[Federal Register Volume 63, Number 44 (Friday, March 6, 1998)]
[Proposed Rules]
[Pages 11177-11198]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-5674]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-208299-90]
RIN 1545-AP01


Allocation and Sourcing of Income and Deductions Among Taxpayers 
Engaged in a Global Dealing Operation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed rules for the allocation among 
controlled taxpayers and sourcing of income, deductions, gains and 
losses from a global dealing operation; rules applying these allocation 
and sourcing rules to foreign currency transactions and to foreign 
corporations engaged in a U.S. trade or business; and rules concerning 
the mark-to-market treatment resulting from hedging activities of a 
global dealing operation. These proposed rules affect foreign and 
domestic persons that are participants in such operations either 
directly or indirectly through subsidiaries or partnerships. These 
proposed rules are necessary to enable participants in a global dealing 
operation to determine their arm's length contribution to a global 
dealing operation. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written comments must be received by June 4, 1998. Outlines of 
oral comments to be discussed at the public hearing scheduled for July 
9, 1998, must be received by June 18, 1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-208299-90), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-208299-90), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., 
Washington, D.C. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations in general, 
Ginny Chung of the Office of Associate Chief Counsel (International), 
(202) 622-3870; concerning the mark-to-market treatment of global 
dealing operations, Richard Hoge or JoLynn Ricks of the Office of 
Assistant Chief Counsel (Financial Institutions & Products), (202) 622-
3920; concerning submissions and the hearing, Michael Slaughter, (202) 
622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance officer, T:FS:FP, Washington, DC 
20224. Comments on the collections of information should be received by 
May 5, 1998.
    Comments are specifically requested concerning: Whether the 
proposed collections of information are necessary for the proper 
performance of the functions of the Internal Revenue Service, including 
whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collections of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.

[[Page 11178]]

    The collections of information in these proposed regulations are in 
Secs. 1.475(g)-2(b), 1.482-8(b)(3), 1.482-8(c)(3), 1.482-8(d)(3), 
1.482-8(e)(5), 1.482-8(e)(6), and 1.863-3(h). The information is 
required to determine an arm's length price. The collections of 
information are mandatory. The likely recordkeepers are business or 
other for-profit institutions.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.
    Estimated total annual recordkeeping burden: 20,000 hours. 
Estimated average annual burden per recordkeeper is 40 hours. Estimated 
number of recordkeepers: 500.

Background

    In 1990, the IRS issued Announcement 90-106, 1990-38 IRB 29, 
requesting comments on how the regulations under sections 482, 864 and 
other sections of the Internal Revenue Code could be improved to 
address the taxation issues raised by global trading of financial 
instruments. Section 482 concerns the allocation of income, deductions, 
credits and allowances among related parties. Section 864 provides 
rules for determining the income of a foreign person that is 
``effectively connected'' with the conduct of a U.S. trade or business 
and therefore can be taxed on a net income basis in the United States. 
Provisions under sections 864(c)(2) and (3) provide rules for 
determining when U.S. source income is effectively connected income 
(ECI); section 864(c)(4) provides rules for determining when foreign 
source income is ECI.
    The rules for determining the source of income generally are in 
sections 861, 862, 863 and 865, and the regulations promulgated under 
those sections. Section 1.863-7 provides a special rule for income from 
notional principal contracts, under which such income will be treated 
as U.S.-source ECI if it arises from the conduct of a U.S. trade or 
business under principles similar to those that apply under section 
864(c)(2). An identical rule applies for determining U.S. source ECI 
under Sec. 1.988-4(c) from foreign exchange gain or loss from certain 
transactions denominated in a foreign currency.
    Because no regulations were issued in response to the comments that 
were received after Announcement 90-106, there remain a number of 
uncertainties regarding the manner in which the existing regulations 
described above apply to financial institutions that deal in financial 
instruments through one or more entities or trading locations. Many 
financial institutions have sought to resolve these problems by 
negotiating advance pricing agreements (APAs) with the IRS. In 1994, 
the IRS published Notice 94-40, 1994-1 CB 351, which provided a generic 
description of the IRS's experience with global dealing operations 
conducted in a functionally fully integrated manner. Notice 94-40 
specified that it was not intended to prescribe rules for future APAs 
or for taxpayers that did not enter into APAs. Moreover, Notice 94-40 
provided no guidance of any kind for financial institutions that do not 
conduct their global dealing operations in a functionally fully 
integrated manner.

