Contents - AL-Tax

44 3 Overview and Critique of Existing Transfer Pricing Methods The relative value of the trading location (the “value factor”); The risk associated with the trading location (the “risk factor”); and The extent of activity at each trading location (the “activity factor”).The “value factor” is intended to measure each trading location’s contributionto the worldwide profits of the group and is often equated with the compensationpaid to all traders at individual trading locations. The “risk factor” measures the riskto which a particular trading location exposes the worldwide capital of the organization.Risk has been measured in a variety of ways (e.g., the maturity-weightedvolume of swap transactions or open commodity positions at year-end by tradinglocation). Finally, the “activity factor” is a measure of each trading location’s contributionsto key support functions. It is frequently quantified by the compensationpaid to such personnel at each trading location. Value, risk and activity factors mustalso be weighted in accordance with their relative importance.Under the proposed global dealing regulations, the allocation of combinedincome across tax jurisdictions must be determined by application of one of thefollowing methods: The comparable uncontrolled financial transaction (CUFT) method; The gross margin method; The gross markup method; and The profit split method (consisting of either a total or residual profit split).Under the CUFT method, one looks to the pricing of uncontrolled financial transactionsto establish or evaluate intercompany prices among members of a groupengaged in global dealing. Pricing data from public exchanges or quotation mediaare acceptable under some circumstances, as are applications of internal proprietarypricing models used to establish pricing on arm’s length financial dealings. Judgingfrom the examples given in the proposed global dealing regulations, the CUFTmethod would generally apply when (a) a controlled group trades standardizedfinancial instruments, (b) each group member operates as a dealer in its own rightvis-a-vis its separate customer base, and (c) intercompany financial transactions takeplace contemporaneously with third party transactions. While the CUFT approachis reasonable on its face, its applicability is somewhat limited, inasmuch as manytrading firms deal in non-standard financial products and commodities and enter intorelatively few (albeit large) trades per day. Moreover, individual trading offices mayconclude contracts in a broad range of geographic markets and are motivated to doso in part by arbitrage opportunities (i.e., because prices differ across markets). Assuch, pricing comparisons across geographic markets are frequently unreliable.As with the CUFT method, the gross margin and gross markup methods presupposethat each member of a global dealing operation has a substantial book of businessthat it carries out independently. The gross margin and gross markup methodscan be applied when individual group members act as market-makers vis-a-vis thirdparties, and a market-determined bid/ask spread can therefore readily be establishedin the relevant time frame (that is, when an intercompany transaction takes place).