Legal Implementation of Profit Splits in Transfer Pricing: Actual Profits vs Anticipated Profits

Some TP methods imply a drafting approach for pricing clauses in the intercompany agreements needed to implement them. An obvious example would be cost plus arrangements.

Other TP methods do not necessarily imply a particular structure for pricing clauses. The transactional profit split method falls squarely within the second category.

One of the reasons is the critical distinction between splitting actual profits versus splitting anticipated profits.

The distinction depends on the intended allocation of risk between the relevant parties.

If both parties are intended to share the relevant risks, then a sharing of actual profits (or losses) may be appropriate. Which means that the calculation of fees payable under the agreement needs to work a bit like a partnership agreement between equity partners in an accounting firm: it’s based on the outcome of the actual profits (or losses) for each year, after the relevant risks have played out. And applying the agreed proportions or profit splitting factors.

On the other hand, if only one party is intended to bear the relevant risks, then a sharing of anticipated profits may be appropriate. Meaning that the pricing / payment clause will probably work more like a commission - for example, a percentage of net revenue - which is payable irrespective of profit outcomes.

In either case, the relevant agreement will need to accurately implemented the intended arrangements as regards the ‘unique and valuable contributions’ of the respective parties, the ownership of intangible assets and the allocation of risks (amongst other things).