Contents - AL-Tax

160 11 Global Trading of Commoditiestrading firms’ own measures of risk will be both more comprehensive and morereadily available than ad hoc measures of risk designed expressly for tax purposes.11.5 ComparisonThe formulary apportionment methodology presupposes that there is a predictable(and possibly causal) relationship between (a) the measure of profits defined inNotice 94–40, and (b) the “factors” used to allocate such profits among group companies.However, the market-determined compensation paid to traders, originators, logisticspersonnel, risk managers and others already reflects the value of their contributionsto the generation of gross profits. Segmenting compensation paid to differentgroupings (e.g., traders and key support personnel, respectively) and superimposingweights onto the resulting “value” and “activity” factors, simply substitutes subjectivejudgment for an existing, and much more reliable, measure of each groupings’economic value.The “risk” factor, as the IRS has applied it, is also problematic. Here, the distinctionbetween accounting profits and free cash flows becomes paramount. Asstated in Notice 94–40, the risk factor is intended to “measure the potential risk towhich a particular trading location exposes the worldwide capital of the organization.”As illustrated by our proposed simplified profit split method, risk, appropriatelymeasured, can in fact serve this purpose. However, reducing risk to a single,point-in-time measure, as described in Notice 94–40 (e.g., open positions at yearend), cannot possibly capture all the dimensions of risk to which a functionallyfully integrated trading firm is subject over the course of a year. Given tradingfirms’ fully justified preoccupation with risk, and their dedication of resources tothe measurement thereof, it makes far more sense to rely on such internal measures.Additionally, as noted, the formulary method applies to “worldwide net income,”rather than after-tax free cash flows. The latter, rather than the former, should beallocated based on capital employed and risks assumed thereby.In summary, the formulary apportionment method’s attribution of worldwidenet income to value, activity and risk factors in itself is unfounded. The measuresand weighting of value, activity and risk are also flawed, and the resultingallocation is therefore wholly arbitrary. One can significantly improve on theIRS’ formulary apportionment methodology vis-a-vis global dealing operations bysubstituting assets for factors, fair market values for weights and after-tax free cashflows for the accounting-based measure of profits defined in Notice 94–40. Withthese modifications, which the proposed simplified profit split method incorporates,the approach has a far more solid economic footing.