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, , and 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 transactions. 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 ...

Guidance on how to determine whether the transactional profit split method is likely to be the most appropriate method is set out below, including the identification of certain features of a transaction which may be relevant. However it is important to note that there is no prescriptive rule for establishing when a particular transfer pricing method is the most appropriate method ...

As is noted in paragraph 2.2, the selection of a transfer pricing method always aims at finding the most appropriate method for a particular case, taking into account the respective strengths and weaknesses of each method, its appropriateness in view of the nature of the accurately delineated controlled transaction, the availability of reliable information (in particular on uncontrolled comparables) needed for application, and the degree of comparability between the controlled and uncontrolled transactions. See also paragraphs 2.4 to 2.7 ...

References to “profits” in this section should generally be taken as applying equally to losses. That is, where a transactional profit split method is determined to be the most appropriate method, it should generally also apply, and apply in the same way, regardless of whether the transaction(s) result in a relevant profit or loss. Asymmetrical splits of profits and losses (i.e. where the parties apply different considerations depending on the results of the transaction) might be arm’s length, but should be used with caution and appropriately documented ...

The transactional profit split method seeks to establish arm’s length outcomes or test reported outcomes for controlled transactions in order to approximate the results that would have been achieved between independent enterprises engaging in a comparable transaction or transactions. The method first identifies the profits to be split from the controlled transactions—the relevant profits—and then splits them between the associated enterprises on an economically valid basis that approximates the division of profits that would have been agreed at arm’s length. As is the case with all transfer pricing methods, the aim is to ensure that profits of the associated enterprises are aligned with the value of their contributions and the compensation which would have been agreed in comparable transactions between independent enterprises for those contributions. The transactional profit split method is particularly useful when the compensation to the associated enterprises can be more reliably valued by reference to the relative shares of their contributions to the profits arising in relation to the transaction(s) than by a more direct estimation of the value of those contributions ...

CF (Pvt) Ltd’s main business was import, distribution and marketing of motor vehicles and spare parts of a specified brand. Following an audit CF had been issued a tax assessment related to the transfer pricing and VAT – import prices, management fees, audit costs etc. Judgement of the High Court The High Court issued a decision predominantly in favor of the tax authorities. In its judgement, the court stated that either the general deduction provision under section 15 (2) or section 24 or section 98 of the Income Tax Act could be employed to deal with transfer pricing matters. Excerpts: “It seems to me that the unsupported persistent assertions maintained by the appellant even after the concession of 14 November 2014 were indicative of both corporate moral dishonesty and a lack of good faith. I therefore find that the appellant through the mind of its management evinced the intention to evade the payment of the correct amount of tax as contemplated by s 46 (6) of the Income Tax Act by claiming the deduction of management fees paid to the intermediary, who was not entitled to such fees. The Court or the Commissioner have no option but to impose a 100% penalty. The penalty imposed by the Commissioner is accordingly confirmed.” “It seems to me that the Commissioner may very well have been justified in invoking the provisions of s 24 of the Income Tax Act by the acts of commission and omission of the appellant in respect of both management fees and goods in transit at the time he did. However, in accordance with the provisions of s 65 (12) of the Income Tax Act I did not find the claim of the Commissioner unreasonable even in respect of the interest issue that the Commissioner conceded at the eleventh hour or the grounds of appeal frivolous. I will therefore make no order of costs against either party other than that each party is to bear its own costs. Disposal Accordingly, it is ordered that: 1. The amended assessments number 20211442 for the year ending 31 December 2009, 20211443 for the year ending 31 December 2010, 202211446 for the year ending 31 December 2011 and 20211448 for the year ending 31 December 2012 that were issued against the appellant by the respondent on 27 June 2014 are hereby set aside. 2. The Commissioner is directed to issue further amended assessments against the appellant in respect of each year of assessment in compliance with this judgment and in doing so shall: a. Add back to income 7% interest on the cost of services rendered by the appellant for the consignment stock in transit to Zambia, Malawi and Tanzania in the sum of US$2 240 for 2009, US$ 2 505.87 for 2010, US$ 2 198.13 for 2011 and US$3 273.20 for 2012 tax years, respectively. b. Add back to income management fees that were deducted by the appellant in each year in the sum of US$130 000 for 2009, US$140 000 for 2010, US$ 256 629 for 2011 and US$ 140 000 for 2012 tax year, respectively. c. Bring to income the provisions for leave pay in the sum of US$10 000 for 2009, US$ 9 960 for 2010, US$2 049 for 2011 and US$ 491 for 2012 tax year. d. Bring to income provisions for audit fees in the sum of US$ 10 199.17 for 2009, US$12 372 for 2010, US$10 575 for 2011 and US$ 1 260 for the 2012 tax year, respectively. e. Discharge the notional interest he sought to impose on loans and advances made to ADI and GS, respectively. 3. The appellant is to pay 100% additional tax on management fees, 4. The appellant shall pay additional penalties of 10% in respect of leave pay and audit fee provisions. 5. The tax amnesty application is dismissed. 6. Each party shall bear its own costs.” Click here for other translation 2018-zwhhc-99 ...

In this case a Japanese company had entered into a series of controlled transactions with foreing group companies granting services and licences to use intangibles – know-how related to manufacturing and sales, training, and provided support by sending over technical experts. The company had used a CUP method to price these transactions based on select “internal comparables”. Tax authorities disagreed with the company and found that the residual profit split method should be applied to price the transactions. 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. The foreign related-party transactions were compared – as a whole – to the comparable transactions selected by the company and the court found that the product lines, how to use them and frequency of dispatching employees to support the foreing group company were not comparable. This could have resulted in differences the value of the intangibles and services provided. The court also found that the circumstances had been different in terms of the countries or areas where products were manufactured or sold and whether or not the license was exclusive or not. On 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 circumstances in which the transactions were took place. Therefore the CUP method was not the best method to price the controlled transactions. The court instead supported the application of the RPSM and ruled in favour of the tax authority. The taxpayer later appealed the decision to the Tokyo High Court ...

