2. The section heading and entries for Sec. 1.482-8 are redesignated as the section heading and entries for Sec. 1.482-9.
Par. 6. Section 1.482-8 is redesignated as Sec. 1.482-9 and a new Sec. 1.482-8 is added to read as follows:
(a) General requirements and definitions--(1) In general. Where two or more controlled taxpayers are participants in a global dealing operation, the allocation of income, gains, losses, deductions, credits and allowances (referred to herein as income and deductions) from the global dealing operation is determined under this section. The arm's length allocation of income and deductions related to a global dealing operation must be determined under one of the methods listed in paragraphs (b) through (f) of this section. Each of the methods must be applied in accordance with all of the provisions of Sec. 1.482-1, including the best method rule of Sec. 1.482-1(c), the comparability analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 1.482- 1(e), as those sections are supplemented or modified in paragraphs (a)(3) and (a)(4) of this section. The available methods are--
(i) The comparable uncontrolled financial transaction method, described in paragraph (b) of this section;
(ii) The gross margin method, described in paragraph (c) of this section;
(iii) The gross markup method, described in paragraph (d) of this section;
(iv) The profit split method, described in paragraph (e) of this section; and
(v) Unspecified methods, described in paragraph (f) of this section.
(2) Definitions--(i) Global dealing operation. A global dealing operation consists of the execution of customer transactions, including marketing, sales, pricing and risk management activities, in a particular financial product or line of financial products, in multiple tax jurisdictions and/or through multiple participants, as defined in paragraph (a)(2)(ii) of this section. The taking of proprietary positions is not included within the definition of a global dealing operation unless the proprietary positions are entered into by a regular dealer in securities in its capacity as such a dealer under paragraph (a)(2)(iii) of this section. Lending activities are not included within the definition of a global dealing operation. Therefore, income earned from such lending activities or from securities held for investment is not income from a global dealing operation and is not governed by this section. A global dealing operation may consist of several different business activities engaged in by participants. Whether a separate business activity is a global dealing operation shall be determined with respect to each type of financial product entered on the taxpayer's books and records.
(ii) Participant--(A) A participant is a controlled taxpayer, as defined in Sec. 1.482-1(i)(5), that is--
(1) A regular dealer in securities as defined in paragraph (a)(2)(iii) of this section; or
(2) A member of a group of controlled taxpayers which includes a regular dealer in securities, but only if that member conducts one or more activities related to the activities of such dealer.
(B) For purposes of paragraph (a)(2)(ii)(A)(2) of this section, such related activities are marketing, sales, pricing, risk management or brokering activities. Such related activities do not include credit analysis, accounting services, back office services, general supervision and control over the policies of the controlled taxpayer, or the provision of a guarantee of one or more transactions entered into by a regular dealer in securities or other participant.
(iii) Regular dealer in securities. For purposes of this section, a regular dealer in securities is a taxpayer that--
(A) Regularly and actively offers to, and in fact does, purchase securities from and sell securities to customers who are not controlled taxpayers in the ordinary course of a trade or business; or
(B) Regularly and actively offers to, and in fact does, enter into, assume, offset, assign or otherwise terminate positions in securities with customers who are not controlled entities in the ordinary course of a trade or business.
(iv) Security. For purposes of this section, a security is a security as defined in section 475(c)(2) or foreign currency.
(3) Factors for determining comparability for a global dealing operation. The comparability factors set out in this paragraph (a)(3) must be applied in place of the comparability factors described in Sec. 1.482-1(d)(3) for purposes of evaluating a global dealing operation.
(i) Functional analysis. In lieu of the list set forth in Sec. 1.482-1(d)(3)(i)(A) through (H), functions that may need to be accounted for in determining the comparability of two transactions are--
(A) Product research and development;
(B) Marketing;
(C) Pricing;
(D) Brokering; and
(E) Risk management.
(ii) Contractual terms. In addition to the terms set forth in Sec. 1.482-1(d)(3)(ii)(A), and subject to Sec. 1.482-1(d)(3)(ii)(B), significant contractual terms for financial products transactions include--
(A) Sales or purchase volume;
(B) Rights to modify or transfer the contract;
(C) Contingencies to which the contract is subject or that are embedded in the contract;
(D) Length of the contract;
(E) Settlement date;
(F) Place of settlement (or delivery);
(G) Notional principal amount;
(H) Specified indices;
(I) The currency or currencies in which the contract is denominated;
(J) Choice of law and jurisdiction governing the contract to the extent chosen by the parties; and
(K) Dispute resolution, including binding arbitration.
(iii) Risk. In lieu of the list set forth in Sec. 1.482-1(d)(3), significant risks that could affect the prices or profitability include--
(A) Market risks, including the volatility of the price of the underlying property;
(B) Liquidity risks, including the fact that the property (or the hedges of the property) trades in a thinly traded market;
(C) Hedging risks;
(D) Creditworthiness of the counterparty; and
(E) Country and transfer risk.
(iv) Economic conditions. In lieu of the list set forth in Sec. 1.482-1(d)(3)(iv) (A) through (H), significant economic conditions that could affect the prices or profitability include
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(A) The similarity of geographic markets;
(B) The relative size and sophistication of the markets;
(C) The alternatives reasonably available to the buyer and seller;
(D) The volatility of the market; and
(E) The time the particular transaction is entered into.
(4) Arm's length range--(i) General rule. Except as modified in this paragraph (a)(4), Sec. 1.482-1(e) will apply to determine the arm's length range of transactions entered into by a global dealing operation as defined in paragraph (a)(2)(i) of this section. In determining the arm's length range, whether the participant is a buyer or seller is a relevant factor.
(ii) Reliability. In determining the reliability of an arm's length range, it is necessary to consider the fact that the market for financial products is highly volatile and participants in a global dealing operation frequently earn only thin profit margins. The reliability of using a statistical range in establishing a comparable price of a financial product in a global dealing operation is based on facts and circumstances. In a global dealing operation, close proximity in time between a controlled transaction and an uncontrolled transaction may be a relevant factor in determining the reliability of the uncontrolled transaction as a measure of the arm's length price. The relevant time period will depend on the price volatility of the particular product.
(iii) Authority to make adjustments. The district director may, notwithstanding Sec. 1.482-1(e)(1), adjust a taxpayer's results under a method applied on a transaction by transaction basis if a valid statistical analysis demonstrates that the taxpayer's controlled prices, when analyzed on an aggregate basis, provide results that are not arm's length. See Sec. 1.482-1(f)(2)(iv). This may occur, for example, when there is a pattern of prices in controlled transactions that are higher or lower than the prices of comparable uncontrolled transactions.
