What Is the Profit Split Method?
The Profit Split Method (PSM) is one of the six methods India's transfer pricing law lets a taxpayer use to price a transaction between related parties at "arm's length" — the price two unrelated parties would have agreed to. Unlike methods that compare a single transaction to an external benchmark, PSM works on the combined profit two or more related enterprises jointly earn from a transaction, then divides that pool between them according to what each side actually contributed. It is designed for the cases where the transaction cannot honestly be sliced apart and priced piece by piece.
PSM is listed as method (d) in section 165(1) of the Income-tax Act, 2025 (section 92C(1) of the Income-tax Act, 1961), which prescribes six methods for determining the arm's length price of an international transaction or large "specified domestic transaction": comparable uncontrolled price, resale price, cost plus, profit split, transactional net margin, and any other method the Central Board of Direct Taxes (CBDT) may prescribe.
How the Profit Split Method Works
The mechanics of PSM are prescribed by Rule 79(1)(d) of the Income-tax Rules, 2026 (Rule 10B(1)(d) of the Income-tax Rules, 1962), the rule made under section 165 (section 92C of the 1961 Act) that sets out how each of the six methods is actually applied. The rule names PSM as applicable mainly where a transaction involves the transfer of unique intangibles or unique and valuable contributions by each enterprise, or where multiple transactions are so inter-related that they cannot be evaluated separately. It then sets out two distinct approaches.
Contribution Profit Split
Under the contribution approach, the steps run as follows:
- Determine the combined net profit. Work out the combined net profit the associated enterprises earn from the international transaction or specified domestic transaction they are jointly engaged in.
- Evaluate relative contribution. Assess each enterprise's relative contribution to that combined profit, based on the functions performed, assets employed (or to be employed), and risks assumed by each enterprise — benchmarked, where possible, against reliable external market data showing how unrelated enterprises performing comparable functions in similar circumstances would value such contributions.
- Split the combined profit. Divide the combined net profit among the enterprises in proportion to their relative contributions as evaluated in step 2.
- Arrive at the arm's length price. The profit apportioned to the assessee under step 3 is used to arrive at the arm's length price for the transaction.
Residual Profit Split
The residual approach is a two-stage variant, used where part of the combined profit reflects routine contributions that can be benchmarked directly:
- The combined net profit from the transaction is determined, as above.
- A portion of that profit is first allocated to each enterprise to provide it with an arm's length return for the contributions that can be reliably benchmarked using comparable uncontrolled transactions — typically routine manufacturing, distribution, or support functions.
- The residual profit left after that initial allocation — the part attributable to unique intangibles or unique contributions that cannot be benchmarked directly — is then split among the enterprises in proportion to their relative contributions, using the same functions/assets/risks analysis as the contribution approach.
- Each enterprise's total arm's length profit is the sum of its initial (routine) allocation plus its share of the residual split.
No Preferred Method Among the Six
It is a common misconception that PSM is the "default" or preferred choice whenever a transaction involves unique intangibles. The Central Board of Direct Taxes addressed this directly: an earlier Circular No. 2/2013 on the application of PSM, dated 26 March 2013, was withdrawn with immediate effect by Circular No. 5/2013, dated 29 June 2013, because it "appeared to give the impression that there was a hierarchy among the six method[s] listed in section 92C and that Profit Split Method (PSM) was the preferred method" for transactions involving unique intangibles or multiple interrelated transactions. There is no such hierarchy. Section 165(2) requires the taxpayer to select whichever of the six methods is the "most appropriate method" for the actual facts — having regard to the nature of the transaction, the class of transaction or enterprise, the functions performed, and other CBDT-prescribed factors. PSM must be justified on the facts each time, not assumed because intangibles are involved.
When PSM Is the Right Method — and When It Isn't
India's rule text points to two indicators for PSM: unique intangibles or unique and valuable contributions, and transactions too interrelated to evaluate separately. The OECD Transfer Pricing Guidelines (Chapter II, as revised by the 2018 BEPS Action 10 guidance on profit splits) describe the same two indicators in more operational terms, as secondary guidance consistent with India's rule. On unique and valuable contributions, the OECD guidance states that "the existence of unique and valuable contributions by each party to the controlled transaction is perhaps the clearest indicator that a transactional profit split may be appropriate" (paragraph 2.126). On integration, it explains that "a high degree of integration means that the way in which one party to the transaction performs functions, uses assets and assumes risks is interlinked with, and cannot reliably be evaluated in isolation from," the other party's (paragraph 2.133).
In practice, this points PSM toward situations such as: two group companies that jointly develop and commercially exploit intellectual property, where neither side's contribution can be benchmarked against an external comparable in isolation; global trading or integrated manufacturing operations where functions, assets, and risks are shared across borders in a single value chain; and joint contract-R&D or co-development arrangements where both the Indian entity and its foreign affiliate contribute intangibles of real value. PSM is a poor fit — and other methods such as the cost plus method or the transactional net margin method usually work better — where one side simply performs a routine, benchmarkable function (a contract manufacturer, a limited-risk distributor, a captive service provider) and the other side owns all the valuable intangibles and bears the residual business risk.
Legal Basis and Filing Obligations
PSM sits inside the same compliance chain as every other transfer pricing method:
- Section 165(2) requires selection of the "most appropriate method" — PSM among them — having regard to the nature of the transaction, the class of transaction or enterprise, the functions performed, and other factors the CBDT may prescribe.
- Section 165(3)(a)(ii) gives a limited tolerance band: if only one arm's length price is determined and the actual transaction price varies from it by no more than a percentage (up to 3%) that the Central Government notifies, no adjustment is needed.