C Uyemura & Co, Ltd. is engaged in the business of 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 C Uyemura & Co, Ltd 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 2000 – 2004. C Uyemura & Co, Ltd disapproved of the assessment. The company 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 C Uyemura & Co, Ltd. and affirmed the assessment made by the Japanese tax authority. On 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 circumstances in which the transactions were took place. Therefore the CUP method was not the best method to price the controlled transactions. The Court recognised that C Uyemura & Co, Ltd had intangible assets created by its research and development activities. The Court also recognised that the Taiwanese, Malaysian and Singaporean 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 Tokyo 24 November 13090 ...

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 combined 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 combined profits, appropriately allocable expenses, and the reliability of factors used to divide combined 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 2.115). 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 at 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 combined 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 ...

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 ...

B.3. METHODS B .3 .1 .       Introduction to Transfer Pricing Methods B.3.1.1.                         This part of the chapter describes several transfer pricing methods that can be used to determine an arm’s length price and describes how to apply these methods in practice. Transfer pricing methods (or “methodologies”) are used to calculate or test the arm’s length nature of prices or profits. Transfer pricing methods are ways of establishing arm’s length prices or profits from transactions between associated enterprises. The transaction between related enterprises for which an arm’s length price is to be established is referred to as the “controlled transaction”. The application of transfer pricing methods helps assure that transactions conform to the arm’s length standard. It is important to note that although the term “profit margin” is used, companies may also have legitimate reasons to report losses at arm’s length. Furthermore, transfer pricing methods are not determinative in and of themselves. If an associated enterprise reports an arm’s length amount of income, without the explicit use of one of the recognized transfer pricing methods, this does not mean that its pricing should automatically be regarded as not being at arm’s length and there may be no reason to impose adjustments. B.3.1.2.           Selection of Methods (How, Why and Use of Methods) B.3.1.2.1.            The selection of a transfer pricing method serves to find the most appropriate method for a particular case. Considerations involved in selecting a method can include: the respective strengths and weaknesses of each method; the nature of the controlled transaction; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method; and the degree of comparability between the controlled and uncontrolled transactions. B.3.1.2.2.            The starting point in selecting a method is an understanding of the controlled transaction (inbound or outbound), in particular based on the functional analysis which is necessary regardless of which transfer pricing method is selected. The functional analysis is a major part of selecting the transfer pricing method as it helps: To identify and understand the intra-group transactions; To identify the characteristics that would make a particular transaction or function suitable for use as a comparable; To determine any necessary adjustments to the comparables; To check the relative reliability of the method selected; and Over time, to determine if modification of the method is appropriate because the transaction, function, allocation of risks or allocation of assets have been modified. B.3.1.2.3.            The major components of a functional analysis are analyzes of the functions, assets and risks. The functional analysis is described and discussed in detail in Chapter B.2, at Paragraph B.2.3.2.7. Appendix I provides examples of a functional analysis for a manufacturing business and a distribution business. A summary is provided here for context in the case of selection of appropriate methods. B.3.1.2.4.            The functions performed: The functional analysis describes the activities performed such as design, purchasing, inbound logistics, manufacturing, research and development (R&D), assembling, inventory management, outbound logistics, marketing and sales activities, after sale services, supporting activities, services, advertising, financing and management, etc. The functional analysis must specify which party performs each activity and in case both parties are involved in performing an activity it should provide for the relevant differences; for example if both have inventories but Company A holds inventories for a period of up to two years whereas Company B holds inventories for a period of one month. The activities that add most value must be identified and should be discussed in more detail. B.3.1.2.5.            The risks undertaken: The functional analysis should identify risks undertaken. Examples are: financial risk (currency, interest rate, funding risks etc.) credit and collection risk (trading credit risk, commercial credit risk), operational risk (systems failure risk), commodity price risk, inventory risk and carrying costs, R&D risk, environmental and other regulatory risks, market risk (country political risk, reliability of customers, fluctuation in demand and prices) and product risk (product liability risk, warranty risk and costs and contract enforceability). A risk-bearing party would expect to have higher earnings than a non-risk bearing party, and will incur the expenses and perhaps related loss if and when risk materializes. B.3.1.2.6.  The assets used or contributed: The functional analysis must identify and distinguish between tangible and intangible assets. Tangible assets such as property, plant and equipment have to be financed and an investment in such capital assets would usually be expected to earn a long term return based on the use and risk level  of the investment. Intangible assets are very important as substantial competitive advantage is often achieved by the use of intangible assets. Some intangibles have legal protection (e.g. patents, trademarks, trade names) but other intangibles with less legal protection may be equally important and valuable (e.g. know-how, trade secrets, marketing intangibles, etc.). B.3.1.2.7.            Interplay of above factors: Today, in a multinational group, operations tend to be more integrated across jurisdictional boundaries and the functions, risks and assets are often shared between entities in different jurisdictions. This makes functional analyzes both more difficult and more necessary. The functional analysis can help identify which functions, risks and assets are attributable to the various related parties. For example, the functional analysis may reveal that one company performs one particular function but the cost of this  is borne by the other party to the transaction. The functional analysis could highlight that situation and consider the legal allocation of risk and the economic substance of the transaction. Another example would be where a company performs one particular function and bears the cost thereof but the benefit also accrues to the other party to the transaction. The functional analysis could emphasize that situation and consider which party bears the risk in legal terms and which party bears the risk according to the economic substance of the transaction. The functional analysis typically includes a discussion of the industry in which the tested party operates, the contractual terms of the transaction at issue, the economic circumstances of the parties and the business strategies they employ. The functional analysis helps to identify ...