(5) Examples. The following examples illustrate the principles of this paragraph (a).
Example 1. Identification of participants. (i) B is a foreign bank that acts as a market maker in foreign currency in country X, the country of which it is a resident. C, a country Y resident corporation, D, a country Z resident corporation, and USFX, a U.S. resident corporation are all members of a controlled group of taxpayers with B, and each acts as a market maker in foreign currency. In addition to market-making activities conducted in their respective countries, C, D, and USFX each employ marketers and traders, who also perform risk management with respect to their foreign currency operations. In a typical business day, B, C, D, and USFX each enter into several hundred spot and forward contracts to purchase and sell Deutsche marks (DM) with unrelated third parties on the interbank market. In the ordinary course of business, B, C, D, and USFX also enter into contracts to purchase and sell DM with each other.
(ii) Under Sec. 1.482-8(a)(2)(iii), B, C, D, and USFX are each regular dealers in securities because they each regularly and actively offer to, and in fact do, purchase and sell currencies to customers who are not controlled taxpayers, in the ordinary course of their trade or business. Consequently, each controlled taxpayer is also a participant. Together, B, C, D, and USFX conduct a global dealing operation within the meaning of Sec. 1.482-8(a)(2)(i) because they execute customer transactions in multiple tax jurisdictions. Accordingly, the controlled transactions between B, C, D, and USFX are evaluated under the rules of Sec. 1.482-8.
Example 2. Identification of participants. (i) The facts are the same as in Example 1, except that USFX is the only member of the group of controlled taxpayers that buys from and sells foreign currency to customers. C performs marketing and pricing activities with respect to the controlled group's foreign currency operation. D performs accounting and back office services for B, C, and USFX, but does not perform any marketing, sales, pricing, risk management or brokering activities with respect to the controlled group's foreign currency operation. B provides guarantees for all transactions entered into by USFX.
(ii) Under Sec. 1.482-8(a)(2)(iii), USFX is a regular dealer in securities and therefore is a participant. C also is a participant because it performs activities related to USFX's foreign currency dealing activities. USFX's and C's controlled transactions relating to their DM activities are evaluated under Sec. 1.482-8. D is not a participant in a global dealing operation because its accounting and back office services are not related activities within the meaning of Sec. 1.482-8(a)(2)(ii)(B). B also is not a participant in a global dealing operation because its guarantee function is not a related activity within the meaning of Sec. 1.482-8(a)(2)(ii)(B). Accordingly, the determination of whether transactions between B and D and other members of the controlled group are at arm's length is not determined under Sec. 1.482-8.
Example 3. Scope of a global dealing operation. (i) C, a U.S. resident commercial bank, conducts a banking business in the United States and in countries X and Y through foreign branches. C regularly and actively offers to, and in fact does, purchase from and sell foreign currency to customers who are not controlled taxpayers in the ordinary course of its trade or business in the United States and countries X and Y. In all the same jurisdictions, C also regularly and actively offers to, and in fact does, enter into, assume, offset, assign, or otherwise terminate positions in interest rate and cross-currency swaps with customers who are not controlled taxpayers. In addition, C regularly makes loans to customers through its U.S. and foreign branches. C regularly sells these loans to a financial institution that repackages the loans into securities.
(ii) C is a regular dealer in securities within the meaning of Sec. 1.482-8(a)(2)(ii) because it purchases and sells foreign currency and enters into interest rate and cross-currency swaps with customers. Because C conducts these activities through U.S. and foreign branches, these activities constitute a global dealing operation within the meaning of Sec. 1.482-8(a)(2)(i). The income, expense, gain or loss from C's global dealing operation is sourced under Secs. 1.863-3(h) and 1.988-4(h). Under Sec. 1.482-8(a)(2)(i), C's lending activities are not, however, part of a global dealing operation.
Example 4. Dissimilar products. The facts are the same as in Example 1, but B, C, D, and USFX also act as a market maker in Malaysian ringgit-U.S. dollar cross-currency options in the United States and countries X, Y, and Z. The ringgit is not widely traded throughout the world and is considered a thinly traded currency. The functional analysis required by Sec. 1.482-8(a)(3)(i) shows that the development, marketing, pricing, and risk management of ringgit-U.S. dollar cross-currency option contracts are different than that of other foreign currency contracts, including option contracts. Moreover, the contractual terms, risks, and economic conditions of ringgit-U.S. dollar cross-currency option contracts differ considerably from that of other foreign currency contracts, including option contracts. See Sec. 1.482-8(a)(3)(ii) through (iv). Accordingly, the ringgit-U.S. dollar cross-currency option contracts are not comparable to contracts in other foreign currencies.
Example 5. Relevant time period. (i) USFX is a U.S. resident corporation that is a regular dealer in securities acting as a market maker in foreign currency by buying from and selling currencies to customers. C performs marketing and pricing activities with respect to USFX's foreign currency operation. Trading in Deutsche marks (DM) is conducted between 10:00 a.m. and 10:30 a.m. and between 10:45 a.m. and 11:00 a.m. under the following circumstances.
10:00 a.m.......................... 1.827DM: $1................ Uncontrolled Transaction. 10:04 a.m.......................... 1.827DM: $1................ Controlled Transaction. 10:06 a.m.......................... 1.826DM: $1................ Uncontrolled Transaction. 10:08 a.m.......................... 1.825DM: $1................ Uncontrolled Transaction. 10:10 a.m.......................... 1.827DM: $1................ Controlled Transaction. 10:12 a.m.......................... 1.824DM: $1................ Uncontrolled Transaction. 10:15 a.m.......................... 1.825DM: $1................ Uncontrolled Transaction.
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10:18 a.m.......................... 1.826DM: $1................ Controlled Transaction. 10:20 a.m.......................... 1.824DM: $1................ Uncontrolled Transaction. 10:23 a.m.......................... 1.825DM: $1................ Uncontrolled Transaction. 10:25 a.m.......................... 1.825DM: $1................ Uncontrolled Transaction. 10:27 a.m.......................... 1.827DM: $1................ Controlled Transaction. 10:30 a.m.......................... 1.824DM: $1................ Uncontrolled Transaction. 10:45 a.m.......................... 1.822DM: $1................ Uncontrolled Transaction. 10:50 a.m.......................... 1.821DM: $1................ Uncontrolled Transaction. 10:55 a.m.......................... 1.822DM: $1................ Uncontrolled Transaction. 11:00 a.m.......................... 1.819DM: $1................ Uncontrolled Transaction.
