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

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

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

15. The facts are the same as Example 1, except that the per-unit value of Service 2 is 120 (that is, both Service 1 and Service 2 are equally valuable, and neither are low-value services). 16. Under the CCA, the value of Company A and Company B’s contributions should each correspond to their respective proportionate shares of expected benefits i.e. 50%. Since the total value of contributions under the CCA is 6 000, this means each party must contribute 3 000. The value of Company A’s in-kind contribution is 3 600. The value of Company B’s in- kind contribution is 2 400. Accordingly, Company B should make a balancing payment to Company A of 600. This has the effect of “topping up” Company B’s contribution to 3 000; and offsets Company A’s contribution to the same amount. Example 3 illustrates that, in general, assessing contributions at cost will not result in an arm’s length outcome even in those situations in which the arm’s length mark-up on the cost of contributions is identical ...

Example 2 12. The facts are the same as Example 1, except that the per-unit value of Service 1 is 103 (that is, both Service 1 and Service 2 are low-value services). Assume, therefore, that the calculation of the costs and value of the services is as follows: Cost to Company A of providing services (30 units * 100 per unit) 3 000 (60% of total costs) Cost to Company B of providing services (20 units * 100 per unit) 2 000 (40% of total costs Total cost to group 5 000 Value of contribution made by Company A (30 units * 103 per unit) 3 090 (59.5% of     total contributions) Value of contribution made by Company B (20 units * 105 per unit) 2 100 (40.5% of     total contributions) Total value of contributions made under the CCA 5 190 Company A and Company B each consume 15 units of Service 1 and 10 units of Service 2: Benefit to Company A: Benefit to Company B Service 1: 15 units * 103 per unit 1 545 Service 2: 10 units * 105 per unit 1 050 Total 2 595 (50% of total value of 5190) Service 1: 15 units * 103 per unit 1 545 Service 2: 10 units * 105 per unit 1 050 Total 2 595 (50% of total value of 5190) 13. Under the CCA, the value of Company A and Company B’s contributions should each correspond to their respective proportionate shares of expected benefits, i.e. 50%. Since the total value of contributions under the CCA is 5 190, this means each party must contribute 2 595. The value of Company A’s in-kind contribution is 3 090. The value of Company B’s in-kind contribution is 2 100. Accordingly, Company B should make a balancing payment to Company A of 495. This has the effect of “topping up” Company B’s contribution to 2 595; and offsets Company A’s contribution to the same 14. In this example, since all contributions to the CCA are low-value services, for practical reasons, contributions may be valued at cost since this will achieve results which are broadly consistent with the arm’s length principle. Under this practical approach, the cost of Company A’s in-kind contribution is 3 000; the cost of Company B’s in-kind contribution is 2 000; and each participant should bear the costs associated with 50% of the total cost of contributions (2 500). Accordingly, Company B should make a balancing payment to Company A of 500 ...

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 ...

In considering the arm’s length compensation for functional contributions of various members of the MNE group, certain important functions will have special significance. The nature of these important functions in any specific case will depend on the facts and circumstances. For self-developed intangibles, or for self-developed or acquired intangibles that serve as a platform for further development activities, these more important functions may include, among others, design and control of research and marketing programmes, direction of and establishing priorities for creative undertakings including determining the course of “blue-sky” research, control over strategic decisions regarding intangible development programmes, and management and control of budgets. For any intangible (i.e. for either self-developed or acquired intangibles) other important functions may also include important decisions regarding defence and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible. Those important functions usually make a significant contribution to intangible value and, if those important functions are outsourced by the legal owner in transactions between associated enterprises, the performance of those functions should be compensated with an appropriate share of the returns derived by the MNE group from the exploitation of intangibles ...