A Japanese distributor “Banana Corp” imported Ecuadorian bananas from a group company for wholesale in Japan. The Japanese tax administration ruled that the amount of consideration paid by Japanese distributor had exceeded the arm’s length price and issued an assessment of additional tax and penalties for FY 1999 – 2004. At first Banana Corp brought the case before the regional court who decision in favour of the tax administration. Banana Corp appealed this decision to Tokyo High Court. Tokyo High Court dismissed the appeal and upheld the decision of the regional court. Click here for English Translation Click here for other translation Ban-Co-2013-084405_hanrei ...

Annex III to Chapter II Illustration of Different Measures of Profits When Applying a Transactional Profit Split Method [See Chapter II, Part III, Section C of these Guidelines for general guidance on the application of the transactional profit split method. The assumptions about arm’s length arrangements in the following examples are intended for illustrative purposes only and should not be taken as prescribing adjustments and arm’s length arrangements in actual cases of particular industries. While they seek to demonstrate the principles of the sections of the Guidelines to which they refer, those principles must be applied in each case according to the specific facts and circumstances of that case. Furthermore, the comments below relate to the application of a transactional profit split method in the situations where, given the facts and circumstances of the case and in particular the comparability (including functional) analysis of the transaction and the review of the information available on uncontrolled comparables, such a method is found to be the most appropriate method to be used.] Below are some illustrations of the effect of choosing a measure of profits to determine the combined profits to be split when applying a transactional profit split method. Assume A and B are two associated enterprises situated in two different tax jurisdictions. Both manufacture the same widgets and incur expenditure that results in the creation of an intangible asset which they can mutually use. For the purpose of this example, it is assumed that the nature of this particular asset is such that the value of the asset contribution attributable to each of A and B in the year in question is proportional to A and B’s relative expenditure on the asset in that year. (It should be noted that this assumption will not always be true in practice. This is because there may be cases where the relative values of asset contributions attributable to each party would be based on accumulated expenditure from the prior, as well as current years.) Assume A and B exclusively sell products to third parties. Assume that it is determined that the most appropriate method to be used is a residual profit split method, that the manufacturing activities of A and B are simple, non-unique transactions that should be allocated an initial return of 10% of the Cost of Goods Sold and that the residual profit should be split in proportion to A’s and B’s intangible asset expenditure. The following figures are for illustration only: Step one: determining the initial return for the non-unique manufacturing transactions (Cost of Goods Sold + 10% in this example) Step two: determining the residual profit to be split a) In case it is determined as the operating profit: 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 combined profits to be split): As shown in the above example, excluding some specific items from the determination of the combined 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 comparability (including functional) analysis of the transaction. As another example, in some cases it may be appropriate to back out a category of expenses to the extent that the allocation key used in the residual profit split analysis relies on those expenses. For example, in cases where relative expenditure contributing to the development of an intangible asset is determined to be the most appropriate profit split factor, residual profits can be based on operating profits before that expenditure. After determining the split of residual profits, each associated enterprise then subtracts its own expenditure. This can be illustrated as follows. Assume the facts are the same as in the example at paragraph 2 above and assume the overhead expenses are not excluded from the determination of the residual profit to be split. Step one: determining the basic return for the manufacturing activities (Cost of Goods Sold + 10% in this example) Same as at paragraph 3. Step two: determining the residual profit to be split a) In case it is determined as the operating profit after intangible asset expenditure: Same as at paragraph 4, case a) b) In case it is determined as the operating profit before intangible asset expenditure: i.e. A and B are allocated the same profits as in the case where the profit to be split is determined as the operating profit after intangible asset expenditure, see case a) above. This example illustrates the fact that, when the allocation key used to split the residual profit relies on a category of expenses incurred during the period, it is indifferent whether the residual profit to be split is determined before said expenses and the expenses are deducted by each party, or whether the residual profit to be split is determined after said expenses. The outcome can however be different in the case where the split factor is based on the accumulated expenditure of the prior as well as current years (see paragraph 2 above) ...

In all cases, caution must be used to determine whether a transactional profit method as applied to a particular aspect of a case can produce an arm’s length answer, either in conjunction with a traditional transaction method or on its own. The question ultimately can be resolved only on a case-by-case basis taking into account the strengths and weaknesses set forth above for a particular transactional profit method to be applied, the comparability (including functional) analysis of the parties to the transaction, and the availability and reliability of comparable data. In addition, these conclusions assume that countries will have a certain degree of sophistication in their underlying tax systems before applying these methods ...

The recognition that the use of transactional profit methods may be necessary is not intended to suggest that independent enterprises would use these methods to set prices. As with any method, it is important that it be possible to calculate appropriate corresponding adjustments when transactional profit methods are used, recognising that in certain cases corresponding adjustments may be determined on an aggregate basis consistent with the aggregation principles in paragraphs 3.9-3.12 ...

As discussed in these Guidelines, there are concerns regarding the use of the transactional net margin method, in particular that it is sometimes applied without adequately taking into account the relevant differences between the controlled and uncontrolled transactions being compared. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the transactional net margin method. Thus, where differences in the characteristics of the transactions being compared have a material effect on the net profit indicators being used, it would not be appropriate to apply the transactional net margin method without making adjustments for such differences. See paragraphs 2.68-2.75 (the comparability standard to be applied to the transactional net margin method) ...

Paragraphs 2.1-2.11 provide guidance on the selection of the most appropriate transfer pricing method to the circumstances of the case ...

