Contents - AL-Tax

46 3 Overview and Critique of Existing Transfer Pricing Methodsreasonable results than the formulary apportionment method (albeit less reasonableresults than a straightforward profit split based on assets employed).3.7.4.1 “Factors” Should Be Replaced with AssetsAssets alone generate free cash flows. Factors other than assets, such as “traderexpertise” and “activity levels,” should not be used to allocate free cash flows,because they do not generate free cash flows in the first instance. Rather, traders,marketers and key support personnel are paid the fair market value of their services,47 and, for accounting purposes, compensation is included in cost of goodssold and/or below-the-line expenses. Stated differently, operating profits and freecash flows do not embody the fair market value of services rendered by traders,marketers and key support personnel. In allocating after-tax free cash flows (i.e.,the return to providers of debt and equity capital), one should look only to the fairmarket values of income-generating assets leased or purchased with such capital.3.7.4.2 Risk is Multi-facetedThe formulary apportionment method outlined in Notice 94–40 incorporates a single“risk factor,” variously measured as the maturity-weighted volume of swap transactions,open commodity positions at year-end, etc. Leaving aside the reasonablenessof including this type of factor in the allocation formula, risk, in a trading context,cannot be reduced to single measure. Nor is the nature of risk constant over time.As discussed in Chapter 11 at much greater length, the current commoditiestrading environment, characterized by extremely volatile prices, has greatly exacerbatedtrading firms’ price and credit risk, and effectively precluded open positionsof any duration. Non-performance risk is probably the single most important riskat present, and it is not reflected at all in the measures of risk briefly describedin Notice 94–40. There is also much greater risk that delayed payment (and theattendent interest costs) will eliminate the narrow margins that firms currently earnin traditional merchant trading activities. Additionally, commodities trading firms’investments in upstream hard assets (e.g., stakes in bauxite, alumina and coppermining companies) have given rise to other risks not contemplated in Notice 94–40.3.7.4.3 Weights are Subjective and Factors Change in Relative ImportanceAgain, leaving aside the appropriateness of including non-asset “factors” in theapportionment formula, the weights assigned to individual factors under theformulary apportionment method are purely subjective, and are held fixed forthe multi-year term of an APA agreement. Given the highly fluid nature of globaltrading, such constancy is not a viable working assumption.47 If such individuals were compensated at less than their fair market value, they would presumablyseek employment elsewhere.