(ii) USFX and C are participants in a global dealing operation under Sec. 1.482-8(a)(2)(i). Therefore, USFX determines its arm's length price for its controlled DM contracts under Sec. 1.482- 8(a)(4). Under Sec. 1.482-8(a)(4), the relevant arm's length range for setting the prices of USFX's controlled DM transactions occurs between 10:00 a.m. and 10:30 a.m. Because USFX has no controlled transactions between 10:45 a.m. and 11:00 a.m., and the price movement during this later time period continued to decrease, the 10:45 a.m. to 11:00 a.m. time period is not part of the relevant arm's length range for pricing USFX's controlled transactions.
(b) Comparable uncontrolled financial transaction method--
(1) General rule. The comparable uncontrolled financial transaction (CUFT) method evaluates whether the amount charged in a controlled financial transaction is arm's length by reference to the amount charged in a comparable uncontrolled financial transaction.
(2) Comparability and reliability--(i) In general. The provisions of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section, apply in determining whether a controlled financial transaction is comparable to a particular uncontrolled financial transaction. All of the relevant factors in paragraph (a)(3) of this section must be considered in determining the comparability of the two financial transactions. Comparability under this method depends on close similarity with respect to these factors, or adjustments to account for any differences. Accordingly, unless the controlled taxpayer can demonstrate that the relevant aspects of the controlled and uncontrolled financial transactions are comparable, the reliability of the results as a measure of an arm's length price is substantially reduced.
(ii) Adjustments for differences between controlled and uncontrolled transactions. If there are differences between controlled and uncontrolled transactions that would affect price, adjustments should be made to the price of the uncontrolled transaction according to the comparability provisions of Sec. 1.482-1(d)(2) and paragraph (a)(3) of this section.
(iii) Data and assumptions. The reliability of the results derived from the CUFT method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply the method. See Sec. 1.482-1(c)(2)(ii). In the case of a global dealing operation in which the CUFT is set through the use of indirect evidence, participants generally must establish data from a public exchange or quotation media contemporaneously to the time of the transaction, retain records of such data, and upon request furnish to the district director any pricing model used to establish indirect evidence of a CUFT, in order for this method to be a reliable means of evaluating the arm's length nature of the controlled transactions.
(3) Indirect evidence of the price of a comparable uncontrolled financial transaction--(i) In general. The price of a CUFT may be derived from data from public exchanges or quotation media if the following requirements are met--
(A) The data is widely and routinely used in the ordinary course of business in the industry to negotiate prices for uncontrolled sales;
(B) The data derived from public exchanges or quotation media is used to set prices in the controlled transaction in the same way it is used for uncontrolled transactions of the taxpayer, or the same way it is used by uncontrolled taxpayers; and
(C) The amount charged in the controlled transaction is adjusted to reflect differences in quantity, contractual terms, counterparties, and other factors that affect the price to which uncontrolled taxpayers would agree.
(ii) Public exchanges or quotation media. For purposes of paragraph (b)(3)(i) of this section, an established financial market, as defined in Sec. 1.1092(d)-1(b), qualifies as a public exchange or a quotation media.
(iii) Limitation on use of data from public exchanges or quotation media. Use of data from public exchanges or quotation media is not appropriate under extraordinary market conditions. For example, under circumstances where the trading or transfer of a particular country's currency has been suspended or blocked by another country, causing significant instability in the prices of foreign currency contracts in the suspended or blocked currency, the prices listed on a quotation medium may not reflect a reliable measure of an arm's length result.
(4) Arm's length range. See Sec. 1.482-1(e)(2) and paragraph (a)(4) of this section for the determination of an arm's length range.
(5) Examples. The following examples illustrate the principles of this paragraph (b).
Example 1. Comparable uncontrolled financial transactions. (i) B is a foreign bank resident in country X that acts as a market maker in foreign currency in country X. C, a country Y resident corporation, D, a country Z resident corporation, and USFX, a U.S. resident corporation are all members of a controlled group of taxpayers with B, and each acts as a market maker in foreign currency. In addition to market marking activities conducted in their respective countries, C, D, and USFX each employ marketers and traders, who also perform risk management with respect to their foreign currency operations. In a typical business day, B, C, D, and USFX each enter into several hundred spot and forward contracts to purchase and sell Deutsche marks (DM) with unrelated third parties on the interbank market. In the ordinary course of business, B, C, D, and USFX also each enter into contracts to purchase and sell DM with each other. On a typical day, no more than 10% of USFX's DM trades are with controlled taxpayers. USFX's DM-denominated spot and forward contracts do not vary in their terms, except as to the volume of DM purchased or sold. The differences in volume of DM purchased and sold by USFX do not affect the pricing of the DM. USFX maintains contemporaneous records of its trades, accounted for by type of trade and counterparty. The daily volume of USFX's DM- denominated spot and forward contracts consistently provides USFX with third party transactions that are contemporaneous with the transactions between controlled taxpayers.
(ii) Under Sec. 1.482-8(a)(2)(iii), B, C, D, and USFX each are regular dealers in securities because they each regularly and actively offer to, and in fact do, purchase and sell currencies to customers who are not controlled taxpayers, in the ordinary course of their trade or business. Consequently, each controlled taxpayer is also a participant. Together, B, C, D, and USFX conduct a global dealing operation within the meaning of Sec. 1.482-8(a)(2)(i) because they execute
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customer transactions in multiple tax jurisdictions. To determine the comparability of USFX's controlled and uncontrolled DM- denominated spot and forward transactions, the factors in Sec. 1.482-8(a)(3) must be considered. USFX performs the same functions with respect to controlled and uncontrolled DM-denominated spot and forward transactions. See Sec. 1.482-8(a)(3)(i). In evaluating the contractual terms under Sec. 1.482-8(a)(3)(ii), it is determined that the volume of DM transactions varies, but these variances do not affect the pricing of USFX's uncontrolled DM transactions. Taking into account the risk factors of Sec. 1.482- 8(a)(3)(iii), USFX's risk associated with both the controlled and uncontrolled DM transactions does not vary in any material respect. In applying the significant factors for evaluating the economic conditions under Sec. 1.482-8(a)(3)(iv), USFX has sufficient third party DM transactions to establish comparable economic conditions for evaluating an arm's length price. Accordingly, USFX's uncontrolled transactions are comparable to its controlled transactions in DM spot and forward contracts.
