3.12. In determining the relevant profits, it is therefore essential to first identify and accurately delineate the transactions to be covered by the transactional profit split method, and from this identify the relevant income and expense amounts for each party in relation to those transactions. See section C.4.2, below. Example 12 in Annex II to Chapter II of these Guidelines illustrates the principles of this section ...

Example 11 in Annex II to Chapter II illustrates the application of a residual analysis under a transactional profit split method ...

Where the contributions of the parties are such that some can be reliably valued by reference to a one-sided method and benchmarked using comparables, while others cannot, the application of a residual analysis may be appropriate. A residual analysis divides the relevant profits from the controlled transactions under examination into two categories. In the first category are profits attributable to contributions which can be reliably benchmarked: typically less complex contributions for which reliable comparables can be found. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of the residual profit among the parties will be based on the relative value of the second category of contributions of the parties in the same way as in the application of the contribution analysis outlined above and in accordance with the guidance as described in section C.5 ...

It can be difficult to determine the relative value of the contribution that each of the associated enterprises makes to the relevant profits, and the approach will depend on the facts and circumstances of each case. The determination might be made by comparing the nature and degree of each party’s contribution of differing types (for example, provision of services, development expenses incurred, assets used or contributed, capital invested) and assigning a percentage based upon the relative comparison and external market data. See section C.5 for a discussion of how to split the relevant profits ...

Under a contribution analysis, the relevant profits, which are the total profits from the controlled transactions under examination, are divided between the associated enterprises in order to arrive at a reasonable approximation of the division that independent enterprises would have achieved from engaging in comparable transactions. This division can be supported by comparables data where available. In the absence thereof, it should be based on the relative value of the contributions by each of the associated enterprises participating in the controlled transactions, determined using information internal to the MNE group, as a proxy for the division that independent enterprises would have achieved (see section C.5.2). In cases where the relative value of the contributions can be measured, it may not be necessary to estimate the actual market value of each party’s contributions ...

There are a number of approaches to the application of the transactional profit split method, depending on the characteristics of the controlled transactions, and the information available. As has been described above, the method seeks to split the relevant profits from controlled transactions on an economically valid basis, in order to approximate the results that would have been achieved between independent enterprises in comparable circumstances. This may be done by considering the relative contributions of each party (a “contribution analysis”). Where the transactional profit split method is the most appropriate method but at least one party also makes some less complex contributions which are capable of being benchmarked by reference to comparable, uncontrolled transactions, a two-stage “residual analysis” may be appropriate ...

In addition, If the transactional profit split method is used to set transfer pricing in controlled transactions at the outset, it would be reasonable to expect the life-time of the arrangement and the criteria or profit splitting factors to be agreed in advance of the transaction, The person using the transactional profit split method (taxpayer or tax administration) should be prepared to explain why it is regarded as the most appropriate method in the circumstances of the case, as well as the way it is implemented, and in particular the criteria or profit splitting factors used to split the relevant profits, and The determination of the relevant profits to be split and of the profit splitting factors should generally be used consistently over the life-time of the arrangement, including during loss years, unless the rationale for using differing relevant profits or profit splitting factors over time is supported by the facts and circumstances and is documented ...

Under the transactional profit split method, the relevant profits are to be split between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. In general, the determination of the relevant profits to be split and of the profit splitting factors should: Be consistent with the functional analysis of the controlled transaction under review, and in particular reflect the assumption of the economically significant risks by the parties, and Be capable of being measured in a reliable manner ...

These Guidelines do not seek to provide an exhaustive catalogue of ways in which the transactional profit split method may be applied. Application of the method will depend on the facts and circumstances of the case and the information available, but the overriding objective should be to approximate as closely as possible the split of profits that would have been realised had the parties been independent enterprises ...

This section has described certain characteristics of the transactional profit split method and provided a number of potential indicators as to when it may be found to be the most appropriate method, as well as a number of factors which may point in the opposite direction. The guidance in this regard does not seek to be comprehensive, nor is it prescriptive. The presence or absence of one or more of the indicators described in this section will not necessarily lead to the conclusion that the transactional profit split will (or will not) be the most appropriate method in a particular case. Each case needs to be analysed on its own facts, and it will be important to consider the relative merits and shortcomings of available transfer pricing methods ...

While the transactional profit split method can be applied in cases where there are no uncontrolled comparables, information from transactions between independent parties may still be relevant to the application of the method, for example to guide the splitting of relevant profits (see section C.3.1.1), or where a residual analysis approach is used (see section C.3.1.2) ...

In general, it will tend to be the case that the presence of factors indicating that a transactional profit split is the most appropriate method will correspond to an absence of factors indicating that an alternative transfer pricing method—one which relies entirely on comparables—is the most appropriate method, determined in accordance with paragraph 2.2 of these Guidelines. Put another way, if information on reliable comparable uncontrolled transactions is available to price the transaction in its entirety, it is less likely that the transactional profit split method will be the most appropriate method. However, a lack of comparables alone is insufficient to warrant the use of a transactional profit split. See paragraph 2.128 ...

