Profit split method (PSM)
Description of the method: the profit split method (PSM) is the first of the transactional profit methods set out in Polish tax law. It consists in determining the combined profits that related parties achieved in connection with a given transaction or transactions and splitting those profits between them in the proportion in which independent parties would have done so.
The combined profits are determined using a common accounting standard and a common currency, where the related parties for which that profit is determined apply a common accounting standard and keep their books in a common currency. Otherwise the combined profits are determined using one of the accounting standards and one of the currencies applied by the related parties.
Splitting profits in business practice: the methods
The profits may be split in the proportion referred to above in two ways:
- residual analysis
Name: profit split method (PSM), residual analysis
Type of method: a statutory method from the group of transactional profit methods
Description of the method: residual analysis means a method that splits the total profits earned in connection with a given transaction or transactions by the related parties taking part in it in two stages.
In the first stage each party to the transaction is allocated the minimum profit that independent parties achieve in transactions of that kind; in the second stage any profits remaining after the first-stage split are divided between the related parties taking part in the transaction in accordance with the rules that independent parties taking part in such a transaction would have agreed; where the total profits achieved by the related parties is lower than the total profits allocated in the first stage, the profits allocated are reduced; the adjustment made in the second stage takes into account economic functions such as:
- the allocation of business risk and of the responsibilities of the parties to the transaction,
- the scale of the resources, machinery and equipment engaged,
- the value of the intangible assets engaged.
Residual analysis splits the profits from a transaction on the basis of objective measures, which may be profitability indicators, in particular the return on sales or on operating activity. It should be noted that profitability indicators reflect the ratio of a defined profit (on gross sales, net sales, operating activity, business activity, gross or net) to defined measures of revenue, which shows the direct profitability of the transactions a party carries out within its individual lines of business.
Such an indicator makes it possible to assess how profitable a party's activity is by showing how much profit on revenue each złoty of that revenue generates, so they may be regarded as a criterion for splitting the transactional profit that unrelated parties would expect. Where, on the other hand, an enterprise sells its products or services only to related parties, as is the case with advisory firms serving a capital group, the above measures may be applied by reference to the same measures achieved by unrelated parties carrying on similar business activity, after adjusting them appropriately for the following elements:
- the volume of turnover,
- the structure of turnover,
- the length of time present on the given market,
- the nature of the services provided or of the products sold,
- other elements that materially demonstrate the differences between the companies compared (benchmarking is a good tool here for examining the comparability of measures).
Comparability of transactions: required by Chapter 2, Examination of the comparability of transactions, in conjunction with Chapter 3, Transfer pricing methods, of the Regulation of the Minister of Finance of 21 December 2018 on transfer pricing for corporate income tax purposes.
- contribution analysis
Name: profit split method (PSM)
Description of the method: contribution analysis is one of the two methods of proportionally splitting profit. It divides between related parties the combined profit from a transaction whose subject matter is goods produced or improved by those parties, on the basis of the relative value of the activities undertaken by each of them, taking into account the following factors:
- the scale of the resources, machinery and equipment engaged,
As the above shows, contribution analysis rests in essence on subjective factors, consisting in justifying the relative value of the activities undertaken in order to earn the transaction revenue. The relative value of those activities may be examined using the measures described for residual analysis, but the main elements here are the functional analysis of the parties to the transaction, the assets used, the risks assumed and the costs connected with the transaction.
Mathematical formula: there is no single formula that would allow this method to be applied.
Profits are split proportionally by correctly determining the revenue earned by each of the related parties and the costs incurred in connection with the given transaction or transactions. The absence of rules on the methods of determining the profits and costs connected with a transaction means that any approach may be chosen that results in the profit being determined in accordance with the principles of tax law.
In order to define correctly the transactional profits achieved by related parties, the structure of the transaction must first be considered. It is difficult to rely solely on a one-sided transaction, such as the supply of raw materials or the sale of finished products, without taking into account the profits from the sale of finished products in which those raw materials are a factor of production. Practice shows that only where the subject of the transaction is intangible assets or services can the transaction be considered one-sidedly. In such a case the profits on the side of the supplier or provider are determined directly, while on the side of the purchaser the relative value of the benefit obtained from acquiring those rights or services is indicated, or calculated. The proportional profit follows from splitting the transactional profit by one of the two methods and allocating it accordingly to the parties taking part in the transaction.
Mathematical formula: it is set out in the description of the profit split method performed by residual analysis and by contribution analysis.