Example 2. Lack of comparable uncontrolled financial transactions. The facts are the same as in Example 1, except that USFX trades Italian lira (lira) instead of DM. USFX enters into few uncontrolled and controlled lira-denominated forward contracts each day. The daily volume of USFX's lira forward purchases and sales does not provide USFX with sufficient third party transactions to establish that uncontrolled transactions are sufficiently contemporaneous with controlled transactions to be comparable within the meaning of Sec. 1.482-8(a)(3). In applying the comparability factors of Sec. 1.482-8(a)(3), and of paragraph (a)(3)(iv) of this section in particular, USFX's controlled and uncontrolled lira forward purchases and sales are not entered into under comparable economic conditions. Accordingly, USFX's uncontrolled transactions in lira forward contracts are not comparable to its controlled lira forward transactions.
Example 3. Indirect evidence of the price of a comparable uncontrolled financial transaction. (i) The facts are the same as in Example 2, except that USFX uses a computer quotation system (CQS) that is an interdealer market, as described in Sec. 1.1092(d)- 1(b)(2), to set its price on lira forward contracts with controlled and uncontrolled taxpayers. Other financial institutions also use CQS to set their prices on lira forward contracts. CQS is an established financial market within the meaning of Sec. 1.1092(d)- 1(b).
(ii) Because CQS is an established financial market, it is a public exchange or quotation media within the meaning of Sec. 1.482- 8(b)(3)(i). Because other financial institutions use prices from CQS in the same manner as USFX, prices derived from CQS are deemed to be widely and routinely used in the ordinary course of business in the industry to negotiate prices for uncontrolled sales. See Sec. 1.482- 8(b)(3)(i)(A) and (B). If USFX adjusts the price quoted by CQS under the criteria specified in Sec. 1.482-8(b)(2)(ii)(A)(3), the controlled price derived by USFX from CQS qualifies as indirect evidence of the price of a comparable uncontrolled financial transaction.
Example 4. Indirect evidence of the price of a comparable uncontrolled financial transaction--internal pricing models. (i) T is a U.S. resident corporation that acts as a market maker in U.S. dollar-denominated notional principal contracts. T's marketers and traders work together to sell notional principal contracts (NPCs), primarily to T's North and South American customers. T typically earns 4 basis points at the inception of each standard 3 year U.S. dollar-denominated interest rate swap that is entered into with an unrelated, financially sophisticated, creditworthy counterparty. TS, T's wholly owned U.K. subsidiary, also acts as a market maker in U.S. dollar-denominated NPCs, employing several traders and marketers who initiate contracts primarily with European customers. On occasion, for various business reasons, TS enters into a U.S. dollar-denominated NPC with T. The U.S. dollar-denominated NPCs that T enters into with unrelated parties are comparable in all material respects to the transactions that T enters into with TS. TS prices all transactions with T using the same pricing models that TS uses to price transactions with third parties. The pricing models analyze relevant data, such as interest rates and volatilities, derived from public exchanges. TS records the data that were used to determine the price of each transaction at the time the transaction was entered into. Because the price produced by the pricing models is a mid-market price, TS adjusts the price so that it receives the same 4 basis point spread on its transaction with T that it would earn on comparable transactions with comparable counterparties during the same relevant time period.
(ii) Under Sec. 1.482-8(a)(2), T and TS are participants in a global dealing operation that deals in U.S. dollar-denominated NPCs. Because the prices produced by TS's pricing model are derived from information on public exchanges and TS uses the same pricing model to set prices for controlled and uncontrolled transactions, the requirements of Sec. 1.482-8(b)(3)(i)(A) and (B) are met. Because the U.S. dollar-denominated NPCs that T enters into with customers (uncontrolled transactions) are comparable to the transactions between T and TS within the meaning of Sec. 1.482-8(a)(3) and TS earns 4 basis points at inception of its uncontrolled transactions that are comparable to its controlled transactions, TS has also satisfied the requirements of Sec. 1.482-8(b)(3)(i)(C). Accordingly, the price produced by TS's pricing model constitutes indirect evidence of the price of a comparable uncontrolled financial transaction.
(c) Gross margin method--(1) General rule. The gross margin method evaluates whether the amount allocated to a participant in a global dealing operation is arm's length by reference to the gross profit margin realized on the sale of financial products in comparable uncontrolled transactions. The gross margin method may be used to establish an arm's length price for a transaction where a participant resells a financial product to an unrelated party that the participant purchased from a related party. The gross margin method may apply to transactions involving the purchase and resale of debt and equity instruments. The method may also be used to evaluate whether a participant has received an arm's length commission for its activities in a global dealing operation when the participant has not taken title to a security or has not become a party to a derivative financial product. To meet the arm's length standard, the gross profit margin on controlled transactions should be similar to that of comparable uncontrolled transactions.
(2) Determination of an arm's length price--(i) In general. The gross margin method measures an arm's length price by subtracting the appropriate gross profit from the applicable resale price for the financial product involved in the controlled transaction under review.
(ii) Applicable resale price. The applicable resale price is equal to either the price at which the financial product involved is sold in an uncontrolled sale or the price at which contemporaneous resales of the same product are made. If the product purchased in the controlled sale is resold to one or more related parties in a series of controlled sales before being resold in an uncontrolled sale, the applicable resale price is the price at which the product is resold to an uncontrolled party, or the price at which contemporaneous resales of the same product are made. In such case, the determination of the appropriate gross profit will take into account the functions of all members of the controlled group participating in the series of controlled sales and final uncontrolled resales, as well as any other relevant factors described in paragraph (a)(3) of this section.
(iii) Appropriate gross profit. The appropriate gross profit is computed by multiplying the applicable resale price by the gross profit margin, expressed as a percentage of total revenue derived from sales, earned in comparable uncontrolled transactions.