If each party shares the assumption of economically significant risks or separately assumes inter-related, economically significant risks, and a transactional profit split is considered to be the most appropriate method, it is likely that a split of actual profits, rather than anticipated profits, will be warranted since those actual profits, i.e. the actual relevant profits to be split, will reflect the playing out of the risks of each party. Conversely, a profit split of anticipated profits will tend to concentrate the playing out of economically significant risks on one party. That is, the transfer pricing outcome—a sharing of actual or anticipated profits—should align with the accurate delineation of the transaction. See section C.4.1 below on splits of actual and anticipated profits ...

The relevance of this factor as an indicator for the transactional profit split method will depend in large measure on the extent to which the risks concerned are economically significant such that a share of relevant profits would be warranted for each party. The economic significance of the risks should be analysed in relation to their importance to the actual or anticipated relevant profits from the controlled transaction(s), rather than in respect of their importance to any one of the associated enterprises whose business operations may extend beyond those covered by the relevant profits ...

A transactional profit split may also be found to be the most appropriate method where, according to the accurately delineated transaction, the various economically significant risks in relation to the transaction are separately assumed by the parties, but those risks are so closely inter-related and/or correlated that the playing out of the risks of each party cannot reliably be isolated. See Example 10 in Annex II to Chapter II ...

A transactional profit split may be found to be the most appropriate method where, according to the accurately delineated transaction, each party to the controlled transaction shares the assumption of one or more of the economically significant risks in relation to that transaction (see paragraph 1.95) ...

Where the contributions are highly inter-related or inter-dependent upon each other, the evaluation of the respective contributions of the parties may need to be done holistically. That is, a high degree of integration may also affect whether contributions by the enterprises are considered to be unique and valuable. For instance, a unique contribution by one party may have a significantly greater value when considered in combination with the particular unique contribution of the other party. Paragraphs 6.93–6.94 discuss this issue in relation to the combination of intangibles. See also Example 9 in Annex II to Chapter II ...

Where a party contributes to the control of economically significant risk, but that risk is assumed by the other party to the transaction, this may, in some cases, demonstrate that it is appropriate for the first party to share in the potential upside and downside associated with that risk, commensurate with its contribution to control. See paragraph 1.105. However, the mere fact that an entity performs control functions in relation to a risk will not necessarily lead to the conclusion that the transactional profit split is the most appropriate method in the case ...

Where business operations are highly integrated, the extent to which the parties share the assumption of the same economically significant risks or separately assume closely related economically significant risks will be relevant to the determination of the most appropriate method and, if a transactional profit split is considered the most appropriate method, how it should be applied; in particular whether a split of actual profits or of anticipated profits should be used. See section C.4.1 ...

Another example may be where the integration between the parties takes the form of a high degree of inter-dependency. For instance, profit split approaches may be used by independent enterprises engaged in long-term arrangements where each party has made a significant contribution (e.g. of an asset) whose value depends on the counterparty to the arrangement. In these kinds of cases, where each party makes such a contribution, and is dependent on the other party (or where the value of the contribution(s) of one party depends to a significant degree on the contribution(s) of the other party), some form of flexible pricing that takes into account, and varies with, the outcome of the risks assumed by each party arising from its dependence on the other party may be observed ...

In some cases the parties may perform functions jointly, use assets jointly and/or share assumption of risks to such an extent that it is impossible to evaluate their respective contributions in isolation from those of others. As an example, the transactional profit split method can be applied to the global trading of financial instruments by associated enterprises. See in Part III, Section C of the Report on the Attribution of Profits to Permanent Establishments. (See the Report on the Attribution of Profits to Permanent Establishments (OECD, 2010) ...

Although most MNE groups are integrated to some extent, a particularly high degree of integration in certain business operations is an indicator for the consideration of the transactional profit split method. A high degree of integration means that the way in which one party to the transaction performs functions, uses assets and assumes risks is interlinked with, and cannot reliably be evaluated in isolation from, the way in which another party to the transaction performs functions, uses assets and assumes risks. In contrast, many instances of integration within an MNE result in situations in which the contribution of at least one party to the transaction can in fact be reliably evaluated by reference to comparable uncontrolled transactions. For example, where complementary but discrete activities are undertaken by the entities, it may be the case that it is possible to find reliable comparables since the functions, assets and risks involved in each discrete stage may be comparable to those in uncontrolled arrangements. This needs to be borne in mind in considering which transfer pricing method is the most appropriate in a particular case. Examples 6, and in Annex II to Chapter II illustrate the principles of this section ...