In the case of transactions between related entities that are complex, long-term, or involve significant intangible assets, selecting the appropriate method for verifying transfer prices can be challenging. One tool that proves particularly useful in such situations is the Profit Split Method. In this article, we explain what this method entails, when it is worth applying, and what its advantages and limitations are.
What is the Profit Split Method?
The profit split method is one of the two so-called transactional profit methods, alongside the Transactional Net Margin Method (TNMM). Its legal basis can be found in Article 11d(1)(5) of the Corporate Income Tax Act, as well as in §13 of the Regulation of the Minister of Finance dated 29 December 2018 on transfer pricing in the field of corporate income tax.
Unlike traditional transactional methods, which are based on the analysis of a single entity, this method analyses the combined financial result of the controlled transaction and then splits that result between the related parties in a way that reflects the allocation that would have been accepted by unrelated entities under comparable circumstances.
When to Apply the Profit Split Method?
According to the CIT Act, the profit split method may be most appropriate in situations where:
- Transactions are highly integrated and cannot be reliably separated into independent components,
- Each party to the transaction contributes significantly in the form of unique or valuable intangible assets,
- There is a lack of sufficient comparable data, making the application of other methods (such as CUP or TNMM) unfeasible,
- The parties jointly bear significant economic risks (e.g., in R&D projects).
Examples of Application
Example 1: Joint R&D Activities
Two companies from the same capital group – one based in Germany and the other in Poland – jointly develop a new pharmaceutical product. Both parties incur costs, employ scientific teams, share know-how, and bear the risk of the project failing. As it is difficult to assign a “market value” to each contribution, the application of the profit split method is fully justified.
Example 2: Sales Involving Shared Intellectual Property Company A develops and owns the rights to advanced software, while Company B is responsible for its global commercialisation. The companies are related parties. Rather than trying to estimate a licence fee (which is difficult because the product is new and unique), the parties may divide the future profits from commercialisation in proportion to their tangible and intangible contributions.
Types of Approach
In practice, two main approaches are used:
- Actual Profit Split – divides the actual profit achieved, according to proportions determined based on the analysis of functions, assets, and risks.
- Residual Profit Split – first allocates each party a “routine” profit (e.g., for support services provided), and then splits the remaining profit based on the parties’ contributions to intangible value.
Advantages of the Method
- Involves an analysis of contributions from both parties, making it suitable for long-term relationships.
- Works well when comparable market data are lacking.
- Allows for a fair division of profits from the use of shared intangible assets.
Limitations and Risks
- Requires a detailed functional analysis (functions, assets, risks), which can be time-consuming.
- Difficulties in determining profit split proportions, especially when contributions are qualitative in nature.
- Risk of dispute with the tax authority if the profit allocation ratios are considered unreliable or unjustified.
While the profit split method is more complex than other approaches, it is indispensable in highly integrated, long-term transactions based on intangible assets. Its correct application can not only minimise tax risk but also facilitate a fair and market-based allocation of added value within a corporate group.
