Profit Split

3ExplainExplain

When, and how, to split profit

A profit splitProfit split methodA method that splits the combined profit from a transaction between the parties based on their contributions. It suits deals where both sides make unique, valuable contributions.Open in the Glossary fits when each side makes a contribution that is non-routine: no independent company makes one like it, and it is a key source of profit. Then there is nothing reliable to test either side against alone. It can also fit when the two businesses are so tightly linked, or share the same big risks, that you cannot judge one without the other.

US rules give two versions. The comparable profit split copies how independent companies doing similar work split their combined profit. That data is rare. The residual profit split is the one you just used. Step 1 gives each side a market routine returnRoutine returnA modest, steady profit for low-risk activities such as contract manufacturing, distribution, or support services, set by reference to comparable companies.Open in the Glossary for its routine work, using the usual methods and comparables. Step 2 splits the residualResidual profitThe profit left after every routine function has been paid its routine return. It usually goes to the principal.Open in the Glossary by the relative value of each side's non-routine contributions. You may measure that value with market data or with the capitalized cost of building the intangiblesIntangibleSomething of value that is not a physical or financial asset, such as a patent, brand, software or know-how, that a company can own or control and use in its business. Using another company's intangible is usually paid for with a royalty.Open in the Glossary. As always, the best method ruleBest method ruleThe US rule that the arm's length result must be set using the method that gives the most reliable measure on the facts. There is no strict order of methods (Treas. Reg. § 1.482-1(c)).Open in the Glossary decides if a profit split is the most reliable method.

The split key must be objective and kept the same over the life of the deal, in loss years too. A cost key like R&D works only when cost tracks value. Patents of different kinds may need a risk weighting, and spending from years ago may need bringing to today's terms. You also need reliable combined accounts for just this business. That is the method's weak spot: it rests on judgment and on data from both sides.

Why the running story is not a profit split

In the other lessons the US Entrepreneur owns and controls all the IP. The Canada Distributor and the Mexico contract manufacturer do routine work that independent companies also do. So you test each of them on its own with the CPMComparable profits method (CPM)A US method that tests a company's operating profit against the operating profit of comparable companies, using a profit level indicator such as operating margin (Treas. Reg. § 1.482-5). It is close to the OECD's TNMM.Open in the Glossary, against comparables, and the Entrepreneur keeps the residual. Giving a routine company a share of the profit would not be arm's length. A lack of perfect comparables is not, by itself, a reason to split profit.

Sources: Treas. Reg. § 1.482-6(c), comparable and residual profit split; § 1.482-6(b), no equal or arbitrary split; § 1.482-1(c), the best method rule