Profit Split Method: Solution for Integrated and Unique Value Transactions

In the spectrum of transfer pricing methods, the majority of methods like CUP, Resale Price, or TNMM are categorized as "one-sided methods" (one-sided method). These methods only test the return level of one party in the transaction (the tested party/tested party). However, in the complex modern business landscape, often both transacting parties provide very significant contributions so that it is difficult to separate or search for comparables for one party alone.

Here is where the Profit Split Method (PSM) plays a role as a "two-sided method" (two-sided method). This method views the transaction from a holistic perspective, trying to divide the combined profit generated from the affiliated transaction like independent parties working together in a strategic partnership.

Definition and Basic Philosophy of PSM

Based on MoF Regulation (PMK) 172 of 2023, PSM is defined as a transfer pricing determination method carried out by dividing the combined profit of the relevant transaction based on functions, assets, risks, and/or contributions of the parties within the transaction influenced by a special relationship.

The core of PSM is eliminating the impact of the special relationship conditions by way of dividing profit (or loss) among affiliated companies based on an economically valid basis, approximating the profit division that would be anticipated and agreed upon by independent parties. This method ensures that the profit of each entity aligns with its contribution value.

When is PSM Mandatory?

PSM cannot be used arbitrarily just because there is no comparable data for other methods. Its usage must be based on specific transaction characteristics. Based on Indonesian regulations and global standards, PSM is the most suitable method if it meets the following conditions:

A. Unique and Valuable Contributions (Unique and Valuable Contributions)

Both transacting parties provide unique and valuable contributions. Contributions are considered unique and valuable if such contributions are not comparable to independent party contributions in general and become the main source of economic benefits. An example is when both parties equally develop and own significant intangible property (intangibles).

B. Highly Integrated Operations (Highly Integrated Operations)

The business activities of the parties are very unified so that their functions cannot be analyzed separately or evaluated in isolation. An example is the global trading model (global trading) of financial instruments or supply chains that are mutually dependent.

C. Shared Assumption of Risks (Shared Assumption of Risks)

The parties mutually share business risks that are economically significant, or separately bear business risks that are closely related (closely related risks).

Two Approaches in PSM Application

Regulations in Indonesia as well as international guidelines recognize two main technical approaches in applying PSM:

A. Contribution Analysis Approach (Contribution Analysis)

In this approach, the total combined profit is directly divided among the parties based on the relative value of functions performed, assets used, and risks assumed by each party. This approach is suitable when the contributions of both parties are very closely intertwined.

B. Residual Analysis Approach (Residual Analysis)

This is the approach most commonly used in practice. This approach divides profit in two systematic stages:

• Stage 1 (Routine Profit Determination): Each party is given a basic return (basic return) for routine functions performed (such as simple manufacturing or routine services). This return is calculated using standard methods like TNMM.
• Stage 2 (Residual Profit Split): The remaining profit (Combined Profit minus Total Routine Profit) is called "Residual Profit". This profit is divided based on an analysis of the relative value of their unique contributions (for example using the proportion of R&D costs).

Profit Allocation Factors (Allocation Keys)

This factor must reflect the actual value contribution. Based on PMK 172/2023 Article 11 paragraph (8), the allocation factor must be: (1) Independent of the affiliated transaction, (2) Verifiable, and (3) Supported by relevant data.

• Asset Based: Value of operating assets or value of intangibles.
• Cost Based: Relative expenditure for R&D or marketing.
• Others: Number of employees, working time, or sales volume.

Case Study of Residual Profit Split Application

Although PSM is considered most fair for integrated business models, this method has a high level of administrative difficulty. Taxpayers must have access to the financial data of foreign affiliated parties and have a strong basis for determining allocation factors.

In the Indonesian context, the use of PSM must be supported by very detailed documentation. If it fails to prove unique contributions, tax authorities tend to will reject PSM and revert to using one-sided methods (like TNMM), which often result in significant tax corrections.

References

1. Ministry of Finance of the Republic of Indonesia. (2023). Regulation of the Minister of Finance of the Republic of Indonesia Number 172 of 2023 concerning the Application of the Principle of Fairness and Business Prevalence in Transactions Influenced by a Special Relationship.
2. OECD. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing, Paris.
3. Directorate General of Taxes. (2013). Regulation of the Director General of Taxes Number PER-22/PJ/2013 concerning Guidelines for Audit of Taxpayers Having a Special Relationship.
4. United Nations. (2021). Practical Manual on Transfer Pricing for Developing Countries (2021).