The two types of profit split arrangements in transfer pricing

In commercial relationships as in intra-group structures, there are two types of profit split arrangements.

In both types, the participants to the arrangement may make (a) an up front contribution of cash or assets, and/or (b) ongoing contributions of services.

The distinction is in the nature of the interest which each participant receives.

A Type 1 profit split involves a sharing in the growth of the enterprise value of the underlying venture. An example from the commercial world would be a property development joint venture. One party may contribute land. Another may contribute expertise in managing the development. The parties’ respective contributions would often be reflected in their percentage shareholdings in a special purpose vehicle which holds the legal title to the development. The parties will continue to benefit from their proportionate interests, even after their respective contributions have ceased (for example, after the development has been completed).

An example of a Type 2 profit split would be an equity partner joining a large professional partnership. The new joiner would often be required to make a capital contribution, and would participate in the ongoing income profits of the partnership for so long as she remains a partner. However, when that partner leaves the partnership, she would usually just get her capital contribution back – there would be no valuation of partnership assets at that point, and the outgoing partner would not usually receive an additional buy-out payment reflecting any growth in enterprise value.

In the context of intra group arrangements, both types of profit split are possible. However, in general, Type 1 profit splits are less likely to be appropriate, because they imply a split beneficial ownership in the underlying assets (including intangible assets). Such arrangements are more complex to manage, and would have a significant impact on arrangements for the enforcement of intellectual property rights against third parties. For the same reasons, split shareholdings within group structures are usually a recipe for confusion and mistakes later on down the line.

All other things being equal, Type 2 profit splits are more likely to be appropriate within group structures for multinational enterprises, as they make it easier for the group to maintain alignment as between legal / beneficial ownership of intangibles, and the ‘economic’ ownership for transfer pricing purposes.

Whichever approach is chosen, it is clearly fundamental for all parties (including economists who are valuing the respective contributions, as well as the directors of the participating entities) to be clear as to the risks and rewards of the relevant arrangements, including what type of profit split the arrangements represent.

LCN Legal have recently added a template profit split agreement to our toolkit of template intercompany agreements for transfer pricing compliance. The toolkit is available here.

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