(3) Comparability and reliability--(i) In general. The provisions of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section, apply in determining whether a controlled transaction is comparable to a particular uncontrolled transaction. All of the factors described in paragraph (a)(3) of this section must be considered in determining the comparability of two financial products transactions, including the functions performed. The gross margin method considers whether a participant has earned a sufficient gross profit margin
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on the resale of a financial product (or line of products) given the functions performed by the participant. A reseller's gross profit margin provides compensation for performing resale functions related to the product or products under review, including an operating profit in return for the reseller's investment of capital and the assumption of risks. Accordingly, where a participant does not take title, or does not become a party to a financial product, the reseller's return to capital and assumption of risk are additional factors that must be considered in determining an appropriate gross profit margin. An appropriate gross profit margin primarily should be derived from comparable uncontrolled purchases and resales of the reseller involved in the controlled sale. This is because similar characteristics are more likely to be found among different resales of a financial product or products made by the same reseller than among sales made by other resellers. In the absence of comparable uncontrolled transactions involving the same reseller, an appropriate gross profit margin may be derived from comparable uncontrolled transactions of other resellers.
(ii) Adjustments for differences between controlled and uncontrolled transactions. If there are material differences between controlled and uncontrolled transactions that would affect the gross profit margin, adjustments should be made to the gross profit margin earned in the uncontrolled transaction according to the comparability provisions of Sec. 1.482-1(d)(2) and paragraph (a)(3) of this section. For this purpose, consideration of operating expenses associated with functions performed and risks assumed may be necessary because differences in functions performed are often reflected in operating expenses. The effect of a difference in functions performed on gross profit, however, is not necessarily equal to the difference in the amount of related operating expenses.
(iii) Reliability. In order for the gross margin method to be considered a reliable measure of an arm's length price, the gross profit should ordinarily represent an amount that would allow the participant who resells the product to recover its expenses (whether directly related to selling the product or more generally related to maintaining its operations) and to earn a profit commensurate with the functions it performed. The gross margin method may be a reliable means of establishing an arm's length price where there is a purchase and resale of a financial product and the participant who resells the property does not substantially participate in developing a product or in tailoring the product to the unique requirements of a customer prior to the resale.
(iv) Data and assumptions--(A) In general. The reliability of the results derived from the gross margin method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply the method. See Sec. 1.482-1(c)(2)(ii). A participant may establish the gross margin by comparing the bid and offer prices on a public exchange or quotation media. In such case, the prices must be contemporaneous to the controlled transaction, and the participant must retain records of such data.
(B) Consistency in accounting. The degree of consistency in accounting practices between the controlled transaction and the uncontrolled transactions may affect the reliability of the gross margin method. For example, differences as between controlled and uncontrolled transactions in the method used to value similar financial products (including methods of accounting, methods of estimation, and the timing for changes of such methods) could affect the gross profit. The ability to make reliable adjustments for such differences could affect the reliability of the results.
(4) Arm's length range. See Sec. 1.482-1(e)(2) and paragraph (a)(4) of this section for the determination of an arm's length range.
(5) Example. The following example illustrates the principles of this paragraph (c).
Example 1. Gross margin method. (i) T is a U.S. resident financial institution that acts as a market maker in debt and equity instruments issued by U.S. corporations. Most of T's sales are to U.S.-based customers. TS, T's U.K. subsidiary, acts as a market maker in debt and equity instruments issued by European corporations and conducts most of its business with European-based customers. On occasion, however, a customer of TS wishes to purchase a security that is either held by or more readily accessible to T. To facilitate this transaction, T sells the security it owns or acquires to TS, who then promptly sells it to the customer. T and TS generally derive the majority of their profit on the difference between the price at which they purchase and the price at which they sell securities (the bid/offer spread). On average, TS's gross profit margin on its purchases and sales of securities from unrelated persons is 2%. Applying the comparability factors specified in Sec. 1.482-8(a)(3), T's purchases and sales with unrelated persons are comparable to the purchases and sales between T and TS.
(ii) Under Sec. 1.482-8(a)(2), T and TS are participants in a global dealing operation that deals in debt and equity securities. Since T's related purchases and sales are comparable to its unrelated purchases and sales, if TS's gross profit margin on purchases and sales of comparable securities from unrelated persons is 2%, TS should also typically earn a 2% gross profit on the securities it purchases from T. Thus, when TS resells for $100 a security that it purchased from T, the arm's length price at which TS would have purchased the security from T would normally be $98 ($100 sales price minus (2% gross profit margin x $100)).
(d) Gross markup method--(1) General rule. The gross markup method evaluates whether the amount allocated to a participant in a global dealing operation is arm's length by reference to the gross profit markup realized in comparable uncontrolled transactions. The gross markup method may be used to establish an arm's length price for a transaction where a participant purchases a financial product from an unrelated party that the participant sells to a related party. This method may apply to transactions involving the purchase and resale of debt and equity instruments. The method may also be used to evaluate whether a participant has received an arm's length commission for its role in a global dealing operation when the participant has not taken title to a security or has not become a party to a derivative financial product. To meet the arm's length standard, the gross profit markup on controlled transactions should be similar to that of comparable uncontrolled transactions.
(2) Determination of an arm's length price--(i) In general. The gross markup method measures an arm's length price by adding the appropriate gross profit to the participant's cost or anticipated cost, of purchasing, holding, or structuring the financial product involved in the controlled transaction under review (or in the case of a derivative financial product, the initial net present value, measured by the anticipated cost of purchasing, holding, or structuring the product).
(ii) Appropriate gross profit. The appropriate gross profit is computed by multiplying the participant's cost or anticipated cost of purchasing, holding, or structuring a transaction by the gross profit markup, expressed as a percentage of cost, earned in comparable uncontrolled transactions.
(3) Comparability and reliability--(i) In general. The provisions of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section, apply in determining whether a controlled transaction is comparable to a particular uncontrolled transaction. All of the factors described in paragraph (a)(3) of this section must be considered in determining the
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comparability of two financial products transactions, including the functions performed. The gross markup method considers whether a participant has earned a sufficient gross markup on the sale of a financial product, or line of products, given the functions it has performed. A participant's gross profit markup provides compensation for purchasing, hedging, and transactional structuring functions related to the transaction under review, including an operating profit in return for the investment of capital and the assumption of risks. Accordingly, where a participant does not take title, or does not become a party to a financial product, the reseller's return to capital and assumption of risk are additional factors that must be considered in determining the gross profit markup. An appropriate gross profit markup primarily should be derived from comparable uncontrolled purchases and sales of the participant involved in the controlled sale. This is because similar characteristics are more likely to be found among different sales of property made by the same participant than among sales made by other resellers. In the absence of comparable uncontrolled transactions involving the same participant, an appropriate gross profit markup may be derived from comparable uncontrolled transactions of other parties whether or not such parties are members of the same controlled group.
