6.19 Rule 10B(1)(d) profit split method, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated separately for the purpose of
Methods of Computation of Arm’s Length Price (i) the combined net profit of the associated enterprises arising
from the international transaction in which they are engaged, is determined;
(ii) the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the function performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances;
(iii) the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (II);
(iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm’s length price in relation to the international transaction:
Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction.
6.20 Typical transactions where the profit-split method may be used are transactions involving:
(a) integrated services provided by more than one enterprise for e.g., in case of financial service sector, where the activities performed by Indian company and foreign AEs in relation of a merger and acquisition transaction are so interrelated that it may not possible to segregate them;
(b) transfer of unique intangibles, for e.g. two associated enterprises contribute their respective intangibles to develop a new product or process and earn income from such product or process.
6.21 The observations of the OECD, in its Transfer Pricing Guidelines, on this method are as follows :
“This method aims to determine what division of total profits independent enterprise would expect in relation to the relevant transactions. The profits should be split on an economically valid basis that reflects the functions and risks of each of the parties. In order to apply this method, it is necessary to identify the total profit arising from the related party transactions and split that profit between the parties according to their respective contributions.”
6.22 There are two approaches to this method, namely, total profits split and residual profit split.
6.23 Total profits split: The steps involved are as follows:
(i) Determine the combined net profit of the associated enterprises arising from the international transactions in which they are engaged.
Such profits represent the profits earned from third parties due to the combined efforts of the associated enterprises. It may be noted that the ‘combined net profit’ referred to in the rule is not the aggregate of entire profits earned by the associated enterprises. Example: AE1 may earn profits from certain transactions wherein there is no contribution by AE2 and vice versa. Such profits do not enter into the determination of combined net profit. Only those profits that are earned as a result of joint efforts of AE1 and AE2 should be taken as combined net profit.
(ii) Evaluate relative contribution made by each entity involved in the transaction on the basis of:
(a) functions performed;
(b) assets employed;
(c) risks assumed;
(d) the reliable external market data indicating how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. It
Methods of Computation of Arm’s Length Price word ‘external’ does not preclude use of internal CUT. In the process of choosing CUTs, the function performed, assets used and risks taken (FAR) of the uncontrolled transactions would have been compared with the FAR of the international transactions. When the FAR of the international transaction and CUT are similar, the relative contribution adopted in the CUT should be applied to the international transaction. Any significant differences between the two should be suitably adjusted.
(iii) Thereafter, split the combined net profit in proportion to the relative contribution determined as above.
(iv) The profit so apportioned is taken to arrive at the arm’s length price in relation to the international transaction. The profits so apportioned to the AE when added to the costs incurred by it in relation to international transaction would result in arm’s length price.