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Navigating Transfer Pricing: Unraveling the Profit Split Method

According to the Federal Tax Authority's transfer pricing guidance, the PSM is critical in determining transfer prices.

The Profit Split Method (PSM) is one of the five transfer pricing methodologies established by the Organisation for Economic Cooperation and Development (OECD). 

As elucidated in the transfer pricing guidance issued by the Federal Tax Authority, the PSM plays a pivotal role in determining transfer prices, particularly in complex, interdependent transactions where traditional methods may fall short.

Understanding the Profit Split Method:

The OECD defines the PSM as a transactional profit method to identify and allocate the combined profit from controlled transactions among associated enterprises. 

It emphasizes the importance of an economically valid basis for approximating the division of profits that would have been anticipated in an arm’s length agreement.

Two Approaches: Contribution Analysis and Residual Analysis:

The PSM offers two primary approaches for splitting profits: contribution analysis and residual analysis. 

Contribution analysis involves dividing total transaction profits based on comparable data or, in the absence of such data, allocating profits according to functions, risks, and assets. 

Each party’s share is determined by its contribution value, encompassing factors like services, development expenses, and invested capital.

On the other hand, residual analysis bifurcates total profits into routine and residual stages. Routine profits are initially allocated based on traditional methods, such as Comparable Uncontrolled Price (CUP), Resale Price Method (RPM), or cost plus. 

Subsequently, residual profits are distributed using allocation keys like assets, costs, sales, headcounts, or time spent.

Application in Real-Life Scenario: The UKB and Dudlee Ltd Case:

To illustrate the PSM in action, consider a scenario involving a UK beverage company (UKB) and its UAE subsidiary, Dudlee Ltd. Both entities collaborate on producing and selling an energy drink. 

The PSM is applied to allocate profits, considering routine marketing services, research and development (R&D) expenditures, and unique contributions made by each party.

Challenges and Considerations:

While the PSM offers a sophisticated approach, its application comes with challenges. 

Accessing information from foreign affiliates, measuring combined revenue and costs accurately, and identifying appropriate operating expenses pose significant hurdles. 

Additionally, allocating costs between transactions and other activities becomes intricate, particularly when applied to operating profit.

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