Explanation of Provisions

1. Introduction

    This document contains proposed regulations relating to the 
determination of an arm's length allocation of income among 
participants engaged in a global dealing operation. For purposes of 
these regulations, the terms ``global dealing operation'' and 
``participant'' are specifically defined. The purpose of these 
regulations is to provide guidance on applying the arm's length 
principle to transactions between participants in a global dealing 
operation. The general rules in the final regulations under section 482 
that provide the best method rule, comparability analysis, and the 
arm's length range are generally adopted with some modifications to 
conform these principles to the global dealing environment. In 
addition, the proposed regulations contain new specified methods with 
respect to global dealing operations that replace the specified methods 
in Secs. 1.482-3 through 1.482-6.
    This document also contains proposed regulations addressing the 
source of income earned in a global dealing operation and the 
circumstances under which such income is effectively connected to a 
foreign corporation's U.S. trade or business. The regulations proposed 
under section 863 generally source income earned in a global dealing 
operation by reference to the residence of the participant. For these 
purposes, residence is defined under section 988(a)(3)(B) such that 
global dealing income may be sourced between separate qualified 
business units (QBUs) of a single taxpayer or among separate taxpayers 
who are participants, as the case may be. Exceptions to this general 
rule are discussed in further detail below.
    Proposed amendments to the regulations under section 864 provide 
that the principles of the proposed section 482 regulations may be 
applied to determine the amount of income, gain or loss from a foreign 
corporation's global dealing operation that is effectively connected to 
a U.S. trade or business of a participant. Similar rules apply to 
foreign currency transactions that are part of a global dealing 
operation.
    The combination of these allocation, sourcing, and effectively 
connected income rules is intended to enable taxpayers to establish and 
recognize on an arm's length basis the contributions provided by 
separate QBUs to a global dealing operation.
    This document also contains proposed regulations under section 475 
to coordinate the accounting rules governing the timing of income with 
the allocation, sourcing, and effectively connected income rules 
proposed in this document and discussed above.

2. Explanation of Specific Provisions

A. Section 1.482-1(a)(1)
    Section 1.482-1(a)(1) has been amended to include expressly 
transactions undertaken in the course of a global dealing operation 
between controlled taxpayers within the scope of transactions covered 
by section 482. The purpose of this amendment is to clarify that the 
principles of section 482 apply to evaluate whether global dealing 
transactions entered into between controlled taxpayers are at arm's 
length.
B. Section 1.482-8(a)--General Requirements
    Section 1.482-8(a)(1) lists specified methods that may be used to 
determine if global dealing transactions entered into between 
controlled taxpayers are at arm's length. The enumerated 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 rule of 
Sec. 1.482-1(e). The section further requires that any modifications or 
supplemental considerations applicable to a global dealing operation 
set forth in Sec. 1.482-8(a)(3) be taken into account when applying any 
of the transfer pricing methods. Specific modifications to the factors 
for determining

[[Page 11179]]

