Profit Split Method Transfer Pricing Examples

Let’s say a pharmaceutical company has a manufacturing affiliate help with research and
development (R&D) to bring a new drug to market. The R&D company will bear the costs and
risks of launching the new drug. The two related parties need to determine the right profit split
terms to include in their pharmaceutical agreement.

They decide that, based on their relative investments and risks, they’ll use the contribution PSM
to ensure they divide the drug profits fairly. To do so, it’s necessary to determine the
contributions made by both parties for research and development, marketing, and other necessary
expenses.

The two parties invested a total of $500 million to bring the new medication to market. It’s
determined that the R&D company contributed $375 million of the total investment. Because
$375 million is 75% of $500 million, the R&D company will make 75% of future profits, with
the drug manufacturer collecting the remaining 25%.

Consider another example—a manufacturer owns a brand and sells products to an affiliate in
another country. The affiliate sells to third-party customers in that country.

The affiliate has invested money in building the customer base and developing the market in its
country. As a result, not all of the profit generated in that country can be attributed to either the
brand (parent company) or the local affiliate. Using the profit split method of transfer pricing,
they can determine the appropriate split of the profits between the parent company and the local
affiliate.

Start by determining the contributions made by each entity to that profit. How much has the
affiliate invested in advertising and other market-building activities versus investments in these
activities by the parent company? Assign values to the contributions of each to determine how to
split the profit, supposing the parent company has spent $15 million on advertising the brand in
the affiliate’s country, and the affiliate has spent $10 million on advertising and other marketing
activities. 

In this scenario, the brand or parent company has invested 60% of the funds spent on advertising
the brand and building the market, while the affiliate has provided 40% of the investment. Under
the profit split method, the parent company will receive 60% of future profits, while the affiliate
will receive 40%. This is a simplified example, but it explains the concepts underlying the profit
split method.