One possible approach not discussed above is to split the combined profits so that each of the associated enterprises participating in the controlled transactions earns the same rate of return on the capital it employs in that transaction. This method assumes that each participant’s capital investment in the transaction is subject to a similar level of risk, so that one might expect the participants to earn similar rates of return if they were operating in the open market. However, this assumption may not be realistic. For example, it would not account for conditions in capital markets and could ignore other relevant aspects that would be revealed by a functional analysis and that should be taken into account in a transactional profit split ...

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 valuable intangibles and the assumption of significant risks and the importance, relevance and measurement of the factors which gave rise to these valuable intangibles and significant risks ...

Internal data may also be helpful where the allocation key is based on a cost accounting system, e.g. headcounts involved in some aspects of the transaction, time spent by a certain group of employees on certain tasks, number of servers, data storage, floor area of retail points, etc ...

For instance, where an asset-based allocation key 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 a “transactional” balance sheet that will be used for the application of the transactional profit split method. Similarly, where cost-based allocation keys are used that are based on data extracted from the taxpayers’ profit and loss accounts, it may be necessary to draw 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 allocation key. 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. See also paragraph 2.98 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 allocation key is used ...

Where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the combined 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 2.116-2.117 and 2.132. They will frequently be extracted from the taxpayers’ cost accounting or financial accounting ...

Another important issue is the determination of the relevant period of time from which the elements of determination of the allocation key (e.g. assets, costs, or others) should be taken into account. A difficulty arises because there can be a time 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 allocation key, 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 amortization, 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 paragraphs 2.116-2.117 above, the selection of the allocation key 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 ...

Cost-based allocation keys have the advantage of simplicity. It is however not always the case that a strong correlation exists between relative expenses and relative value, as discussed in paragraph 6.27. One possible issue with cost-based allocation keys is that they can be very sensitive to 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 allocation key and to determine the allocation key consistently among the parties ...

An allocation key based on expenses may be appropriate where it is possible to identify a strong correlation between relative expenses incurred and relative value added. For example, marketing expenses may be an appropriate key for distributors-marketers if advertising generates material 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 significant trade intangibles such as patents. However, if, for instance, each party contributes different valuable intangibles, then it is not appropriate to use a cost-based allocation key unless cost is a reliable measure of the relative value of those intangibles. Remuneration is frequently used in situations where people functions are the primary factor in generating the combined profits ...

One particular circumstance where the transactional profit split method may be found to be the most appropriate method is the case where each party to the transaction contributes valuable, unique intangibles. Intangible assets pose difficult issues in relation both to their identification and to their valuation. Identification of intangibles can be difficult because not all valuable intangible assets are legally protected and registered and not all valuable intangible assets are recorded in the accounts. An essential part of a transactional profit split analysis is to identify what intangible assets are contributed by each associated enterprise to the controlled transaction and their relative value. Guidance on intangible property is found at Chapter VI of these Guidelines. See also the examples in the Annex to Chapter VI “Examples to illustrate the Transfer Pricing Guidelines on intangible property and highly uncertain valuation” ...

Asset-based or capital-based allocation keys can be used where there is a strong correlation between tangible or intangible assets or capital employed and creation of value in the context of the controlled transaction. See paragraph 2.145 for a brief discussion of splitting the combined profits by reference to capital employed. In order for an allocation key to be meaningful, it should be applied consistently to all the parties to the transaction. See paragraph 2.98 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 ...

In practice, allocation keys based on assets/capital (operating assets, fixed assets, intangible assets, capital employed) or costs (relative spending and/or investment in key areas such as research and development, engineering, marketing) are often used. Other allocation keys based for instance on incremental sales, headcounts (number of individuals involved in the key functions that generate value to the transaction), time spent by a certain group of employees if there is a strong correlation between the time spent and the creation of the combined profits, number of servers, data storage, floor area of retail points, etc. may be appropriate depending on the facts and circumstances of the transactions ...

In practice, the division of the combined profits under a transactional profit split method is generally achieved using one or more allocation keys. Depending on the facts and circumstances of the case, the allocation key 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 expenditure or other possible keys as discussed below). Where more than one allocation key is used, it will also be necessary to weight the allocation keys used to determine the relative contribution that each allocation key represents to the earning of the combined profits ...

One possible approach is to split the combined profits based on the division of profits that actually results from 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 ...

“The relevance of comparable uncontrolled transactions or internal data 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 allocation keys. See paragraphs 2.115-2.117 for general guidance on the consistency of the determination of the splitting factors. In addition, the criteria or allocation keys used to split the profit should: • Be reasonably 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), and • Be supported by comparables data, internal data, or both.” ...

Generally, the combined profits to be split in a transactional profit split method are operating profits. Applying the transactional profit split in this manner ensures that both income and expenses of the MNE are attributed to the relevant associated enterprise on a consistent basis. However, occasionally, it may be appropriate to carry out a split of gross profits and then deduct the expenses incurred in or attributable to each relevant enterprise (and excluding expenses taken into account in computing gross profits). In such cases, where different analyses are being applied to divide the gross income and the deductions of the MNE among associated enterprises, care must be taken to ensure that the expenses incurred in or attributable to each enterprise are consistent with the activities and risks undertaken there, and that the allocation of gross profits is likewise consistent with the placement of activities and risks. For example, in the case of an MNE that engages in highly integrated worldwide trading operations, involving various types of property, it may be possible to determine the enterprises in which expenses are incurred (or attributed), but not to accurately determine the particular trading activities to which those expenses relate. In such a case, it may be appropriate to split the gross profits from each trading activity and then deduct from the resulting overall gross profits the expenses incurred in or attributable to each enterprise, bearing in mind the caution noted above ...

Where the associated enterprises have determined the conditions in their controlled transactions on a basis other than the transactional profit split method, the tax administration would evaluate such conditions on the basis of the actual profit experience of the enterprise. However, care would need to be exercised to ensure that the application of a transactional profit split method is performed in a context that is similar to what the associated enterprises would have experienced, i.e. on the basis of information known or reasonably foreseeable by the associated enterprises at the time the transactions were entered into, in order to avoid the use of hindsight. See paragraphs 2.11 and 3.74 ...