(ii) Adjustments for differences between controlled and uncontrolled transactions. If there are material differences between controlled and uncontrolled transactions that would affect the gross profit markup, adjustments should be made to the gross profit markup earned in the uncontrolled transaction according to the comparability provisions of Sec. 1.482-1(d)(2) and paragraph (a)(3) of this section. For this purpose, consideration of operating expenses associated with the functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses. The effect of a difference in functions on gross profit, however, is not necessarily equal to the difference in the amount of related operating expenses.
(iii) Reliability. In order for the gross markup method to be considered a reliable measure of an arm's length price, the gross profit should ordinarily represent an amount that would allow the participant who purchases the product to recover its expenses (whether directly related to selling the product or more generally related to maintaining its operations) and to earn a profit commensurate with the functions it performed. As with the gross margin method, the gross markup method may be a reliable means of establishing an arm's length price where there is a purchase and resale of a financial product and the participant who resells the property does not substantially participate in developing a product or in tailoring the product to the unique requirements of a customer prior to the resale.
(iv) Data and assumptions--(A) In general. The reliability of the results derived from the gross markup method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply the method. See Sec. 1.482-1(c)(2)(ii). A participant may establish the gross markup by comparing the bid and offer prices on a public exchange or quotation media. In such case, the prices must be contemporaneous with the controlled transaction, and the participant must retain records of such data.
(B) Consistency in accounting. The degree of consistency in accounting practices between the controlled transaction and the uncontrolled transactions may affect the reliability of the gross markup method. For example, differences as between controlled and uncontrolled transactions in the method used to value similar financial products (including methods in accounting, methods of estimation, and the timing for changes of such methods) could affect the gross profit. The ability to make reliable adjustments for such differences could affect the reliability of the results.
(4) Arm's length range. See Sec. 1.482-1(e)(2) and paragraph (a)(4) of this section for the determination of an arm's length range.
(e) Profit split method--(1) General rule. The profit split method evaluates whether the allocation of the combined operating profit or loss of a global dealing operation to one or more participants is at arm's length by reference to the relative value of each participant's contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the participants for which data is available that includes the controlled transactions (relevant business activity).
(2) Appropriate share of profit and loss--(i) In general. The relative value of each participant's contribution to the global dealing activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the activity, consistent with the comparability provisions of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section. Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity. The relative value of the contributions of each participant in the global dealing operation should be measured in a manner that most reliably reflects each contribution made to the global dealing operation and each participant' s role in that contribution. In appropriate cases, the participants may find that a multi-factor formula most reliably measures the relative value of the contributions to the profitability of the global dealing operation. The profit allocated to any particular participant using a profit split method is not necessarily limited to the total operating profit from the global dealing operation. For example, in a given year, one participant may earn a profit while another participant incurs a loss, so long as the arrangement is comparable to an arrangement to which two uncontrolled parties would agree. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally or in any other arbitrary proportion. The specific method must be determined under paragraph (e)(4) of this section.
(ii) Adjustment of factors to measure contribution clearly. In order to reliably measure the value of a participant's contribution, the factors, for example, those used in a multi-factor formula, must be expressed in units of measure that reliably quantify the relative contribution of the participant. If the data or information is influenced by factors other than the value of the contribution, adjustments must be made for such differences so that the factors used in the formula only measure the relative value of each participant's contribution. For example, if trader compensation is used as a factor to measure the value added by the participant's trading expertise, adjustments must be made for variances in compensation paid to traders due solely to differences in the cost of living.
(3) Definitions. The definitions in this paragraph (e)(3) apply for purposes of applying the profit split methods in this paragraph (e).
Gross profit is gross income earned by the global dealing operation.
Operating expenses includes all expenses not included in the computation of gross profit, except for
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interest, foreign income taxes as defined in Sec. 1.901-2(a), domestic income taxes, and any expenses not related to the global dealing activity that is evaluated under the profit split method. With respect to interest expense, see section 864(e) and the regulations thereunder and Sec. 1.882-5.
Operating profit or loss is gross profit less operating expenses, and includes all income, expense, gain, loss, credits or allowances attributable to each global dealing activity that is evaluated under the profit split method. It does not include income, expense, gain, loss, credits or allowances from activities that are not evaluated under the profit split method, nor does it include extraordinary gains or losses that do not relate to the continuing global dealing activities of the participant.
(4) Application. Profit or loss shall be allocated under the profit split method using either the total profit split, described in paragraph (e)(5) of this section, or the residual profit split, described in paragraph (e)(6) of this section.
(5) Total profit split--(i) In general. The total profit split derives the percentage of the combined operating profit of the participants in a global dealing operation allocable to a participant in the global dealing operation by evaluating whether uncontrolled taxpayers who perform similar functions, assume similar risks, and employ similar resources would allocate their combined operating profits in the same manner.
(ii) Comparability. The total profit split evaluates the manner by which comparable uncontrolled taxpayers divide the combined operating profit of a particular global dealing activity. The degree of comparability between the controlled and uncontrolled taxpayers is determined by applying the comparability standards of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section. In particular, the functional analysis required by Sec. 1.482-1(d)(3)(i) and paragraph (a)(3)(i) of this section is essential to determine whether two situations are comparable. Nevertheless, in certain cases, no comparable ventures between uncontrolled taxpayers may exist. In this situation, it is necessary to analyze the remaining factors set forth in paragraph (a)(3) of this section that could affect the division of operating profits between parties. If there are differences between the controlled and uncontrolled taxpayers that would materially affect the division of operating profit, adjustments must be made according to the provisions of Sec. 1.482-1(d)(2) and paragraph (a)(3) of this section.
(iii) Reliability. As indicated in Sec. 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the reliability of a total profit split also increases. In a global dealing operation, however, the absence of external market benchmarks (for example, joint ventures between uncontrolled taxpayers) on which to base the allocation of operating profits does not preclude use of this method if the allocation of the operating profit takes into account the relative contribution of each participant. The reliability of this method is increased to the extent that the allocation has economic significance for purposes other than tax (for example, satisfying regulatory standards and reporting, or determining bonuses paid to management or traders). The reliability of the analysis under this method may also be enhanced by the fact that all parties to the controlled transaction are evaluated under this method. The reliability of the results, however, of an analysis based on information from all parties to a transaction is affected by the reliability of the data and assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results.