comparability and the arm's length range rule are provided in 
Sec. 1.482-8(a)(3). These modifications and special considerations are 
discussed in more detail under their respective headings below.
C. Section 1.482-8(a)(2)--Definitions Applicable to a Global Dealing 
Operation
    Section 1.482-8(a)(2) defines ``global dealing operation,'' 
``participant,'' ``regular dealer in securities,'' and other terms that 
apply for purposes of these regulations. These definitions supplement 
the general definitions provided in Sec. 1.482-1(i).
    The rules of Sec. 1.482-8 apply only to a 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. 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 connection with its activities as such a dealer. Thus, a 
hedge fund that does not have customers is not covered by these 
regulations. Positions held in inventory by a regular dealer in 
securities, however, are covered by these regulations even if the 
positions are unhedged because the dealer is taking a view as to future 
market changes.
    Similarly, lending activities are not included within the 
definition of a global dealing operation. However, if a person makes a 
market in, by buying and selling, asset-backed securities, the income 
from that activity may be covered by these regulations, regardless of 
whether the dealer was a party to the loans backing the securities. 
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 security may be held 
for investment for purposes of this section even though it is not 
identified as held for investment under section 475.
    Activities unrelated to the conduct of a global dealing operation 
are not covered by these regulations, even if they are accounted for on 
a mark-to-market basis. Accordingly, income from proprietary trading 
that is not undertaken in connection with a global dealing operation, 
and other financial transactions that are not entered into in a dealing 
capacity are not covered by these proposed regulations. The regulations 
require that participants engaged in dealing and nondealing activities 
and/or multiple dealing activities segregate income and expense 
attributable to each separate dealing operation so that the best method 
may be used to evaluate whether controlled transactions entered into in 
connection with a particular dealing activity are priced at arm's 
length. The regulations also require that taxpayers segregate their 
dealer activities from their lending, proprietary trading or other 
investment activities not entered into in connection with a global 
dealing operation. Comments are solicited on whether the proposed 
regulations issued under section 475 in this notice of proposed 
rulemaking are sufficient to facilitate identification of the amount of 
income that should be subject to allocation under the global dealing 
regulations.
    The term participant is defined as a controlled taxpayer that is 
either a regular dealer in securities within the meaning of Sec. 1.482-
8(a)(2)(iii), or a member of a group of controlled taxpayers which 
includes a regular dealer in securities, so long as that member 
conducts one or more activities related to the activities of such 
dealer. For these purposes, such related activities are the marketing, 
sales, pricing, and risk management activities necessary to the 
definition of a global dealing operation. Additionally, brokering is a 
related activity that may give rise to participant status. Related 
activities do not include credit analysis, accounting services, back 
office services, or the provision of a guarantee of one or more 
transactions entered into by a regular dealer in securities or other 
participant. This definition is significant because the transfer 
pricing methods contained in this section can only be used by 
participants, and only to evaluate whether compensation attributable to 
a regular dealer in securities or a marketing, sales, pricing, risk 
management or brokering function is at arm's length. Whether the 
compensation paid for other functions performed in the course of a 
global dealing operation (including certain services and development of 
intangibles) is at arm's length is determined under the appropriate 
section 482 regulations applicable to those transactions.
    The definition of a global dealing operation does not require that 
the global dealing operation be conducted around the world or on a 
twenty-four hour basis. These regulations will apply if the controlled 
taxpayers, or QBUs of a single taxpayer, operate in the aggregate in 
more than one tax jurisdiction. It is not necessary, however, for the 
participants to conduct the global dealing operation in more than one 
tax jurisdiction. For example, a participant that is resident in one 
tax jurisdiction may conduct its participant activities in the global 
dealing operation through a trade or business in another jurisdiction 
that is the same jurisdiction where the dealer activity of a separate 
controlled taxpayer takes place. In this situation, the rules of this 
section apply to determine the allocation of income, gain or loss 
between the two controlled taxpayers even if all of the income, gain or 
loss is allocable within the same tax jurisdiction.
    The term regular dealer in securities is specifically defined in 
this regulation consistently with the definition of a regular dealer 
under Sec. 1.954-2(a)(4)(iv). Under these proposed regulations, a 
dealer in physical securities or currencies is a regular dealer in 
securities if it regularly and actively offers to, and in fact does, 
purchase securities or currencies from and sell securities or 
currencies to customers who are not controlled taxpayers in the 
ordinary course of a trade or business. In addition, a dealer in 
derivatives is a regular dealer in securities if it 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. The IRS solicits comments on whether these regulations should 
be extended to cover dealers in commodities and/or persons trading for 
their own account that are not dealers.
D. Best Method and Comparability
    Consistent with the general principles of section 482, the best 
method rule applies to evaluate the most appropriate method for 
determining whether the controlled transactions are priced at arm's 
length. New specified methods which replace the specified methods of 
Secs. 1.482-2 through 1.482-6 for a global dealing operation are set 
forth in Secs. 1.482-8(b) through 1.482-8(f). The comparable profits 
method of Sec. 1.482-5 has been excluded as a specified method for a 
global dealing operation because of the high variability in profits 
from company to company and year to year due to differences in business 
strategies and fluctuations in the financial markets.
    The proposed regulations do not apply specific methods to certain 
trading models, such as those commonly referred to in the financial 
services industry as ``separate enterprise,'' ``natural home,''

[[Page 11180]]

