Transactional profit methods

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Rethinking International Tax Law

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Universiteit Leiden

Rethinking International Tax Law

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In recent years, the international tax planning strategies of multinationals have become a source of – often heated – debate. This course provides learners with the tools to become fully informed participants in the debate by explaining the foundations and practice of international tax law as well as addressing current developments and the ethical aspects of tax planning.

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Transfer pricing

In this fourth module, we will be focusing on transfer pricing, a technique which is used to allocate the profits made by a group of companies to the individual group members. Transfer pricing is an area of tax law which is becoming increasingly important. Our study will focus on the basics of transfer pricing: the 'arm's length principle', comparability and transfer pricing methods, but will also address business restructurings and include a case study.

Transactional profit methods5:26

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Prof. Dr. Sjoerd Douma
Faculty of Law
International Tax Center

Hi, and welcome to the fourth video of the module on transfer pricing.

In the last video we had a look at the traditional transfer pricing methods.

In this video, I will move on to explain the transaction profit methods.

There are certain situations when transaction profit methods

are more appropriate than traditional transaction methods.

An example is found in cases in which the presence of significant

unique intangibles contributed by each of the parties to the control transaction,

of the engagement in highly integrated activities.

Makes a profit split more appropriate than a one sided method.

Likewise, when there is no, or limited reliable information

publicly available on the gross margin derived by third parties.

Transactional profit methods become the most appropriate ones.

We look in more detail at the transactional profit methods.

First, we will discuss the transaction net margin methods, and

secondly we address the profits break methods.

The transactional net margin method works similarly to the resale price method and

the cost plus method.

What works at the level of the operating profit margin in relation

to an appropriate base such as costs, sales, or assets.

Operating profit is equal to the difference between gross profit and

operating expenses.

In this respect, a net profit margin analysis is found to be more reliable

than a gross margin analysis.

When there are material differences in functions between the tested and

the uncontrolled transaction.

In these first example, the tested party is the distributor and

the operating profit margin is weighted on sales.

The net margin realized by an independent distributor is 5%,

given by an operating profit of 15 on sales of 300.

The application of this percentage to the control

distributor sales of 100, gives an operating profit of 5.

This means in the case attend, the transfer price should 90.

Generally, the transactional net margin method

with an operating profit weighted on sales applies

when the distributor is the simpler party in the intergroup transaction, and

when the resale price method cannot be applied in an equally reliable manner.

In the second example, the tasset party is the manufacturer, and

the net profit margin is weighted on cost.

The markup on total costs applied by an independent manufacturer is 9%,

given by an operating profit of 25,

on the sum of operating expenses of 25, and manufacturing costs of 250.

The application of this percentage to the total cost of the control manufacturer

of 55 gives an operating profit of 5.

This means, that in the case of sales the transfer price should be 60.

The transaction net margin method, weighted upon cost, applies when

a manufacturer or a service provider is the party in an inter-group transaction,

and the cost plus method cannot be applied in an equally reliable manner.

The second transactional profit method,

the profit split method, is based on the division of the total profit

realized by related parties engaged in a controlled transaction.

This method aims to split these profits,

on an economically valid basis that reflects the division of profit.

Would have been agreed between independent parties.

As the example shows, the first step is to identify the consolidated profit, that

is the profit to be split, of the parties involved in the control transaction.

The second step is to then split those profit in a way that equates to

what independent parties would have agreed upon under comparable circumstances.

The third step is to apply the resulting present age

to the combined operating profits.

The determination of the split in percentage can be based on either

comparables, or internal data, such as costs or head counts.

The profit split method frequent returns to be the most appropriate method

when both parties to the transaction own valuable intangibles, and

when the parties are integrated with each other to generate joint efficiencies,

such in economies of scale.

That concludes this video in which we discussed the two transactional

profit makers, the transactional net margin method and the profit split method.

I hope you join us for the next video,

when we will be looking at case study and some real life circumstances.

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