(iv) Data and assumptions--(A) In general. The reliability of the results derived from the total profit split method is affected by the quality of the data used and the assumptions used to apply the method. See Sec. 1.482-1(c)(2)(ii). The reliability of the allocation of income, expense, or other attributes between the participants' relevant business activities and the participants' other activities will affect the reliability of the determination of the combined operating profit and its allocation among the participants. If it is not possible to allocate income, expense, or other attributes directly based on factual relationships, a reasonable allocation formula may be used. To the extent direct allocations are not made, the reliability of the results derived from application of this method is reduced relative to the results of a method that requires fewer allocations of income, expense, and other attributes. Similarly, the reliability of the results derived from application of this method is affected by the extent to which it is possible to apply the method to the participants' financial data that is related solely to the controlled transactions. For example, if the relevant business activity is entering into interest rate swaps with both controlled and uncontrolled taxpayers, it may not be possible to apply the method solely to financial data related to the controlled transactions. In such case, the reliability of the results derived from application of this method will be reduced.
(B) Consistency in accounting. The degree of consistency between the controlled and uncontrolled taxpayers in accounting practices that materially affect the items that determine the amount and allocation of operating profit affects the reliability of the result. Thus, for example, if differences in financial product valuation or in cost allocation practices would materially affect operating profit, the ability to make reliable adjustments for such differences would affect the reliability of the results.
(6) Residual profit split--(i) In general. The residual profit split allocates the combined operating profit or loss between participants following the two-step process set forth in paragraphs (e)(6)(ii) and (iii) of this section.
(ii) Allocate income to routine contributions. The first step allocates operating income to each participant to provide an arm's length return for its routine contributions to the global dealing operation. Routine contributions are contributions of the same or similar kind as those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. Routine contributions ordinarily include contributions of tangible property, services, and intangibles that are generally owned or performed by uncontrolled taxpayers engaged in similar activities. For example, transactions processing and credit analysis are typically routine contributions. In addition, a participant that guarantees obligations of or otherwise provides credit support to another controlled taxpayer in a global dealing operation is regarded as making a routine contribution. A functional analysis is required to identify the routine contributions according to the functions performed, risks assumed, and resources employed by each of the participants. Market returns for the routine contributions should be determined by reference to the returns achieved by uncontrolled taxpayers engaged in similar activities, consistent with the methods described in Secs. 1.482-2 through 1.482-4 and this Sec. 1.482-8.
(iii) Allocate residual profit. The allocation of income to the participant's routine contributions will not reflect
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profits attributable to each participant's valuable nonroutine contributions to the global dealing operation. Thus, in cases where valuable nonroutine contributions are present, there normally will be an unallocated residual profit after the allocation of income described in paragraph (e)(6)(ii) of this section. Under this second step, the residual profit generally should be divided among the participants based upon the relative value of each of their nonroutine contributions. Nonroutine contributions are contributions so integral to the global dealing operation that it is impossible to segregate them from the operation and find a separate market return for the contribution. Pricing and risk managing financial products almost invariably involve nonroutine contributions. Similarly, product development and information technology are generally nonroutine contributions. Marketing may be a nonroutine contribution if the marketer substantially participates in developing a product or in tailoring the product to the unique requirements of a customer. The relative value of the nonroutine contributions of each participant in the global dealing operation should be measured in a manner that most reliably reflects each nonroutine contribution made to the global dealing operation and each participant's role in the nonroutine contributions.
(iv) Comparability. The first step of the residual profit split relies on external market benchmarks of profitability. Thus, the comparability considerations that are relevant for the first step of the residual profit split are those that are relevant for the methods that are used to determine market returns for routine contributions. In the second step of the residual profit split, however, it may not be possible to rely as heavily on external market benchmarks. Nevertheless, in order to divide the residual profits of a global dealing operation in accordance with each participant's nonroutine contributions, it is necessary to apply the comparability standards of Sec. 1.482-1(d), as modified by paragraph (a)(3) of this section. In particular, the functional analysis required by Sec. 1.482-1(d)(3)(i) and paragraph (a)(3)(i) of this section is essential to determine whether two situations are comparable. Nevertheless, in certain cases, no comparable ventures between uncontrolled taxpayers may exist. In this situation, it is necessary to analyze the remaining factors set forth in paragraph (a)(3) of this section that could affect the division of operating profits between parties. If there are differences between the controlled and uncontrolled taxpayers that would materially affect the division of operating profit, adjustments must be made according to the provisions of Sec. 1.482-1(d)(2) and paragraph (a)(3) of this section.
(v) Reliability. As indicated in Sec. 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the reliability of a residual profit split also increases. In a global dealing operation, however, the absence of external market benchmarks (for example, joint ventures between uncontrolled taxpayers) on which to base the allocation of operating profits does not preclude use of this method if the allocation of the residual profit takes into account the relative contribution of each participant. The reliability of this method is increased to the extent that the allocation has economic significance for purposes other than tax (for example, satisfying regulatory standards and reporting, or determining bonuses paid to management or traders). The reliability of the analysis under this method may also be enhanced by the fact that all parties to the controlled transaction are evaluated under this method. The reliability of the results, however, of an analysis based on information from all parties to a transaction is affected by the reliability of the data and assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results.
(vi) Data and assumptions--(A) General rule. The reliability of the results derived from the residual profit split is measured under the standards set forth in paragraph (e)(5)(iv)(A) of this section.
(B) Consistency in accounting. The degree of accounting consistency between controlled and uncontrolled taxpayers is measured under the standards set forth in paragraph (e)(5)(iv)(B) of this section.
(7) Arm's length range. See Sec. 1.482-1(e)(2) and paragraph (a)(4) of this section for the determination of an arm's length range.
(8) Examples. The following examples illustrate the principles of this paragraph (e).
Example 1. Total profit split. (i) P, a U.S. corporation, establishes a separate U.S. subsidiary (USsub) to conduct a global dealing operation in over-the-counter derivatives. USsub in turn establishes subsidiaries incorporated and doing business in the U.K. (UKsub) and Japan (Jsub). Ussub, Uksub, and Jsub each employ marketers and traders who work closely together to design and sell derivative products to meet the particular needs of customers. Each also employs personnel who process and confirm trades, reconcile trade tickets and provide ongoing administrative support (back office services) for the global dealing operation. The global dealing operation maintains a single common book for each type of risk, and the book is maintained where the head trader for that type of risk is located. Thus, notional principal contracts denominated in North and South American currencies are booked in USsub, notional principal contracts denominated in European currencies are booked in UKsub, and notional principal contracts denominated in Japanese yen are booked in Jsub. However, each of the affiliates has authorized a trader located in each of the other affiliates to risk manage its books during periods when the booking location is closed. This grant of authority is necessary because marketers, regardless of their location, are expected to sell all of the group's products, and need to receive pricing information with respect to products during their clients business hours, even if the booking location is closed. Moreover, P is known for making a substantial amount of its profits from trading activities, and frequently does not hedge the positions arising from its customer transactions in an attempt to profit from market changes. As a result, the traders in ``off-hours'' locations must have a substantial amount of trading authority in order to react to market changes.
