[IMGCAP(1)]Inherent conflicts between regulatory restrictions on financial services companies and certain transfer pricing methods become more apparent during times of increased market volatility and can lead to regulatory problems for taxpayers.

One such problem revolves around timing differences and transfer pricing computations that depend on year-end bonuses. Changes to bonus calculations after the fiscal year-end result in modifications to the profit or loss previously reported to regulators, often leading to fines or other negative consequences for U.S. taxpayers.

The IRS released proposed regulations that contained new specified methods for global dealing operations in March 1998. Those regulations have not yet been finalized and remain in their proposed form.

In the ensuing years, many taxpayers have adopted a transfer pricing method that is a residual profit split in which the provision of capital is treated as a routine function and receives remuneration before the trading locations are remunerated. Although transactions are often centrally booked, under this method, the profits and losses are split across the various trading sites based on an allocation key that reflects the contribution of each participating location. The allocation key tends to be based on compensation including bonuses, because compensation is considered to be an indicator of the value contributed by each location in a trading business.

[IMGCAP(2)]Registered U.S. broker-dealers must comply with various SEC requirements, including net capital rules and maintaining accurate books and records. One of these requires filing periodic Focus reports, which provide information on the operating status of the broker-dealer. To comply with this requirement, trading operations report their year-end results, calculating their profit and loss including estimated employee bonuses.

Final transfer pricing calculations rely on actual bonus amounts, which are not typically finalized until after year-end results have been reported to the SEC. The actual bonus amounts can vary substantially from projections, especially if market conditions are volatile.

Any change in bonus calculations after the fiscal year-end results in changes to the total profit and loss allocated to that location. As a result, timing differences have proven to be problematic for U.S.-regulated broker-dealers whose transfer pricing computations differ from those previously reported to regulators. This may result in fines from regulators and other ramifications.

The most obvious solution to this problem is to allocate residual income to the booking location or capital provider, rather than to the trading locations. This approach is in line with the economics of the transaction and is consistent with the regulatory position: the capital provider bears the risk of loss. However, some taxpayers are concerned about deviating from the transfer pricing methods suggested by the proposed regulations. Some taxpayers are also concerned about the risk of deemed permanent establishments if they award the bulk of the profit to the capital provider.

To enable taxpayers to act consistently with the proposed regulations and allocate profits and losses to the trading locations, other approaches must be added to the currently proposed specified methods to keep the taxpayer from facing regulatory violations.

One approach would involve booking profits in the broker-dealer with current losses temporarily retained by the capital provider until the losses can be offset against future profits. The other entity temporarily bearing the losses may be the booking location or may be within the broker-dealer’s consolidated U.S. tax group until these losses are offset by future trading profits.

As compensation, this entity would receive a credit facility fee from the broker-dealer, including liquidity, interest rate and catastrophic risk components. Under this arrangement, the risk of material fluctuations in the profit and loss as a result of transfer pricing would not be borne by the regulated broker-dealer.

If taxpayers apply transfer pricing methods that are in line with the economics of their transactions (i.e., risk is borne by the capital provider), then they are in compliance with the regulators but run the tax audit risk of not being consistent with the proposed global dealing regulations.

In contrast, applying the transfer pricing methods proposed under the global dealing regulations will likely result in regulatory violations, especially during times of market volatility.

Barbara Mace is a financial services principal and Jocelyn Mullis is a financial services executive at Ernst & Young.

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