The relative value of contributions to development, enhancement, maintenance, protection, and exploitation of intangibles varies depending on the particular facts of the case. The MNE group member(s) making the more significant contributions in a particular case should receive relatively greater remuneration. For example, a company that merely funds research and development should have a lower anticipated return than if it both funds and controls research and development. Other things being equal, a still higher anticipated return should be provided if the entity funds, controls, and physically performs the research and development. See also the discussion of funding in Section B.2.2 ...

The relative importance of contributions to the creation of intangible value by members of the group in the form of functions performed, assets used and risks assumed will vary depending on the circumstances. For example, assume that a fully developed and currently exploitable intangible is purchased from a third party by a member of a group and exploited through manufacturing and distribution functions performed by other group members while being actively managed and controlled by the entity purchasing the intangible. It is assumed that this intangible would require no development, may require little or no maintenance or protection, and may have limited usefulness outside the area of exploitation intended at the time of the acquisition. There would be no development risk associated with the intangible, although there are risks associated with acquiring and exploiting the intangible. The key functions performed by the purchaser are those necessary to select the most appropriate intangible on the market, to analyse its potential benefits if used by the MNE group, and the decision to take on the risk-bearing opportunity through purchasing the intangible. The key asset used is the funding required to purchase the intangible. If the purchaser has the capacity and actually performs all the key functions described, including control of the risks associated with acquiring and exploiting the intangible, it may be reasonable to conclude that, after making arm’s length payment for the manufacturing and distribution functions of other associated enterprises, the owner would be entitled to retain or have attributed to it any income or loss derived from the post-acquisition exploitation of the intangible. While the application of Chapters I – III may be fairly straightforward in such a simple fact pattern, the analysis may be more difficult in situations in which: i) Intangibles are self-developed by a multinational group, especially when such intangibles are transferred between associated enterprises while still under development; ii) Acquired or self-developed intangibles serve as a platform for further development; or iii) Other aspects, such as marketing or manufacturing are particularly important to value creation. The generally applicable guidance below is particularly relevant for, and is primarily concerned with, these more difficult cases ...

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

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

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

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

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

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 ...

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

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

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

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

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

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 ...

15. The facts are the same as Example 1, except that the per-unit value of Service 2 is 120 (that is, both Service 1 and Service 2 are equally valuable, and neither are low-value services). 16.          Under the CCA, the value of Company A and Company B’s contributions should each correspond to their respective proportionate shares of expected benefits i.e. 50%. Since the total value of contributions under the CCA is 6 000, this means each party must contribute 3 000. The value of Company A’s in-kind contribution is 3 600. The value of Company B’s in- kind contribution is 2 400. Accordingly, Company B should make a balancing payment to Company A of 600. This has the effect of “topping up” Company B’s contribution to 3 000; and offsets Company A’s contribution to the same amount. Example 3 illustrates that, in general, assessing contributions at cost will not result in an arm’s length outcome even in those situations in which the arm’s length mark-up on the cost of contributions is identical ...

Example 2 12. The facts are the same as Example 1, except that the per-unit value of Service 1 is 103 (that is, both Service 1 and Service 2 are low-value services). Assume, therefore, that the calculation of the costs and value of the services is as follows: Cost to Company A of providing services (30 units * 100 per unit) 3 000 (60% of total costs) Cost to Company B of providing services (20 units * 100 per unit) 2 000 (40% of total costs Total cost to group 5 000 Value of contribution made by Company A (30 units * 103 per unit) 3 090 (59.5%     of     total contributions) Value of contribution made by Company B (20 units * 105 per unit) 2 100 (40.5%     of     total contributions) Total value of contributions made under the CCA 5 190 Company A and Company B each consume 15 units of Service 1 and 10 units of Service 2: Benefit to Company A: Benefit to Company B Service 1: 15 units * 103 per unit 1 545 Service 2: 10 units * 105 per unit 1 050 Total 2 595 (50% of total value of 5 190) Service 1: 15 units * 103 per unit 1 545 Service 2: 10 units * 105 per unit 1 050 Total 2 595 (50% of total value of 5 190) 13. Under the CCA, the value of Company A and Company B’s contributions should each correspond to their respective proportionate shares of expected benefits, i.e. 50%. Since the total value of contributions under the CCA is 5 190, this means each party must contribute 2 595. The value of Company A’s in-kind contribution is 3 090. The value of Company B’s in- kind contribution is 2 100. Accordingly, Company B should make a balancing payment to Company A of 495. This has the effect of “topping up” Company B’s contribution to 2 595; and offsets Company A’s contribution to the same 14. In this example, since all contributions to the CCA are low-value services, for practical reasons, contributions may be valued at cost since this will achieve results which are broadly consistent with the arm’s length principle. Under this practical approach, the cost of Company A’s in-kind contribution is 3 000; the cost of Company B’s in-kind contribution is 2 000; and each participant should bear the costs associated with 50% of the total cost of contributions (2 500). Accordingly, Company B should make a balancing payment to Company A of 500 ...