(ii) Under Sec. 1.482-8(a)(2), USsub, UKsub and Jsub are participants in a global dealing operation in over-the-counter derivatives. P determines that the total profit split method is the best method to allocate an arm's length amount of income to each participant. P allocates the operating profit from the global dealing operation between USsub, UKsub and Jsub on the basis of the relative compensation paid to marketers and traders in each location. In making the allocation, P adjusts the compensation amounts to account for factors unrelated to job performance, such as the higher cost of living in certain jurisdictions. Because the traders receive significantly greater compensation than marketers in order to account for their greater contribution to the profits of the global dealing operation, P need not make additional adjustments or weight the compensation of the traders more heavily in allocating the operating profit between the affiliates. For rules concerning the source of income allocated to Ussub, Uksub and Jsub (and any U.S. trade or business of the participants), see Sec. 1.863-3(h).
Example 2. Total profit split. The facts are the same as in Example 1, except that the labor market in Japan is such that traders paid by Jsub are paid the same as marketers paid by Jsub at the same seniority level, even though the traders contribute substantially more to the profitability of the global dealing operation. As a result, the allocation method used by P is unlikely to compensate the functions provided by each affiliate so as to be a reliable measure of an arm's length result under Secs. 1.482-8(e)(2) and 1.482-
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1(c)(1), unless P weights the compensation of traders more heavily than the compensation of marketers or develops another method of measuring the contribution of traders to the profitability of the global dealing operation.
Example 3. Total profit split. The facts are the same as in Example 2, except that, in P's annual report to shareholders, P divides its operating profit from customer business into ``dealing profit'' and ``trading profit.'' Because both marketers and traders are involved in the dealing function, P divides the ``dealing profit'' between the affiliates on the basis of the relative compensation of marketers and traders. However, because only the traders contribute to the trading profit, P divides the trading profit between the affiliates on the basis of the relative compensation only of the traders. In making that allocation, P must adjust the compensation of traders in Jsub in order to account for factors not related to job performance.
Example 4. Total profit split. The facts are the same as in Example 1, except that P is required by its regulators to hedge its customer positions as much as possible and therefore does not earn any ``trading profit.'' As a result, the marketing intangibles, such as customer relationships, are relatively more important than the intangibles used by traders. Accordingly, P must weight the compensation of marketers more heavily than the compensation of traders in order to take into account accurately the contribution each function makes to the profitability of the business.
Example 5. Residual profit split. (i) P is a U.S. corporation that engages in a global dealing operation in foreign currency options directly and through controlled taxpayers that are incorporated and operate in the United Kingdom (UKsub) and Japan (Jsub). Each controlled taxpayer is a participant in a global dealing operation. Each participant employs marketers and traders who work closely together to design and sell foreign currency options that meet the particular needs of customers. Each participant also employs salespeople who sell foreign currency options with standardized terms and conditions, as well as other financial products offered by the controlled group. The traders in each location risk manage a common book of transactions during the relevant business hours of each location. P has a AAA credit rating and is the legal counterparty to all third party transactions. The traders in each location have discretion to execute contracts in the name of P. UKsub employs personnel who process and confirm trades, reconcile trade tickets, and provide ongoing administrative support (back office services) for all the participants in the global dealing operation. The global dealing operation has generated $192 of operating profit for the period.
(ii) After analyzing the foreign currency options business, has determined that the residual profit split method is the best method to allocate the operating profit of the global dealing operation and to determine an arm's length amount of compensation allocable to each participant in the global dealing operation.
(iii) The first step of the residual profit split method (Sec. 1.482-8(e)(6)(ii)) requires P to identify the routine contributions performed by each participant. P determines that the functions performed by the salespeople are routine. P determines that the arm's length compensation for salespeople is $3, $4, and $5 in the United States, the United Kingdom, and Japan, respectively. Thus, P allocates $3, $4, and $5 to P, UKsub, and Jsub, respectively.
(iv) Although the back office function would not give rise to participant status, in the context of a residual profit split allocation, the back office function is relevant for purposes of receiving remuneration for routine contributions to a global dealing operation. P determines that an arm's length compensation for the back office is $20. Since the back office services constitute routine contributions, $20 of income is allocated to UKsub under step 1 of the residual profit split method. In addition, P determines that the comparable arm's length compensation for the risk to which P is subject as counterparty is $40. Accordingly, $40 is allocated to P as compensation for acting as counterparty to the transactions entered into in P's name by Jsub and UKsub.
(v) The second step of the residual profit split method (Sec. 1.482-8(e)(6)(iii)) requires that the residual profit be allocated to participants according to the relative value of their nonroutine contributions. Under P's transfer pricing method, P allocates the residual profit of $120 ($192 gross income minus $12 salesperson commissions minus $20 payment for back office services minus $40 compensation for the routine contribution of acting as counterparty) using a multi-factor formula that reflects the relative value of the nonroutine contributions. Applying the comparability factors set out in Sec. 1.482-8(a)(3), P allocates 40% of the residual profit to UKsub, 35% of the residual profit to P, and the remaining 25% of residual profit to Jsub. Accordingly, under step 2, $48 is allocated to UKsub, $42 is allocated to P, and $30 is allocated to Jsub. See Sec. 1.863-3(h) for the source of income allocated to P with respect to its counterparty function.
(f) Unspecified methods. Methods not specified in paragraphs (b),(c),(d), or (e) of this section may be used to evaluate whether the amount charged in a controlled transaction is at arm's length. Any method used under this paragraph (f) must be applied in accordance with the provisions of Sec. 1.482-1 as modified by paragraph (a)(3) of this section.
(g) Source rule for qualified business units. See Sec. 1.863-3(h) for application of the rules of this section for purposes of determining the source of income, gain or loss from a global dealing operation among qualified business units (as defined in section 989(c) and Secs. 1.863-3(h)(3)(iv) and 1.989(a)-1).