In March 2019, the JTPF issued a report on the use of profit distribution method (PSM) by related parties.
The document explains the key issues concerning the application of PSM together with the description of the profit splitting mechanism.
In order to gather useful information on the use of PSM, it was decided to conduct a study on the experiences of JTPF members with the practical use of PSM (JTPF meeting of 8 March 2018). The study did not show any direct correlation between PSM and a specific industry. It appeared that PSM is used in several different sectors, such as the financial sector, industrial equipment, the automotive industry, the IT sector, trade in consumer goods, the pharmaceutical industry, chemical industry and the food industry. However, even in these industries PSM has been used only to a limited extent so far.
The lack of a common methodology on determining the profit splitting factors has been indicated as a cause that exacerbates the challenges and could undermine the prospects for applying the PSM even in circumstances where this may be the most appropriate method.
At the meeting of 24 October 2018, the JTPF considered 4 potential areas for further work on the PSM:
- When to use the PSM?
- How to split the profit?
- Is there a need for simplification?
- How to simplify the application of the PSM?
This paper addresses the first stage and aims at clarifying certain concepts in applying the PSM:
- when to use the PSM (i.e. in which circumstances it may be considered the most appropriate transfer pricing method) and
- how to split the profit based on the concepts described in the revised OECD Guidelines as well as by providing an inventory of recurrent splitting factors.
For the avoidance of doubt this report should be regarded as complementary to, and supportive of, the text of the OECD Revised Guidelines on the application of the Transactional Profit Split Method issued in June 2018.
The following is an example of the application of the profit-sharing method described in the report.
Company A is the parent company of an MNE group in the pharmaceutical sector. Company A owns a patent for a new pharmaceutical formulation. Company A designed the clinical trials and performed the research and development functions during the early stages of the development of the product, leading to granting a patent.
Company A enters into a contract with Company S, a subsidiary of Company A, in accordance with which Company A licenses the patent rights relating to the potential pharmaceutical product to Company S. Based on the contract, Company S conducts the subsequent development of the product and performs important enhancement functions. Company S obtains the authorization from the relevant regulatory body. The development of the product is successful and it is sold on various markets around the world.
The accurate delineation of the transaction indicates that the contributions made by both Company A and Company S are unique and valuable to the development of the pharmaceutical product.
Under these circumstances, the transactional profit split method is likely to be the most appropriate method for determining the compensation for the patent rights licensed by Company A to Company S.
The OECD Guidelines indicate that a unique and valuable contribution to product development takes place when it is a key source of actual or potential economic benefits.