John is an insurance agent. In a bid to increase his sales, he approached his friend Peter who was a Doctor and asked him to introduce John to Mr Black, a rich businessperson who happened to take routine services from Peter. Peter agreed and did a great job at mentioning a good word which landed John with a client which wouldn’t have been possible otherwise. John felt really grateful about Peter and wanted to continue with this new tactic of reaching potential clients through referral. However, he was unsure how on what basis should he payback Peter, as Peter was merely marketing without incurring any risk or cost. He approached Peter with the idea and after pondering for a while they decided to ‘Split’ the profits with John keeping the rest 70% as he is the field expert and actually rendering the services, while Peter taking 30% towards referring client and marketing. In a nutshell, John and Peter have used the ‘Profit Split Method’ of deciding Arm’s Length Price.
In modern businesses, the transactions are so interrelated and complex that the costs or sale price cannot be reasonably allocated to the enterprises involved. Consider a project where two associated enterprises are together providing a service as a joint venture where the contract price has been negotiated for the entire project and not its components. In such situations, the traditional methods like the Comparable Uncontrolled Price Method, the Cost Plus Method or the Resale Price Method fail to address how to compute the arm’s length price, as they consider Cost or Sales Price as the basis for arriving transfer price. The profit split method provides a simpler solution to the same by considering the profits as the basis for computing the arm’s length price.
What is the Profit Split Method?
The Profit Split Method is typically used when both or all enterprises involved in the transaction have made a significant contribution towards the supply of goods or provision of services. The profit split method eliminates the effect of special conditions as a result of the joint contract such that each enterprise receives a share of profit that it would have expected to realise otherwise in an independent transaction. The method begins with identifying the profits sharing ratio between the associated enterprises relative to the contribution that each enterprise has made to the transaction. This profit split must reflect the enterprise’s contribution in terms of functions performed, the risks incurred and the assets owned by the enterprise, used in the process. This is usually helpful in cases which involve tangible or intangible property or trading activities or financial services.
The basis on which the profit may be split would vary according to transaction depending on its nature. Where transactions involve heavy investments and form the key factor of the transaction, the profit may be split according to the amount invested. Similarly, profits may be split according to the value of assets used or the direct costs involved.In certain cases, the associated enterprises perform transactions comparable to those performed by other associated enterprises. In such cases, if the market data about the profit split is available, the same can form a reasonable basis of profit split.
Variations of Profit Split Method
There are two stages at which the profit may be split resulting into two different variations of the method – by analysis of contribution profit or by analysis of residual profits.
- Contribution Profit Split Method–
The contribution is the gross amount of profits earned before considering the fixed expenses. In case of a joint project performed by associated enterprises, the total contribution of the project can be arrived at after considering the sale value and the directly attributable expenses. These expenses may also be the ones which have been incurred jointly by the enterprises involved. At the contribution stage the profit is split and the same can be added to the share of direct costs to arrive at the Transfer Price.
- Residual Profit Split Method–
The Contribution Profit Split Method although distributes the profits the amongst enterprises, it does not ensure that each enterprise would earn reasonable profits in the course. This issue is addressed in the Residual Profit Split Method by adopting a two-step approach. At step one, Sufficient Profits are allocated to each enterprise involved to provide basic compensation at arm’s length for the routine contributions made to the transactions. This is determined on the basis of comparable transactions or the functions performed. In practice, the Transactional Net Margin Method is used to determine sufficient profits in step 1.
The balance profits remaining after distribution are known as the Residual Profits which are distributed amongst the associated enterprises based on the facts and circumstances of the transactions. The residual profits can be allocated to the enterprise providing the tangible or intangible assets necessary if the same is held by one enterprise only. Any similar reasonable basis may be adopted for the allocation of special profits or the residual profits at step 2. These profits combined with the costs incurred form the Transfer Price.