In using the transactional profit split method to establish the conditions of controlled transactions, the associated enterprises would seek to achieve the division of profit that independent enterprises would have realized. The evaluation of the conditions of the controlled transactions of associated enterprises using a transactional profit split method will be easiest for a tax administration where the associated enterprises have originally determined such conditions on the same basis. The evaluation may then begin on the same basis to verify whether the division of actual profits is in accordance with the arm’s length principle ...

When a tax administration examines the application of the method used ex ante to evaluate whether the method has reliably approximated arm’s length transfer pricing, it is critical for the tax administration to acknowledge that the taxpayer could not have known what the actual profit experience of the business activity would be at the time that the conditions of the controlled transaction were established. Without such an acknowledgement, the application of the transactional profit split method could penalize or reward a taxpayer by focusing on circumstances that the taxpayer could not reasonably have foreseen. Such an application would be contrary to the arm’s length principle, because independent enterprises in similar circumstances could only have relied upon projections and could not have known the actual profit experience. See also paragraph 3.74 ...

If the profit split method were to be used by associated enterprises to set transfer pricing in controlled transactions (i.e. an ex ante approach), then each associated enterprise would seek to achieve the division of profits that independent enterprises would have expected to realize from engaging in comparable transactions. Depending on the facts and circumstances, profit splits using either actual or projected profits are observed in practice ...

Financial accounting may provide the starting point for determining the profit to be split in the absence of harmonized 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 ...

In order to determine the combined profits to be split, the accounts of the parties to the transaction to which a transactional profit split is applied need to be put on a common basis as to accounting practice and currency, and then combined. Because accounting standards can have significant effects on the determination of the profits to be split, accounting standards should be selected in advance of applying the method and applied consistently over the lifetime of the arrangement. See paragraphs 2.115-2.117 for general guidance on the consistency of the determination of the combined profits to be split ...

The combined profits to be split in a transactional profit split method are the profits of the associated enterprises from the controlled transactions in which the associated enterprises are engaged. The combined profits to be split should only be those arising from the controlled transaction(s) under review. In determining those profits, it is essential to first identify the relevant transactions to be covered by the transactional profit split. It is also essential to identify the level of aggregation, see paragraphs 3.9-3.12. Where a taxpayer has controlled transactions with more than one associated enterprise, it is also necessary to identify the parties in relation to those transactions and the profits to be split among them ...

In some cases an analysis could be performed, perhaps as part of a residual profit split or as a method of splitting profits in its own right, by taking into account the discounted cash flow to the parties to the controlled transactions over the anticipated life of the business. One of the situations in which this may be an effective method could be where a start-up is involved, cash flow projections were carried out as part of assessing the viability of the project, and capital investment and sales could be estimated with a reasonable degree of certainty. However, the reliability of such an approach will depend on the use of an appropriate discount rate, which should be based on market benchmarks. In this regard, it should be noted that industry- wide risk premiums used to calculate the discount do not distinguish between particular companies let alone segments of businesses, and estimates of the relative timing of receipts can be problematic. Such an approach, therefore, would require considerable caution and should be supplemented where possible by information derived from other methods ...

An alternative approach to how to apply a residual analysis could seek to replicate the outcome of bargaining between independent enterprises in the free market. In this context, in the first stage, the initial remuneration provided to each participant would correspond to the lowest price an independent seller reasonably would accept in the circumstances and the highest price that the buyer would be reasonably willing to pay. Any discrepancy between these two figures could result in the residual profit over which independent enterprises would bargain. In the second stage, the residual analysis therefore could divide this pool of profit based on an analysis of any factors relevant to the associated enterprises that would indicate how independent enterprises might have split the difference between the seller’s minimum price and the buyer’s maximum price ...

A residual analysis divides the combined profits from the controlled transactions under examination in two stages. In the first stage, each participant is allocated an arm’s length remuneration for its non-unique contributions in relation to the controlled transactions in which it is engaged. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method, by reference to the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by any unique and valuable contribution by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances, following the guidance as described at paragraphs 2.132-2.145 for splitting the combined profits. (An example illustrating the application of the residual profit split is found in Annex II to Chapter II.) ...

It can be difficult to determine the relative value of the contribution that each of the associated enterprises makes to the controlled transactions, and the approach will often 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, capital invested) and assigning a percentage based upon the relative comparison and external market data. See paragraphs 2.132-2.145 for a discussion of how to split the combined profits ...

Under a contribution analysis, the combined profits, which are the total profits from the controlled transactions under examination, would be divided between the associated enterprises based upon a reasonable approximation of the division of profits that independent enterprises would have expected to realize from engaging in comparable transactions. This division can be supported by comparables data where available. In the absence thereof, it is often based on the relative value of the functions performed by each of the associated enterprises participating in the controlled transactions, taking account of their assets used and risks assumed. In cases where the relative value of the contributions can be measured directly, it may not be necessary to estimate the actual market value of each participant’s contributions ...

There are a number of approaches for estimating the division of profits, based on either projected or actual profits, as may be appropriate, to which independent enterprises would have agreed, two of which are discussed in the following paragraphs. These approaches – contribution analysis and residual analysis – are not necessarily exhaustive or mutually exclusive ...

