In March 2019, the EU’s Joint Transfer Pricing Forum (“JTPF”) published a report (the “Report”) on the application of the Profit Split Method (“PSM”) within the EU. The PSM is one of the five transfer pricing methods recommended by the OECD’s transfer pricing guidelines to establish whether conditions of an intragroup transaction are at arm’s length. The Report builds on the OECD’s revised guidelines and clarifies the appropriate and correct application of the PSM.
Whereas former guidelines described the PSM as a method of ‘last resort’, the OECD is now increasingly recommending the PSM as the most appropriate method. The OECD justifies this change in approach by the increased integration of multinational enterprises and the globalisation of national economies and markets, which calls for appropriate transfer pricing methods. In this context, the JTPF believes that the PSM could be applied more often in the future, to accommodate the emergence of these new business models, especially in the digital economy.
The Report first discusses when the PSM should be applied. It is most suitable in cases where all relevant parties make unique and valuable contributions and when there is a high degree of integration. Moreover, the PSM is appropriate when there is insufficient information on comparables to apply another transfer pricing method and/or where parties share the assumption of economically significant risks or assume closely related risks. By contrast, the PSM should not be applied when one of the parties to the transactions performs only simple functions and/or when the transactions can be benchmarked adequately.
The second part of the report then describes how to apply the PSM. Two approaches are foreseen: the contribution analysis and the residual analysis. Under the contribution analysis, the combined profits or losses from controlled transactions are allocated among the associated enterprises on the basis of the relative value of the functions performed, assets used and risk assumed. Under the residual analysis, the relevant profits are divided into two categories. While the first category includes profits attributable to contributions for which a benchmark exists, the second category of profits should derive from unique and valuable contributions, shared assumption of economically significant risks and/or a high level of business integration.
In identifying these key value-drivers and weightings, the Report recommends that an inventory of profit splitting factors should be established, which differentiates between people-based factors, sales/volume based factors, asset-based factors, cost-based factors and other factors. With regard to splitting profits derived from intangibles, the Report stresses that no significant value should be attributed to mere legal ownership of such assets.