- Section 166 lets the Assessing Officer, with the Principal Commissioner or Commissioner's prior approval, refer the determination of the arm's length price to a Transfer Pricing Officer (TPO), who can independently examine and re-determine the split.
- Section 171 requires every person who has entered into an international transaction or specified domestic transaction to keep and maintain prescribed information and documentation — the FAR (functions, assets, risks) analysis and combined-profit computation that support a PSM split fall here.
- Section 172 requires an accountant's report (Form 48 (formerly Form 3CEB) in current practice) for every international transaction or specified domestic transaction regardless of method used, filed by the "specified date" under section 173(d) — one month before the due date for filing the return of income under section 263(1).
- The domestic-transaction leg of this framework only applies once the aggregate of specified domestic transactions in a tax year exceeds twenty crore rupees, under section 164.
Why PSM Matters for Foreign Companies in India
Foreign groups run into PSM most often where an Indian subsidiary is not a simple cost centre but a genuine co-creator of value — an Indian engineering team that co-develops core technology with its foreign parent, an Indian entity that shares integrated supply-chain or trading risk with affiliates abroad, or a joint marketing and product arrangement where both sides hold real intangibles. In each case, a one-sided method that tests only the Indian entity's margin misses the point: both sides' contributions have to be measured and the combined profit divided accordingly. Getting the relative-contribution analysis wrong, or failing to document how functions, assets, and risks were weighed, invites a TPO reference under section 166 and a primary adjustment under section 165(6) — with no matching downward relief for the foreign affiliate under section 165(8).
Worked Example
Meridian Health Analytics Inc., a US-based health-tech company, and its wholly owned Indian subsidiary, Meridian Health Analytics India Pvt Ltd, jointly develop a clinical-data analytics platform. Meridian US contributes the core machine-learning algorithms and holds the global sales relationships; Meridian India's engineering team built and owns patents on the data-processing pipeline that makes the platform viable at scale. Neither contribution can be benchmarked in isolation, so the two apply the contribution profit split method to the combined licensing income the platform earns from third-party hospital networks.
For the tax year, the combined net profit from exploiting the platform is ₹40 crore. Based on a functions/assets/risks analysis — R&D headcount and patents held on each side, development risk borne, and external market data on comparable technology co-development arrangements — the relative contribution is evaluated at 60% to Meridian US and 40% to Meridian India. The combined profit is split accordingly: Meridian US's share is ₹24 crore (60% of ₹40 crore) and Meridian India's share is ₹16 crore (40% of ₹40 crore) — the two shares add back to the full ₹40 crore combined profit, and Meridian India returns its ₹16 crore share as income from the international transaction.
If the two sides had instead used the residual approach — carving out a ₹5 crore basic return to Meridian US for routine sales support and a ₹10 crore basic return to Meridian India for routine platform maintenance, both benchmarked against comparable service providers — the residual profit would be ₹40 crore minus ₹15 crore, or ₹25 crore, attributable to the platform's unique intangibles. Split 60:40, that residual gives Meridian US a further ₹15 crore and Meridian India a further ₹10 crore. Each side's total is then ₹20 crore (₹5 crore + ₹15 crore for Meridian US; ₹10 crore + ₹10 crore for Meridian India) — again reconciling exactly to the ₹40 crore combined profit, just divided differently between the two enterprises because part of it was priced as a routine return rather than folded into the intangible-driven split.
Frequently Asked Questions
How is PSM different from the other five transfer pricing methods?
The other five methods each test one side of a transaction against an external comparable — a price, a margin, or a mark-up earned by unrelated parties. PSM does not look for an external comparable for the transaction as a whole; instead, it starts from the combined profit both related parties actually earned together and divides it based on each side's contribution. It is used precisely when the transaction is too integrated to test one side alone.
Is PSM the preferred method whenever unique intangibles are involved?
No. The CBDT withdrew Circular No. 2/2013 through Circular No. 5/2013 because it wrongly implied a hierarchy among the six methods with PSM as preferred for unique intangibles. Section 165(2) requires the "most appropriate method" to be selected on the facts each time; unique intangibles are one indicator favouring PSM, not an automatic trigger for it.
What is the difference between contribution profit split and residual profit split?
Contribution profit split divides the entire combined profit in proportion to each enterprise's relative contribution in one step. Residual profit split first carves out a benchmarked, arm's length return for each side's routine, comparable contributions, and only splits the leftover residual profit — the part attributable to unique intangibles — by relative contribution. Residual split is generally used when part of the value chain can be benchmarked directly and part cannot.
What happens if the Transfer Pricing Officer disagrees with the contribution ratio used?
Under section 166, the Assessing Officer can refer the transaction to a Transfer Pricing Officer, who can independently re-evaluate the functions, assets, and risks analysis and determine a different split. If the resulting price differs from the price actually reported by more than the notified tolerance under section 165(3)(a)(ii), the difference is added to the taxpayer's income under section 165(6), with no matching relief for the other associated enterprise under section 165(8).
Does using PSM change India's documentation or accountant's report requirements?
No. Section 172 requires an accountant's report for every international transaction or specified domestic transaction regardless of which of the six methods is used, filed by the specified date defined in section 173(d). Section 171 documentation for a PSM computation additionally needs to show the combined-profit calculation and the functions/assets/risks analysis behind the contribution split, which is typically more extensive than for a one-sided method.
See also: Transfer Pricing, Arm's Length Pricing, and Transfer Pricing Documentation.
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