The profit split method (PSM) is one of the five transfer pricing methods, which are used to ensure that transactions between related companies are carried out at “arm’s length,” or a fair market price. (To get an overview of all the transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)
How The Profit Split Method Works
In some cases, companies engage in transactions that are too interconnected to be observed on a separate basis. For example, two related companies might work together on a separate joint venture, such as developing and launching a new brand. As the PSM looks at the combined profits of two related parties entering into a transaction with one another, it can be used for determining how profits will be divided in a way that is fair to both organizations.
It can be applied in three different ways: the comparable profit split method, contribution profit split method, and residual profit split method. Companies select an approach based on how the transaction is structured and the data available.
- To apply the comparable profit split method, related companies must find a comparable transaction where two related parties split profits, and then use it as a baseline for how their own profits should be divided.
- The contribution profit split method is applied by looking at the relative financial or other contributions made by the two companies entering into a transaction. A fair profit split is then determined based on those contributions.
- The residual profit split method looks at total profits, removes the profits made by the routine functions of both parties—computed using the comparable profits method—and residual profits are split, generally based on each party’s investments and relative spending.
The PSM is most often applied by companies in complex industries with relatively high profits, such as high technology and pharmaceutical organizations. It’s especially useful when dealing with intangible goods, such as intellectual property, as these transactions are often too complex for the other methods to be applied.
A Profit Split Method Transfer Pricing Example
Let’s say a pharmaceutical company has a manufacturing affiliate help with research and development (R&D) to bring a new drug to market. The R&D company will bear the costs and risks of launching the new drug. The two related parties need to to determine the right profit split terms to include in their pharmaceutical agreement.
They decide that, based on their relative investments and risks, they’ll use the contribution PSM to ensure they divide the drug profits fairly. To do so, it’s necessary to determine the contributions made by both parties for research and development, marketing, and other necessary expenses.
The two parties invested a total of $500 million to bring the new medication to market. It’s determined that the R&D company contributed $375 million of the total investment. Because $375 million is 75 percent of $500 million, the R&D company will make 75 percent of future profits, with the drug manufacturer collecting the remaining 25 percent.
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Benefits & Risks Of The Profit Split Method
Like all of the transfer pricing methods, there are advantages and disadvantages to applying the PSM. One of its main benefits is that it looks at profit allocation in a holistic way, providing a more complete picture of what’s going on and demonstrating a broader, more accurate assessment of the company’s transfer pricing policies.
It’s particularly useful when two companies want to share risk, rather than having all the risk of a transaction falling solely on one party. It’s also an excellent way to handle situations where both parties are making significant contributions that share many synergies and can’t be easily segregated.
Alternatively, the method can be risky because profit splitting is often very subjective. Even minor split shifts can lead to significantly different results. Applying the PSM also comes with challenges—it requires a lot of information and a significant amount of analysis, and, as a result, is usually a complex and expensive method to carry out.
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