``centralized product management,'' or ``integrated trading.'' Rather, 
the proposed regulations adopt the best method rule of Sec. 1.482-1(c) 
to determine the most appropriate transfer pricing methodology, taking 
into account all of the facts and circumstances of a particular 
taxpayer's trading structure. Consistent with the best method rule, 
there is no priority of methods.
    Application of the best method rule will depend on the structure 
and organization of the individual taxpayer's global dealing operation 
and the nature of the transaction at issue. Where a taxpayer is engaged 
in more than one global dealing operation, it will be necessary to 
segregate each activity and determine on a transaction-by-transaction 
basis within each activity which method provides the most reliable 
measure of an arm's length price. It may be appropriate to apply the 
same method to multiple transactions of the same type within a single 
business activity entered into as part of a global dealing operation. 
For example, if a taxpayer operates its global dealing activity in 
notional principal contracts differently than its foreign exchange 
trading activity, then the income from notional principal contracts may 
be allocated using a different methodology than the income from foreign 
exchange trading. Moreover, the best method rule may require that 
different methods be used to determine whether different controlled 
transactions are priced at arm's length even within the same product 
line. For example, one method may be the most appropriate to determine 
if a controlled transaction between a global dealing operation and 
another business activity is at arm's length, while a different method 
may be the most appropriate to determine if the allocation of income 
and expenses among participants in a global dealing operation is at 
arm's length.
    Section 1.482-8(a)(3) reiterates that the principle of 
comparability in Sec. 1.482-1(d) applies to transactions entered into 
by a global dealing operation. The comparability factors provided in 
Sec. 1.482-8(a)(3) (functional analysis, risk, and economic 
conditions), however, must be applied in place of the comparability 
factors discussed in Sec. 1.482-1(d)(3). The comparability factors for 
contractual terms in Sec. 1.482-8(a)(3) supplement the comparability 
factors for contractual terms in Sec. 1.482-1(d)(3)(ii). The 
comparability factors in this section have been included to provide 
guidance on the factors that may be most relevant in assessing 
comparability in the context of a global dealing operation.
E. Arm's Length Range
    In determining the arm's length range, Sec. 1.482-1(e) will apply 
except as modified by these proposed regulations. In determining the 
reliability of an arm's length range, the IRS believes that 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.
    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.
    Comments are solicited on the types of analyses and factors that 
may be relevant for pricing controlled financial transactions in a 
global dealing operation. Section 1.482-1(e) continues to apply in its 
entirety to transactions among participants that are common to 
businesses other than a global dealing operation. In this regard, the 
existing rules continue to apply to pricing of certain services from a 
participant to a regular dealer in securities other than services that 
give rise to participant status.
F. Comparable Uncontrolled Financial Transaction Method
    The comparable uncontrolled financial transaction (CUFT) method is 
set forth in Sec. 1.482-8(b). The CUFT method evaluates whether 
controlled transactions satisfy the arm's length standard by comparing 
the price of a controlled financial transaction with the price of a 
comparable uncontrolled financial transaction. Similarity in the 
contractual terms and risks assumed in entering into the financial 
transaction are the most important comparability factors under this 
method.
    Ordinarily, in global dealing operations, proprietary pricing 
models are used to calculate a financial product's price based upon 
market data, such as interest rates, currency rates, and market risks. 
The regulations contemplate that indirect evidence of the price of a 
CUFT may be derived from a proprietary pricing model if the data used 
in the model is widely and routinely used in the ordinary course of the 
taxpayer's business to price uncontrolled transactions, and adjustments 
are made to the amount charged to reflect differences in the factors 
that affect the price to which uncontrolled taxpayers would agree. In 
addition, the proprietary pricing model must be used in the same manner 
to price transactions with controlled and uncontrolled parties. If a 
taxpayer uses its internal pricing model as evidence of a CUFT, it 
must, upon request, furnish the pricing model to the district director 
in order to substantiate its use.
G. Gross Margin Method
    The gross margin method is set forth in Sec. 1.482-8(c) and should 
be considered in situations where a taxpayer performs only a routine 
marketing or sales function as part of a global dealing operation. 
Frequently, taxpayers that perform the sales function in these 
circumstances participate in the dealing of a variety of, rather than 
solely identical, financial products. In such a case, the variety of 
financial products sold within a relevant time period may limit the 
availability of comparable uncontrolled financial transactions. Where 
the taxpayer has performed a similar function for a variety of 
products, however, the gross margin method can be used to determine if 
controlled transactions are priced at arm's length by reference to the 
amount earned by the taxpayer for performing similar functions with 
respect to uncontrolled transactions.
    The gross margin method determines if the gross profit realized on 
sales of financial products acquired from controlled parties is at 
arm's length by comparing that profit to the gross profit earned on 
uncontrolled transactions. Since comparability under this method 
depends on the similarity of functions performed and risks assumed, 
adjustments must be made for differences between the functions 
performed in the disposition of financial products acquired in 
controlled transactions and the functions performed in the disposition 
of financial products acquired in uncontrolled transactions. Although 
close product similarity will tend to improve the

