Contents - AL-Tax

3.5 Profit Split Methods 29intercompany services fee. As a practical matter, many European taxing authoritiesare more concerned with the services cost base than the particular markup appliedthereto, because it is generally more consequential from a tax revenue perspective.3.5 Profit Split MethodsThe profit split methods address circumstances in which two (or more) members ofa controlled group own valuable intangible property. In these instances, neither thetraditional transactions methods nor the CPM/TNMM apply. The U.S. regulationscontain two profit split methods: The residual profit split method and the comparableprofit split method. The OECD Guidelines take a more flexible approach and allowfor a range of profit split methods, including the residual and comparable profit splits(and, seemingly, game-theoretic analyses. 24 )3.5.1 Residual Profit Split MethodConsider first the residual profit split method.3.5.1.1 Description of Residual Profit Split MethodThe residual profit split method (RPSM) is applied in several discrete steps. In thefirst step, each member of a controlled group engaged in a joint endeavor is allocateda portion of combined before-tax operating income. Such allocations are generallyquantified by application of the CPM: Individual group members earn a certainmarkup over associated costs or tangible assets for their “routine contributions,”such as sales functions, manufacturing functions, etc. These markups are determinedby reference to samples of functionally comparable standalone companies.In the second step of the RPSM, “residual” income is quantified by reducingadjusted operating profits by each entity’s returns to routine functions, as determinedin Step 1. Adjusted operating profits, in turn, are computed by eliminating deductionsfor investments in intangible assets from combined reported operating profits,and imputing deductions for the amortization of such assets (thereby conformingthe accounting treatment of intangible assets to that of tangible assets).Lastly, residual income is allocated among group members based on the relativevalue of intangible property that they each contribute to the joint endeavor. U.S.practitioners generally determine the relative value of intangible assets by capitalizingand amortizing intangibles-creating expenditures. This procedure necessitates(a) identifying all expenditures that give rise to intellectual property; (b) estimatingthe gestation lag between these outlays and the realization of benefits (improved24 See Organization for Cooperation and Development, para. 3.21, Chapter III. Transfer PricingGuidelines for Multinational Corporations and Tax Administrations, July 1995.