How do you assess the arm's length nature of intangible asset transactions using the profit split method? (2024)

The profit split method is one of the transfer pricing methods endorsed by the OECD and the UN as a way to determine the appropriate allocation of profits among related parties that engage in transactions involving intangible assets. The profit split method applies when the parties make unique and valuable contributions to the transaction, such as owning or developing intangible assets, or performing high-risk functions. The profit split method aims to split the combined profits (or losses) of the transaction in proportion to the relative value of each party's contribution, based on objective and verifiable criteria.

The profit split method can be applied in two ways: the residual profit split method and the contribution profit split method. The residual profit split method first allocates a routine return to each party based on their routine functions, assets, and risks, and then splits the remaining residual profit (or loss) according to the value of their intangible contributions. The contribution profit split method splits the combined profits (or losses) of the transaction based on the relative value of each party's contribution, without distinguishing between routine and non-routine elements. Both methods require a reliable measure of the combined profits (or losses) of the transaction, as well as a reliable way to quantify and compare the value of each party's contribution.

The profit split method has several advantages over other transfer pricing methods when dealing with intangible assets. It reflects the economic reality of the transaction and the interdependence of the parties, rather than relying on hypothetical or comparable transactions. Additionally, it allows for a flexible and dynamic approach that can accommodate changing market conditions, business strategies, or intangible asset development. Moreover, it can avoid double taxation or double non-taxation by allocating profits (or losses) among the parties without leaving any unallocated profit.

The profit split method has some drawbacks and challenges that should be taken into account before using it. It can be complicated and subjective to apply, as it requires a lot of data, investigation, and decision-making to decide the combined profits (or losses) of the transaction and the value of each party's contribution. Additionally, it can lead to uncertainty and disagreement, as different parties may have different understandings or interpretations of the applicable criteria, factors, or indicators used to divide the profits (or losses). Furthermore, it can raise compliance and audit costs, as more documentation and proof is needed to back up the chosen method and its outcomes.

The profit split method should not be applied without caution and care. The OECD and the UN provide some guidance and examples on how to apply it in different scenarios, but emphasize that each case must be analyzed based on its own facts and circ*mstances. When utilizing the profit split method, you should identify the transaction and parties involved, determine the combined profits (or losses) of the transaction, choose between the residual profit split or contribution profit split method, quantify the value of each party's contribution, split the combined profits in proportion to the value of each party's contribution, and document and justify your chosen method and results. Furthermore, regular reviews and updates should be conducted to reflect any changes or developments.

Transfer Pricing

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