“2.117 In addition, • If a transactional profit split method is used to set transfer pricing in controlled transactions (ex ante approach), it would be reasonable to expect the life-time of the arrangement and the criteria or allocation keys to be agreed in advance of the transaction, • The person using a transactional profit split method (taxpayer or tax administration) should be prepared to explain why it is regarded as the most appropriate method to the circumstances of the case, as well as the way it is implemented, and in particular the criteria or allocation keys used to split the combined profits, and • The determination of the combined profits to be split and of the splitting factors should generally be used consistently over the life-time of the arrangement, including during loss years, unless independent parties in comparable circumstances would have agreed otherwise and the rationale for using differing criteria or allocation keys is documented, or if specific circumstances would have justified a re-negotiation between independent parties.” ...

Under the transactional profit split method, the combined 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 combined profits to be split and of the splitting factors should: • Be consistent with the functional analysis of the controlled transaction under review, and in particular reflect the allocation of risks among the parties, • Be consistent with the determination of the combined profits to be split and of the splitting factors which would have been agreed between independent parties, • Be consistent with the type of profit split approach (e.g. contribution analysis, residual analysis, or other; ex ante or ex post approach, as discussed at paragraphs 2.118-2.145 below), 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 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 ...

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 information from foreign affiliates. In addition, it may be difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions, which would 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 ...

A further strength of the transactional profit split method is that it is less likely that either party to the controlled transaction will be left with an extreme and improbable profit result, since both parties to the transaction are evaluated. This aspect can be particularly important when analysing the contributions by the parties in respect of the intangible property employed in the controlled transactions. This two-sided approach may also be used to achieve a division of the profits from economies of scale or other joint efficiencies that satisfies both the taxpayer and tax administrations ...

Another strength of the transactional profit split method is that it offers flexibility by taking into account specific, possibly unique, facts and circumstances of the associated enterprises that are not present in independent enterprises, while still constituting an arm’s length approach to the extent that it reflects what independent enterprises reasonably would have done if faced with the same circumstances ...

However, in those cases 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 division of functions (taking account of the assets used and risks assumed) between the associated enterprises themselves ...

Where comparables data are available, they can be relevant in the profit split analysis to support the division of profits that would have been achieved between independent parties in comparable circumstances. Comparables data can also be relevant in the profit split analysis to assess the value of the contributions that each associated enterprise makes to the transactions. In effect, the assumption is that independent parties would have split the combined profits in proportion to the value of their respective contributions to the generation of profit in the transaction. On the other hand, the external market data considered in valuing the contribution each associated enterprise makes to the controlled transactions will be less closely connected to those transactions than is the case with the other available methods ...

The main strength of the transactional profit split method is that it can offer a solution for highly integrated operations for which a one-sided method would not be appropriate. For example, see the discussion of the appropriateness and application of profit split methods to the global trading of financial instruments between associated enterprises in Part III, Section C of the Report on the Attribution of Profits to Permanent Establishments.2 A transactional profit split method may also be found to be the most appropriate method in cases where both parties to a transaction make unique and valuable contributions (e.g. contribute unique intangibles) to the transaction, because in such a case independent parties might wish to share the profits of the transaction in proportion to their respective contributions and a two-sided method might be more appropriate in these circumstances than a one-sided method. In addition, in the presence of unique and valuable contributions, reliable comparables information might be insufficient to apply another method. On the other hand, a transactional profit split method would ordinarily not be used in cases where one party to the transaction performs only simple functions and does not make any significant unique contribution (e.g. contract manufacturing or contract service activities in relevant circumstances), as in such cases a transactional profit split method typically would not be appropriate in view of the functional analysis of that party. See paragraphs 3.38-3.39 for a discussion of limitations in available comparables. (See Report on the Attribution of Profits to Permanent Establishments, approved by the Committee on Fiscal Affairs on 24 June 2008 and by the Council for publication on 17 July 2008 and the 2010 Sanitised Version of the Report on the Attribution of Profits to Permanent Establishments, approved by the Committee on Fiscal Affairs on 22 June 2010 and by the Council for publication on 22 July 2010.) ...

The transactional profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction (or in controlled transactions that are appropriate to aggregate under the principles of paragraphs 3.9-3.12) by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction or transactions. The transactional profit split method first identifies the profits to be split for the associated enterprises from the controlled transactions in which the associated enterprises are engaged (the “combined profits”). References to “profits” should be taken as applying equally to losses. See paragraphs 2.124-2.131 for a discussion of how to measure the profits to be split. It then splits those combined profits 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. See paragraphs 2.132–2.145 for a discussion of how to split the combined profits ...

The “Banana Group” is based in Ecuador and is engaged in the business of exporting Ecuadorian bananas. The Japanese distributor was part of the Banana Group. An Ecuadorian group company purchases bananas produced on plantations in Ecuador, exports and sells them to another intermediate group company, who in turn sells them to the Japanese distributor for wholesale in Japan. At issue was the arms length price of the bananas imported by the Japanese distributor. The tax administration held that the price paid for the bananas had been to high and issued an assessment for FY 1999-2004. The Japanese company disagreed and brought the case to court. Decision of the Court The Tokyo District court decided in favour of the tax administration and upheld the tax assessment. Click here for English translation Click here for other translation EB 082672_hanrei ...

Microsoft appealed an IRS ruling, which had disallowed the use of the profit-split method to recalculate Microsoft’s taxable income. In this decision, the United States Tax Court found in Microsoft’s favor, granting the motion for summary judgment. US-Microsoft_decision_02101998 ...

Another possibility is to determine the profit split based on the division of profits that actually results from comparable transactions among independent enterprises. In most cases where traditional transaction methods would not be used, it will be difficult to find independent enterprises engaged in transactions that are sufficiently comparable to use this approach as the primary method.Even where such transactions exist, adequate information on the independent enterprises might not be available to taxpayers and tax administrations. However, co-operative arrangements are not confined to associated enterprises, but also sometimes occur between independent enterprises. Independent enterprises may set up joint-venture-like arrangements because they want to carry out, for example, a specific research project. In such a situation, independent enterprises might come to an arrangement in which prices are corrected afterwards, for instance because the profitability is unpredictable and because they want to share the risks or the costs involved. Independent enterprises might choose to set up a real joint venture, and in such a case probably would agree to some form of profit split ...