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 ...

In considering the arm’s length compensation for functional contributions of various members of the MNE group, certain important functions will have special significance. The nature of these important functions in any specific case will depend on the facts and circumstances. For self-developed intangibles, or for self-developed or acquired intangibles that serve as a platform for further development activities, these more important functions may include, among others, design and control of research and marketing programmes, direction of and establishing priorities for creative undertakings including determining the course of “blue-sky” research, control over strategic decisions regarding intangible development programmes, and management and control of budgets. For any intangible (i.e. for either self-developed or acquired intangibles) other important functions may also include important decisions regarding defence and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible. Those important functions usually make a significant contribution to intangible value and, if those important functions are outsourced by the legal owner in transactions between associated enterprises, the performance of those functions should be compensated with an appropriate share of the returns derived by the MNE group from the exploitation of intangibles ...

The relative value of contributions to development, enhancement, maintenance, protection, and exploitation of intangibles varies depending on the particular facts of the case. The MNE group member(s) making the more significant contributions in a particular case should receive relatively greater remuneration. For example, a company that merely funds research and development should have a lower anticipated return than if it both funds and controls research and development. Other things being equal, a still higher anticipated return should be provided if the entity funds, controls, and physically performs the research and development. See also the discussion of funding in Section B.2.2 ...

The relative importance of contributions to the creation of intangible value by members of the group in the form of functions performed, assets used and risks assumed will vary depending on the circumstances. For example, assume that a fully developed and currently exploitable intangible is purchased from a third party by a member of a group and exploited through manufacturing and distribution functions performed by other group members while being actively managed and controlled by the entity purchasing the intangible. It is assumed that this intangible would require no development, may require little or no maintenance or protection, and may have limited usefulness outside the area of exploitation intended at the time of the acquisition. There would be no development risk associated with the intangible, although there are risks associated with acquiring and exploiting the intangible. The key functions performed by the purchaser are those necessary to select the most appropriate intangible on the market, to analyse its potential benefits if used by the MNE group, and the decision to take on the risk-bearing opportunity through purchasing the intangible. The key asset used is the funding required to purchase the intangible. If the purchaser has the capacity and actually performs all the key functions described, including control of the risks associated with acquiring and exploiting the intangible, it may be reasonable to conclude that, after making arm’s length payment for the manufacturing and distribution functions of other associated enterprises, the owner would be entitled to retain or have attributed to it any income or loss derived from the post-acquisition exploitation of the intangible. While the application of Chapters I – III may be fairly straightforward in such a simple fact pattern, the analysis may be more difficult in situations in which: i) Intangibles are self-developed by a multinational group, especially when such intangibles are transferred between associated enterprises while still under development; ii) Acquired or self-developed intangibles serve as a platform for further development; or iii) Other aspects, such as marketing or manufacturing are particularly important to value creation. The generally applicable guidance below is particularly relevant for, and is primarily concerned with, these more difficult cases ...