On March 7, 2016, the Internal Revenue Service (IRS) released a new International Practice Unit (IPU) on a specific transfer pricing method—the residual profit split method (RPSM). The IPU explains to IRS examiners how to determine if the RPSM is the “best method” under Section 482, and if so, how to apply such method between a US parent and its controlled foreign corporation in a transaction where intangible property is employed. As stated in a previous post, IPUs generally identify strategic areas of importance to the IRS but they are not official pronouncements of law or directives and cannot be used, cited or relied upon as such. However, taxpayers should benefit from reviewing IPUs, as they reflect the current thinking of the IRS on pertinent issues, and therefore allow taxpayers to structure and document their transfer pricing arrangements in a manner that is consistent with such thinking, as noted in a prior post available here.

Section 482 was designed to prevent the improper shifting or distorting of the true taxable income of related enterprises. Section 482 accomplishes this by requiring that all transactions between related enterprises must satisfy the arm’s length standard. That is, the terms of intercompany transactions generally must reflect the same pricing that would have occurred if the parties had been uncontrolled taxpayers engaged in the same transaction under the same circumstances. One of several possible transfer pricing methods for determining whether a transaction meets the arm’s length standard is the profit split method. One specific application of the profit split method is the RPSM. This IPU focuses on the application of the RPSM as it applies to outbound transactions involving intangible property.

The IPU outlines four steps for IRS examiners to follow in determining whether the RPSM is the best method to evaluate a controlled transaction and if so, how to apply the RPSM to that particular transaction.

  1. Identify the routine and nonroutine contributions made by the parties. The IPU cautions that if there are no nonroutine contributions, or if only one controlled taxpayer is making nonroutine contributions (most commonly of intangibles), then the RPSM should not be used. The IPU provides three examples of when the RPSM may be used: (a) a tangible goods sale if the seller uses nonroutine manufacturing intangibles to make the goods, and another controlled party purchases and resells the goods using its nonroutine marketing intangibles; (b) a licensing transaction where one controlled party licenses nonroutine manufacturing intangibles to a second controlled party, who then manufactures goods using those manufacturing intangibles and sells the goods using its own nonroutine marketing intangibles; and (c) a commercial sale of software product, if two controlled parties each contribute nonroutine software intangibles to manufacture the product, and the controlled parties share the revenue from the sales.
  2. Determine if the RPSM is the best method. The RPSM is the best method only if it provides the most reliable measure of an arm’s length result. The IPU cautions that the RPSM should be used when both controlled parties in the controlled transaction have made significant nonroutine contributions (e.g., significant contributions for which it is not possible to identify a market return).
  3. Allocate income to the parties based on routine contributions using market rates of return achieved by uncontrolled taxpayers engaged in similar activities. Routine contributions ordinarily include contributions of tangible property, services and intangible property that are generally owned by uncontrolled taxpayers engaged in similar routine activities. The IPU cautions that when determining the market rates of return for routine contributions, generally another transfer pricing method listed in Treasury Regulations Sections 1.482-3, -4, -5 and -9 will be utilized.
  4. Allocate residual profit or loss to the parties based on nonroutine contributions. Nonroutine contributions normally consist of intangible assets and/or services provided using intangible assets. The relative value of the nonroutine contributions may be measured by external benchmarks, internal data (e.g., capitalized costs of developing intangibles) or other internal data (e.g., actual recent expenditures). The IPU cautions that where the allocation of profits is based on costs rather than market benchmarks, the RPSM is generally unsuitable where only one party has incurred intangible development costs.

Finally, the IPU provides an application of the RPSM by using an example in the Treasury Regulations under Section 482.

As the US Treasury Regulations and the OECD Guidelines have arguably become more restrictive with respect to the application of transactional methods and the comparable profits method (i.e., the transactional net margin method under the OECD Guidelines) and have increasingly focused on reviewing both sides of transfer pricing arrangements, it appears almost certain that taxpayers and tax authorities will increasingly rely upon the RPSM. As such, the profit split methods should be of increased interest to taxpayers in this new era of country-by-country transfer pricing documentation. Taking these considerations into account, the recent IPU is therefore timely.