One possible approach not discussed above is to split the combined profit so that each of the associated enterprises participating in the controlled transactions earns the same rate of return on the capital it employs in that transaction. This method assumes that each participant’s capital investment in the transaction is subject to a similar level of risk, so that one might expect the participants to earn similar rates of return if they were operating in the open market. However, this assumption may not be realistic. For example, it would not account for conditions in capital markets and could ignore other relevant aspects that would be revealed by a functional analysis and that should be taken into account in a profit split. Therefore, this method should be used with great care and, in any event, other profit split methods should be considered before electing its use ...

This Report does not seek to provide an exhaustive catalogue of ways in which the profit split method may be applied. Application of the method will depend on the 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 operating at arm’s length ...

In some cases an analysis could be performed, perhaps as part of a residual profit split or as a method of splitting profits in its own right, by taking into account the discounted cash flow to the parties to the controlled transactions over the anticipated life of the business. This may be an effective method in the following circumstances: where a start-up is involved, cash flow projections were carried out as part of assessing the viability of the project, and capital investment and sales could be estimated with a reasonable degree of certainty. However, the reliability of such an approach will depend on the use of an appropriate discount rate, which should be based on market benchmarks. In this regard, it should be noted that industry-wide risk premiums used to calculate the discount do not distinguish between particular companies let alone segments of businesses, and estimates of the relative timing of receipts can be problematic. Such an approach, therefore, would require considerable caution and should be supplemented where possible by information derived from other methods ...

One approach to a residual analysis would seek to replicate the outcome of bargaining between independent enterprises in the free market. In this context, the basic return provided to each participant would correspond to the lowest price an independent seller reasonably would accept in the circumstances and the highest price that the buyer would be reasonably willing to pay. Any discrepancy between these two figures could result in the residual profit over which independent enterprises would bargain. The residual analysis therefore could divide this pool of profit based on an analysis of any factors relevant to the associated enterprises that would indicate how independent enterprises might have split the difference between the seller’s minimum price and the buyer’s maximum price ...

The residual could derive from the application of other methods. For example, market data from traditional transaction methods could assist in the preliminary ascertainment of normal profits attributable to associated enterprises where one enterprise manufactures a unique product using proprietary processes and then transfers the product to another associated enterprise for further processing using other proprietary processes and for distribution ...

A residual analysis divides the combined profit from the controlled transactions under examination in two stages. In the first stage, each participant is allocated sufficient profit to provide it with a basic return appropriate for the type of transactions in which it is engaged. Ordinarily this basic return would be determined by reference to the market returns achieved for similar types of transactions by independent enterprises. Thus, the basic return would generally not account for the return that would be generated by any unique and valuable assets possessed by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances that might indicate how this residual would have been divided between independent enterprises. Indicators of the parties’ contributions of intangible property and relative bargaining positions could be particularly useful in this context ...

It can be difficult to determine the relative value of the contribution that each of the related participants makes to the controlled transactions, and the approach will often 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, capital invested) and assigning a percentage based upon the relative comparison and external market data ...

Generally, the profit to be combined and divided under the contribution analysis is operating profit. Applying the profit split in this manner ensures that both income and expenses of the MNE are attributed to the relevant associated enterprise on a consistent basis. However, occasionally, it may be appropriate to carry out a split of gross profits and then deduct the expenses incurred in or attributable to each relevant enterprise (and excluding expenses taken into account in computing gross profits). In such cases, where different analyses are being applied to divide the gross income and the deductions of the MNE among associated enterprises, care must be taken to ensure that the expenses incurred in or attributable to each enterprise are consistent with the activities and risks undertaken there, and that the allocation of gross profits is likewise consistent with the placement of activities and risks. For example, in the case of an MNE that engages in highly integrated worldwide trading operations, involving various types of property, it may be possible to determine the enterprises in which expenses are incurred (or attributed), but not to accurately determine the particular trading activities to which those expenses relate. In such a case, it may be appropriate to split the gross profits from each trading activity and then deduct from the resulting overall gross profits the expenses incurred in or attributable to each enterprise, bearing in mind the caution noted above ...

Under a contribution analysis, the combined profits, which are the total profits from the controlled transactions under examination, would be divided between the associated enterprises based upon the relative value of the functions performed by each of the associated enterprises participating in the controlled transactions, supplemented as much as possible by external market data that indicate how independent enterprises would have divided profits in similar circumstances. In cases where the relative value of the contributions can be measured directly, it may not be necessary to estimate the actual market value of each participant’s contributions ...

There are a number of approaches for estimating the division of profits, based on either projected or actual profits, as may be appropriate, that independent enterprises would have expected, two of which are discussed in the following paragraphs. These approaches — contribution analysis and residual analysis — are not necessarily exhaustive or mutually exclusive ...

Where the associated enterprises have determined the conditions in their controlled transactions on a basis other than the profit split method (as will almost always be the case), the tax administration would evaluate such conditions on the basis of the actual profit experience of the enterprise. However, care would need to be exercised to ensure that the application of a profit split method is performed in a context that is similar to what the associated enterprises would have experienced, i.e. on the basis of information known or reasonably foreseeable by the associated enterprises at the time the transactions were entered into, in order to avoid the use of hindsight ...

In using the profit split method to establish the conditions of controlled transactions, the associated enterprises would seek to achieve the division of profit that independent enterprises would have realized. The evaluation of the conditions of the controlled transactions of associated enterprises using a profit split method will be easiest for a tax administration where the associated enterprises have originally determined such conditions on the same basis. The evaluation may then begin on the same basis to verify whether the division of actual profits is in accordance with the arm’s length principle ...

