The PSM forms part of the transactional transfer pricing approach used in determining the arm's length price for transactions between related parties (or controlled transactions).

Specifically, the PSM involves testing the share of profits earned by related parties on a particular transaction (or arrangement) based on each party’s contribution to the overall profit.

In other words, the PSM is akin to partnership or joint venture arrangements where shares of profit are split between the parties based on respective contributions.

The PSM is highly complex in nature and time-consuming to apply than other transfer pricing methods as it requires significant analysis and judgement.

The PSM is fluid, and the application of the method will depend on the controlled transaction being analysed. Unlike other methods, the PSM relies on the application of assigning value to contributions by each party to a transaction. These contributions are evaluated based on the functions performed, assets used, and risks assumed by each enterprise.

Therefore, a critical analysis of the PSM generally includes an analysis of the supply chain and identifying functions that are being performed, assets that are being utilised and risks that are borne by each party.

Once this analysis has been performed it is important to assign value to these contributions in order to allocate profits in an arm’s length manner.

Typically, a transfer pricing analysis heavily relies on external and internal data for comparison, however in the application of the PSM only the analysis and judgement are considered.

Given the nature of this method, it invites the possibility of scrutiny from tax offices.

The example below provides how a controlled transaction can be analysed using the PSM.

Under the diagram above, Co. A purchases materials from a third party supplier and sells these materials to is related party, Co. B, at cost. In turn, Co. B sells the materials to third party customers at a margin of 10%.

Under this arrangement, the contribution of each party to the transaction is briefly provided below.

According to the analysis of the functions performed in the table above, Co. A and Co. B each perform 3 functions. Accordingly the profit earned in this arrangement should be split between Co. A and Co. B equally (i.e. out of the 10% margin earned by Co. B on its sales, 5% should be attributed to Co. A for compensation of functions performed by Co. A).

The example above is an over-simplification of the PSM and in reality the analysis may not be as straight forward as provided in the example above.

Furthermore, the PSM is generally used when there is significant value contributed by each party to the transaction and should be resorted to when it has been difficult to determine an arm's length price using other transfer pricing methods.