The residual profit split method is generally preferred over the contribution profit split method owing to two reasons. Firstly, this method breaks up the complicated issue of transfer pricing into two simpler steps easing the work. Where the first step analyses the comparables and decides the basic returns, the second step considers special points and value of tangible or intangible assets to determine the distribution of residual profits. The second reason is the potential conflict if any raised by the tax authorities, the same is often reduced to the residual profits only, and thereby, a comparatively small figure becomes the controversial point of a tax arbitration, instead of encircling the entire transaction.
Computation of Arm’s Length Price under the Profit Split Method
Step 1 – Determine the Sale Price of the transaction and the associated direct costs and indirect costs incurred by each enterprise jointly or individually. The difference between the sale price and joint costs or direct costs would provide the contribution.
Step 2 – Determine the variation of profit split to be used. In the case of contribution profit split, the profit would have to be split at one step while in case of residual profit split, the profit would have to be split at two stages.
Step 3 – Determinethe profit split ratio by considering other comparable transactions between independent entities or such other comparable transactions between the associated enterprises which may have been undertaken in the past. Perform comparability analysis on the transactions being considered, and select the most appropriate transactions as comparables. Comparability analysis must consider the following points:
- Product Comparability – characteristics, quality, end-use, novelties, features, addon products, after-sales services, etc.
- Contractual Terms –the credit period offered, allied transactions, term period of the contract, the quantity contracted, the place of delivery, etc.
- Risk Incurred – In a transaction between Associated Enterprises, the associated enterprise may not be selling directly to end consumers. However, in an open market transaction, an independent entity is exposed to inventory risk and consumer default risk. These risks undertaken by the other associated enterprise must be quantified and adjusted to the price. There may be similar risks which may require adjustments.
- Geographical Factors – the location where the product is sold or produced, the Government regulations, the applicable taxes, the sources of raw materials, etc.
Step 4 – Analyse the differences between the controlled transactions and the uncontrolled transactions considered as comparable, which have an impact on the profit split. Quantify the functional differences in terms of impact on the profit split and make necessary adjustments to arrive at the appropriate profit split. In the case of residual profit split, additional factors would have to be considered to determine the basis of distributing the residual profits.
Step 5 –Distribute the contribution profit, or the basic and special profits in case of residual profit split method, according to the basis of distribution determined in stage 3.
Step 6 – Transfer Price would comprise of the amount recoverable from the other enterprise i.e. the net settlement amount comprising of the share of joint costs incurred on behalf of other entity, net of the share of costs incurred by the other entity adjusted by the share of profit.
Advantages and Disadvantages of the Profit Split Method
- The method is suitable when the transactions are highly integrated and the transfer price cannot be decided on the basis of one-sided approach.
- It ensures that the transfer price does not result in extreme results for either of the entities if the residual profit split variation is followed.
- This method carefully deals with the synergies involved in the transaction owing to the combined use of resources or assets.
- The profit split is more arbitrary and subjective in this method as compared to other methods and thus, the tax authorities would always prefer to have a closer look into the basis of arriving the same.
- Accounting policies may not be consistent amongst associated enterprises especially when they are located in different geographies resulting in difficulty to arrive at combined costs or revenue.
- External data with regards to profit split isn’t readily available in most cases.
When to use the Profit Split Method?
The Profit Split Method works only under specific circumstances and therefore, one must firstly brainstorm on the following points, before proceeding with this method, to ensure the viability of its results:
- Complex Integrated Transactions–The Profit Split Method will have to be used when the transactions are highly interconnected and it is practically impossible to evaluate the transactions on their own. Cases, where the entities incur joint costs or earn combined revenues are examples, were only profit split method would result inappropriate results.
- Determination of factors deciding profit split–A reliable understanding of the factors contributing to the profit split decision is pre-requisite to using this method. The enterprises must be able to identify the factors which form the basis of distributing the profits. If profits cannot be distributed on any rational basis, this method would not provide reliable results.
- Value Additions by all Enterprises – Where each enterprise involved the transaction contributes functionally or by provides significant tangible or intangible assets, one-sided approaches adopted in traditional methods provides inconclusive results while the profit split method would be more appropriate.