When a tax administration examines the application of the method to evaluate whether the method has reliably approximated arm’s length transfer pricing, it is critical for the tax administration to acknowledge that the taxpayer could not have known what the actual profit experience of the business activity would be at the time that the conditions of the controlled transaction were established. Without such an acknowledgement, the application of the profit split method could penalize or reward a taxpayer by focusing on circumstances that the taxpayer could not reasonably have foreseen. Such an application would be contrary to the arm’s length principle, because independent enterprises in similar circumstances could only have relied upon projections and could not have known the actual profit experience ...

If the profit split method were to be used by associated enterprises to establish transfer pricing in controlled transactions, then each associated enterprise would seek to achieve the division of profits that independent enterprises would have expected to realize in a joint venture relationship. Generally, conditions established in this manner would have to be based upon projected profits rather than actual profits, because it is not possible for the taxpayers to know what the profits of the business activity would be at the time the conditions are established ...

The foregoing considerations should be taken into account in determining whether any particular application of the profit split method is appropriate given the facts and circumstances. More importantly, because of the foregoing considerations, the application of the profit split method is subject to the conclusions and limitations on transactional profit methods set forth in Section iii) ...

A second weakness relates to difficulties in applying the profit split method. On first review, the 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 information from foreign affiliates. Moreover, independent enterprises do not ordinarily use the profit split method to determine their transfer pricing (except perhaps in joint ventures). In addition, it may be difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions, which would require stating books and records on a common basis and making adjustments in accounting practices and currencies. Further, when the 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 ...

There are also a number of weaknesses to the profit split method. One such weakness is that the external market data considered in valuing the contribution each associated enterprise makes to the controlled transactions will be less closely connected to those transactions than is the case with the other available methods. The more tenuous the nature of the external market data used when applying the profit split method, the more subjective will be the resulting allocation of profits ...

Another strength is that under the profit split method, it is less likely that either party to the controlled transaction will be left with an extreme and improbable profit result, since both parties to the transaction are evaluated. This aspect can be particularly important when analysing the contributions by the parties in respect of the intangible property employed in the controlled transactions. This two-sided approach may also be used to achieve a division of the profits from economies of scale or other joint efficiencies that satisfies both the taxpayer and tax administrations ...

One strength of the profit split method is that it generally does not rely directly on closely comparable transactions, and it can therefore be used in cases when no such transactions between independent enterprises can be identified. The allocation of profit is based on the division of functions between the associated enterprises themselves. External data from independent enterprises is relevant in the profit split analysis primarily to assess the value of the contributions that each associated enterprise makes to the transactions, and not to determine directly the division of profit. As a consequence, the profit split method offers flexibility by taking into account specific, possibly unique, facts and circumstances of the associated enterprises that are not present in independent enterprises, while still constituting an arm’s length approach to the extent that it reflects what independent enterprises reasonably would have done if faced with the same circumstances ...

Where transactions are very interrelated it might be that they cannot be evaluated on a separate basis. Under similar circumstances, independent enterprises might decide to set up a form of partnership and agree to a form of profit split. Accordingly, the profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction (or in controlled transactions that are appropriate to aggregate under the principles of Chapter I) by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction or transactions. The profit split method first identifies the profit to be split for the associated enterprises from the controlled transactions in which the associated enterprises are engaged. It then splits those profits 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. The combined profit may be the total profit from the transactions or a residual profit intended to represent the profit that cannot readily be assigned to one of the parties, such as the profit arising from high-value, sometimes unique, intangibles. The contribution of each enterprise is based upon a functional analysis as described in Chapter I, and valued to the extent possible by any available reliable external market data. The functional analysis is an analysis of the functions performed (taking into account assets used and risks assumed) by each enterprise. The external market criteria may include, for example, profit split percentages or returns observed among independent enterprises with comparable functions. Subsection c) of this Section provides guidance for applying the profit split method ...

During the years in issue, 1975 through 1981, the worldwide operations of Perkin-Elmer (P-E) and its subsidiaries were organized into five operating groups, each of which was responsible for the research, manufacturing, sales, and servicing of its products. The five product areas were analytical instruments, optical systems, computer systems, flame spray equipment and materials, and military avionics. P-E and PECC entered into a General Licensing Agreement dated as of October 1, 1970, by the terms of which P-E granted PECC an exclusive right to manufacture in Puerto Rico and a nonexclusive right to use and sell worldwide the instruments and accessories to be identified in specific licenses. P-E also agreed to furnish PECC with all design and manufacturing information, including any then still to be developed, associated with any licensed products. PECC agreed to pay royalties on the products based upon the “Net Sales Price”, defined as “the net amount billed and payable for *** [licensed products] excluding import duties, insurance, transportation costs, taxes which are separately billed and normal trade discounts.” In practice, P-E and PECC interpreted this definition to mean the amount PECC billed P-E rather than the amount P-E billed upon resale. The specified term of this agreement was until the expiration of the last license entered into pursuant to the agreement. Following an audit the tax authorities issued an assessment of additional income taxes related to controlled transactions between the above parties. The issues presently before the Tax Court for decision were: [1) Whether the tax authorities’s allocations of gross income to P-E under section 482 were arbitrary, capricious, or unreasonable; (2) whether the prices FE paid for finished products to a wholly owned subsidiary operating in Puerto Rico were arm’s-length amounts; (3) whether the prices the subsidiary paid to P-E for parts that went into the finished products were arm’s-length amounts; (4) whether the royalties the subsidiary paid to P-E on sales of the finished products to P-E were arm’s-length amounts; and (5) for prices or royalties that were not arm’s length, what the arm’s-length amounts are. US vs Perkin-Elmer TCMemo 1993-414 ...