TPG2022 Chapter II Annex II example 14

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Category: OECD Transfer Pricing Guidelines (2022), TPG2022 Annex to Chapter III – Working Capital Adjustment | Tag: ,
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74. Below are some illustrations of the effect of choosing a measure of profits to determine the relevant profits to be split when applying a transactional profit split

Scenario 1
74. Assume A and B are two associated enterprises situated in two different tax jurisdictions. Both manufacture the same widgets and incur expenditure that results in the creation of a unique and valuable intangible which they can mutually use. For the purpose of this example, it is assumed that the nature of this particular unique and valuable intangible is such that the value of A and B’s respective unique and valuable contributions in the year in question is proportional to A and B’s relative expenditure on the intangible in that year. (It should be noted that this assumption will not always be true in ) Assume A and B exclusively sell products to third parties. Assume that it is determined that the most appropriate method to be used is a residual profit split method; that the manufacturing activities of A and B are less complex, non-unique transactions that should be allocated an initial return of 10% of the Cost of Goods Sold; and that the residual profit should be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible. The following figures are for illustration only:

 

  A B Combined A + B
Sales 100 300 400
Cost Of Goods Sold 60 170 230
Gross Profit 40 130 170
Overhead expenses 3 6 9
Other operating expenses 2 4 6
Expenditure in relation to the unique and valuable

intangible

 30 40 70
Operating Profit 5 80 85
Step one: determining the initial return for the non-unique manufacturing transactions (Cost of Goods Sold + 10% in this example)
A 60 + (60 * 10 %) = 66 à Initial return for the manufacturing transactions of A = 6
B 170 + (170 * 10 %) = 187 à Initial return for the manufacturing transactions of B = 17
  Total profit allocated through initial returns (6+17) = 23

 

Step two: determining the residual profit to be split

a) In case it is determined as the operating profit:

 

Combined Operating Profit 85
Profit already allocated (initial returns for manufacturing transactions) 23
Residual profit to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible 62
 
Residual profit allocated to A: 62 * 30/70 26.57
Residual profit allocated to B: 62 * 40/70 35.43
 
Total profits allocated to A: 6 (initial return) + 26.57 (residual) 32.57
Total profits allocated to B: 17 (initial return) + 35.43 (residual) 52.43
Total   85

b) In case it is determined as the operating profit before overhead expenses (assuming it is determined that the overhead expenses of A and B do not relate to the transaction examined and should be excluded from the determination of the relevant profits to be split):

 

  A B Combined A + B
Sales 100 300 400
Cost Of Goods Sold 60 170 230
Gross Profit 40 130 170
Other operating expenses 2 4 6
Expenditure in relation to the unique and valuable intangible 30 40 70
Operating Profit before overhead expenses 8 86 94
Overhead expenses 3 6 9
Operating Profit 5 80 85

 

Combined Operating Profit before overhead expenses 94
Profit already allocated (initial returns for manufacturing transactions) 23
Residual profit before overhead expenses to be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible  

71
 
Residual profit allocated to A: 71 * 30/70 30.43
Residual profit allocated to B: 71 * 40/70 40.57
 
Total profits allocated to A: 6 (initial return) + 30.43 (residual) – 3 (overhead expenses) 33.43
Total profits allocated to B: 17 (initial return) + 40.57 (residual) – 6 (overhead expenses) 51.57
Total   85

76. As shown in the above example, excluding some specific items from the determination of the relevant profits to be split implies that each party remains responsible for its own expenses in relation to it. As a consequence, the decision whether or not to exclude some specific items must be consistent with the accurate delineation of the

 

Scenario 2
77. As another example, in some cases it may be appropriate to back out a category of expenses to the extent that the profit splitting factor(s) used in the residual profit split analysis relies on those expenses. For example, in cases where relative expenditure contributing to the development of a unique and valuable intangible is determined to be the most appropriate profit splitting factor, residual profits can be based on operating profits before that expenditure. After determining the split of residual profits, each associated enterprise then subtracts its own expenditure. This can be illustrated as follows. Assume the facts are the same as in Scenario 1 to this example at paragraph 2.74 above and assume the overhead expenses are not excluded from the determination of the residual profit to be split.
Step one: determining the basic return for the manufacturing activities (Cost of Goods Sold + 10% in this examplel
78. Same as at Scenario 1, Step 1
Step two: determining the residual profit to be split
a) In case it is determined as the operating profit after expenditure in relation to the unique and valuable intangible:

Same as at Scenario 1, Step 2, case a)

b) In case it is determined as the operating profit before expenditure in relation to the unique and valuable intangible:

 

  A B Combined A + B
Sales 100 300 400
Cost Of Goods Sold 60 170 230
Gross Profit 40 130 170
Overhead expenses 3 6 9
Other operating expenses 2 4 6
Operating profit before expenditure in relation to the unique and valuable intangible  

35

  

120

  

155
Expenditure in relation to the unique and valuable intangible 30 40 70
Operating Profit 5 80 85
 
Relevant Operating Profit before Expenditure in relation to the unique and valuable intangible  

155
Profit already allocated (initial returns for manufacturing transactions) 23
Residual profit before Expenditure in relation to the unique and valuable intangible to be split in proportion to A’s and B’s expenditure in relation to the unique and

valuable intangible

  

 

132
 
Residual profit allocated to A: 132 * 30/70 56.57
Residual profit allocated to B: 132 * 40/70 75.43
 
Total profits allocated to A: 6 (initial return) + 56.57 (residual) – 30 (expenditure in relation to the unique and

valuable intangible)

  

32.57
Total profits allocated to B: 17 (initial return) + 75.43 (residual) – 40 (expenditure in relation to the unique and valuable intangible)  

52.43
Total   85

i.e. A and B are allocated the same profits as in the case where the relevant profit to be split is determined as the operating profit after expenditure in relation to the unique and valuable intangible, see case a) above

 

79. This example illustrates the fact that, when the profit splitting factor used to split the residual profit relies on a category of expenses incurred during the period, it is irrelevant whether the residual profit to be split is determined before the expenses are deducted by each party, or whether the residual profit to be split is determined after the expenses are deducted. The outcome can however be different in the case where the splitting factor is based on the accumulated expenditure of the prior as well as current

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