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Profit Split Method Transfer Pricing.

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June 1, 2021 |

12 mins read

Profit Split Method Transfer Pricing

The application of Arm’s Length Principle while implementing the provisions of Transfer Pricing, to arrive at the price of a transaction between unrelated parties is essential. However different situations call for application of different methods of the ALP principle, depending on the mitigating factors in every transaction. One such method is the Profit Split Method. Let’s take an in- depth look into this concept.

Principle of International Taxation Transfer Pricing
Transaction between International Parties
Transfer Price Price charged between two Associated Enterprises
Arm’s Length Price Principle Price charged between two unrelated parties
Governing Provision Section 92C, Income Tax Act, 1961
Type of Method Transactional Profit Method
Application in cases Transfer of unique intangibles or multiple international transactions which are so interrelated that individual evaluation cannot be done.
Application of method Evaluation whether profits or loss allocated to an entity out of combined operating profit in a controlled transaction is as per ALP, with regards to their individual contribution to the overall profit or loss.
Types of Profit Allocation Method
  • Comparable Profit Split Method;
  • Residual Profit Split Method.

 Profit Split Method Transfer Pricing – In case of a transaction between two related Enterprises, both the enterprise maybe earning certain profits or losses. Under the profit split method (PSM) Transfer Pricing, the total operating profit earned by  the parties involved in the transaction is first ascertained. There after it is splitted, amongst the parties, based on the respective contributions.

PSM evaluates, if, the profits or loss, allocated to a particular entity, out of combined operating profit, of controlled transaction, is at arm’s length, considering their individual contribution in the overall profit or loss.

Note : –

PSM is typically applicable in international transactions or Specified Domestic Transactions, involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for determining the ALP of any one transaction.

Steps involved in PSM

Step 1 : – Determine Combined Net Profit

Determine combined total net profit of the AEs, arising from the controlled international transaction.

Step 2 : –

Evaluate the relative contribution made by each AE through their activities, to the earning of such combined net profit.

Note : –

  • Such evaluation of the contribution made by each AE is based on functions performed, assets employed and risks assumed by each enterprise.
  • Reliable external market data , on evaluating  such contribution should be obtained, by considering cases where   unrelated enterprises perform  comparable functions in similar circumstances, and  comparied with AEs functions.

Step 3 : –

The combined net profit is then splitted amongst the Associated Enterprises in proportion to their relative contributions.

Step 4 : –

The profit so apportioned to the tested party, is considered to arrive at an arm’s length price of the international transaction.

Allocation Methods under PSM

The allocation of profit or loss under the PSM must be made in accordance with one of the following allocation methods : –

  1. Comparable Profit split; or
  2. Residual Profit split.

(a) Comparable Profit Split Method (PSM) Transfer Pricing

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

International Taxation Services

(b) Residual Profit Split Method (PSM) Transfer Pricing

The combined operating profit or loss from the relevant business activity is allocated between the controlled taxpayers following the two-step process : –

  1. Allocate operating income to each party to the controlled transactions to provide a market return for its routine contributions to the relevant business activity.
  2. Allocate residual profit among the controlled taxpayers, based upon the relative value of their contributions of intangible property to the relevant business activity that was not accounted for as a routine contribution.

Profit Split Method Transfer Pricing – Example

MNC US entered into a contract for manufacturing of Dam on a river, for which its subsidiaries in US, Singapore and India worked together. The total contract price of deal was $100M. Net profit earned by MNC US from the entire deal transactions was $15M, of which the routine contribution is $5M, wherein the relative efforts put in by group companies are 35%, 30% and 35% respectively.

Non routine profit are to be splitted amongst the group companies on the basis of ownership of non-routine intangibles i.e. 20%, 30% and 50%.

Compute the Arm’s length profit of related party in US, Singapore and India in accordance with Profit Split Method ?

SOLUTION : –

Parties Distribution of income for routine transaction ($ in M) (A) Distribution of income as residual profit ($ in M) (B) Total arm’s length profit of related parties ($ in M) (A+B)
US 1.75
(5 * 35%)
2
(15 – 5) * 20%
3.75
Singapore 1.50
(5 * 30%)
3
(15 – 5) * 30%
4.50
India 1.75
(5 * 35%)
5
(15 – 5) * 50%
6.75

Profit Split Method

Judicial Rulings on the selection of Profit Split Method (PSM) Transfer Pricing

Case laws Held
Orange Business Services India Networks Private Limited vs. DCIT –  [2015] 63 taxmann.com 304 (Delhi – Trib.) The Court held that when any transaction requires deployment of functions and assets of various entities, located in different geographical locations, to deliver service which generate revenues. PSM is the most appropriate method for determining arm’s length price.
Global One India Private Limited vs. ACIT – [2014] 44 taxmann.com 100 (Delhi – Trib.) Global One India Private Limited was engaged in providing internet and related network services to the group’s customers in India. It adopted PSM for benchmarking its international transaction which has rejected, and AO adopted TNMM. Court accepted the PSM on the basis that Global One India Private Limited generates revenue out of operations that are highly integrated.

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Arinjay Jain

Bio of author

Arinjay is a Chartered Accountant with more than 20 years of post-qualification experience. He worked as Director, in the M&A Tax Division at KPMG in India. Presently, he is advising several MNCs in UAE on Economic Substance Regulations and impact of the UAE Corporate Tax Law on their business and clients across globe on International Tax issues . He is a well recognised Trainer of International Tax and UAE Corporate Tax. The areas of service include the following : - Advise and Compliance relating to International Tax Issues; Advise relating to UAE Corporate Tax Issues; Advise and Compliance relating to UAE Economic Substance Regulations; Advise and Compliance relating to Indian Income Tax Issues; Other connected matters from a Regulatory perspective.

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