Profit Split Method Under Indian Transfer Pricing Rules

This article sets out when the Profit Split Method (PSM) is the right method for determining the arm's length price (ALP) of an international transaction, how the combined profit is divided, and how the Income Tax Appellate Tribunal has dealt with it in four decisions delivered between 2018 and 2022.

PSM is rarely used, and that is the reason it is worth understanding. Where an associated enterprise (AE) relationship involves jointly built intangibles or shared strategic decisions, a one-sided benchmark may be attacked by either side, and a practitioner needs to know whether the facts support PSM and what evidence will be asked for.

Where PSM Sits Among the Prescribed Methods

The Indian transfer pricing regulations recognise six methods. In practice PSM is applied only in a narrow set of situations.

One-sided methods, most commonly the Transactional Net Margin Method (TNMM), test a single party. That party is the less complex or routine one, such as a contract manufacturer, a low-risk distributor or a back-office service provider. Its margin is benchmarked against independent comparables. The approach holds while one party is genuinely routine and the other carries the value and the risk.

PSM examines the transaction as a whole. It aggregates the combined profit of the AEs and divides it according to each party's relative contribution, measured by functions performed, assets employed (intangibles in particular) and risks assumed, the functional, asset and risk (FAR) profile.

Facts That Point Towards PSM

PSM becomes relevant where:

• both parties make unique and valuable contributions;
• group entities jointly develop valuable intangibles or jointly drive innovation;
• strategic decisions are shared across borders; or
• the transactions are so interlinked that testing one party alone would be unreliable.