Profit Split Method
Comparable Profit Split and Residual Profit Split Approaches to Valuing Related-Party Transactions
While the IRS Regulations refers to the "profit split method," they might have referenced "profit split methods," since there are two distinct approaches authorized under that heading. Both variations rely on the contribution of the parties to a transaction to the combined operating profit or loss associated with the business activity in question. The first variation, the comparable profit split method — described in 26CFR 1.146-6(c)(2) — evaluates the profitabity of the transaction in reference to a comparable uncontrolled transaction. In cases where there are no comparable uncontrolled transactions whose profitability can be examined, the residual proft split method is used, as described in 26CFR 1.146-6(c)(3). The residual profit split method attempts to allocate income and expenses associated with the business activity between the parties in the transaction using a structured methodology described in this section. The level of detail required to conduct a residual profit split analysis can be significant, particularly in complex business activities involving multiple vendors and shared expenses. These methods are avalable for transactions involving both tangible and intangible property. The official definition of this method can be found in 26CFR 1.482-6 of the transfer pricing regulations:
§ 1.482–6 Profit split method
(a) In general. The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).
(b) Appropriate share of profits and losses. The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of § 1.482– 1(d)(3). Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity. The profit allocated to any particular member of a controlled group is not necessarily limited to the total operating profit of the group from the relevant business activity. For example, in a given year, one member of the group may earn a profit while another member incurs a loss. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally, or in any other arbitrary proportion. The specific method of allocation must be determined under paragraph (c) of this section.
(c) Application—(1) In general. The allocation of profit or loss under the profit split method must be made in accordance with one of the following allocation methods—(i) The comparable profit split, described in paragraph (c)(2) of this section; or (ii) The residual profit split, described in paragraph (c)(3) of this section.
Here is a pdf of the complete regulations: 26 CFR 1.482.
The profit split method is further discussed in the following articles: