D.Prifit Split Method
Cases applicable: This would normally happen when transactions are very interrelated that they cannot be evaluated separately.
The method is based on the concept that profits earned in a controlled transaction should be equitably divided between associated parties involved in the transaction according to the functions performed.
Guideline mentioned 2 approaches to split profit which they are not necessarily exhaustive or mutually exclusive
(I)Residual profit split approach
- There are two stages of profit division under this approach. Firstly, the combined profit is apportioned according to basic returns assigned to each party to the transaction.
- The next stage involves the allocation of the remaining residual profit/loss.
(II)Contribution analysis approach
Under a contribution analysis, the combined profits would be divided between the associated enterprises based on the relative value of the functions (i.e. contribution) performed by each of the associated enterprises participating in the controlled transaction
Example 4
X, Y and Z are companies located in different countries. Company X
designs and manufactures the major components of a high quality
electrical product which it sells to its subsidiary Y. From these components,
Y further develops and manufactures them into the final product which it
exports to Z, an independent distributor.
| The trading accounts of X and Y are as follows: | ||||
| X | Y | |||
| Sales | 100 | 300 | ||
| Purchases | 15 | 100 | ||
| Manufacturing cost | 20 | 35 | ||
| Gross profit | 65 | 165 | ||
| R&D | 20 | 15 | ||
| Other operating expenses | 15 | 10 | ||
| Net profit | 30 | 140 | ||
(I)Residual analysis of the group profit
Step1.Calculation of total profit Net Profit (X) + Net Profit (Y) = 30 +140 = 170
Step2. Calculation of basic return
The mark-ups derived from external data will be used to calculate basic returns to X and Y.
Lets :
- Transfer Price (TP)
- Adjusted Transfer Price(ATP) = Arm’s Length Transfer Price
- adjusted COGS_Y = COGS_Ya
- COGS include TP from X = COGS_Yx
Basic return to X = 30% of (COGS_X + Other operating Expenses_X)
= 30%(35+15)
=15……<1>
Basic return to Y =20% of (COGS_Y + Other operating Expenses_Y)……<2>
Since COGS of Y included the purchase price from associate X,
Thus, COGS_Ya = COGS_Yx - purchase price from X + ATP……<3>
Bring <3> into <2>:
Basic return to Y =20% (COGS_Yx - purchase price from X + ATP + Other operating Expenses_Y)
= 20% (35 + 10 + ATP)
= 9 + 0.2ATP……<4>
(II) Residual profit split:
Step3. Calculation of residual profit
(if you are good in Algebra, it is similar to the concept of marginal error)
Residual profit = Net profit - [(Return to X) + (Return to Y)]
= 170 – (<1>+<4>)
= 170 - (15+9+0.2ATP)……<5>
~Contribution analysis approach~
Assume that in this case R&D is a reliable indicator of X and Y's relative contribution
Step4.Get residual return :-
Total R&D = 20 + 15 = 35
Share for X =20/35 = 57%
Residual return to X = 57% <5>
=57% [170 - (15+9+0.2ATP)]
=83.22 - 0.114ATP……<6>
Share for Y =15/35 = 43%
Residual return to Y = 43% <5>
= 43%[170 - (15+9+0.2ATP)]
= 62.78 - 0.086ATP……<7>
Step5, Get Net profit :-
Net Profit for X = Basic return to X + Residual return to X
= <1> + <6>
= 15 + 83.22 - 0.114ATP
= 98.22 - 0.114ATP ……<8>
Net Profit for Y = Basic return to Y + Residual return to Y
= <4> + <7>
= 9 + 0.2ATP + 62.78 - 0.086ATP
=71.78 + 0.114ATP ……<9>
Step6, Finding unknown ATP:-
Setting formula with X
ATP = Total cost_X + Net Profit for X
= (15+20+20+15) + <8>
ATP =70 + 98.22 - 0.114ATP
ATP+0.114ATP = 70 + 98.22
1.114ATP = 168.22
ATP = 168.22/1.114
ATP = 151.005386
ATP ~ 151
or setting formula with Y
Net Profit for Y = Sales – Cost – ATP
<9> = 300 – (35+15+10) – ATP
71.78 + 0.114ATP = 300 – (60) – ATP
0.114ATP + ATP = 240 – 71.78
1.114ATP = 168.22
ATP = 168.22/1.114
ATP = 151.005386
ATP ~ 151
Thus solved unknown ATP = 151
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