[[Page 11181]]

reliability of the gross margin method, the reliability of this method 
is not as dependent on product similarity as the CUFT method.
    Participants in a global dealing operation may act simply as 
brokers, or they may participate in structuring complex products. As 
the role of the participant exceeds the brokerage function, it becomes 
more difficult to find comparable functions because the contributions 
made in structuring one complex financial product are not likely to be 
comparable to the contributions made in structuring a different complex 
financial product. Accordingly, the regulations provide that the 
reliability of this method is decreased where a participant is 
substantially involved in developing a financial product or in 
tailoring the product to the unique requirements of a customer prior to 
resale.
H. Gross Markup Method
    Like the gross margin method, the gross markup method set forth in 
Sec. 1.482-8(d) should generally be considered in situations where a 
taxpayer performs only a routine marketing or sales function as part of 
a global dealing operation, and, as is often the case, handles a 
variety of financial products within a relevant time period. The gross 
markup method is generally appropriate in cases where the taxpayer 
performs a routine sales function in buying a financial product from an 
uncontrolled party and reselling or transferring the product to a 
controlled party.
    The gross markup method determines if the gross profit earned on 
the purchase of financial products from uncontrolled parties and sold 
to controlled taxpayers is at arm's length by comparing that profit to 
the gross profit earned on uncontrolled transactions. Like the gross 
margin method, comparability under this method depends on the 
similarity of the functions performed and risks assumed in the 
controlled and uncontrolled transactions. Accordingly, adjustments 
should be made for differences between the functions performed in the 
sale or transfer of financial products to controlled parties, and the 
functions performed with respect to the sale or transfer of financial 
products to uncontrolled parties. Although close product similarity 
will tend to improve the reliability of the gross markup method, the 
reliability of this method is not as dependent on product similarity as 
the CUFT method.
    As in the gross margin method, the regulations provide that the 
reliability of this method generally is decreased where a participant 
is substantially involved in developing a financial product or in 
tailoring the product to the unique requirements of a customer prior to 
resale.
I. Profit Split Methods
    New profit split methods are proposed for global dealing 
participants under Sec. 1.482-8(e). Global dealing by its nature 
involves a certain degree of integration among the participants in the 
global dealing operation. The structure of some global dealing 
operations may make it difficult to apply a traditional transactional 
method to determine if income is allocated among participants on an 
arm's length basis. Two profit split methods, the total profit split 
method and the residual profit split method, have been included as 
specified methods for determining if global dealing income is allocated 
at arm's length.
    Profit split methods may be used to evaluate if the allocation of 
operating profit from a global dealing operation compensates the 
participants at arm's length for their contribution by evaluating if 
the allocation is one which uncontrolled parties would agree to. 
Accordingly, the reliability of this method is dependent upon clear 
identification of the respective contributions of each participant to 
the global dealing operation.
    In general, the profit split methods must be based on objective 
market benchmarks that provide a high degree of reliability, i.e., 
comparable arrangements between unrelated parties that allocate profits 
in the same manner and on the same basis. Even if such comparable 
uncontrolled transactions are not available, however, the taxpayer may 
be able to demonstrate that a total profit split provides arm's length 
results that reflect the economic value of the contribution of each 
participant, by reference to other objective factors that provide 
reliability due to their arm's length nature. For example, an 
allocation of income based on trader bonuses may be reliable, under the 
particular facts and circumstances of a given case, if the taxpayer can 
demonstrate that such bonuses are based on the value added by the 
individual traders. By contrast, an allocation based on headcount or 
gross expenses may be unreliable, because the respective participants 
might, for example, have large differences in efficiency or cost 
control practices, which would tend to make such factors poor 
reflections of the economic value of the functions contributed by each 
participant.
    The proposed regulations define gross profit as gross income earned 
by the global dealing operation. Operating expenses are those not 
applicable to the determination of gross income earned by the global 
dealing operation. The operating expenses are global expenses of the 
global dealing operation and are subtracted from gross profit to 
determine the operating profit. Taxpayers may need to allocate 
operating expenses that relate to more than one global dealing 
activity.
    The regulations state that in appropriate circumstances a multi-
factor formula may be used to determine whether an allocation is at 
arm's length. Use of a multi-factor formula is permitted so long as the 
formula allocates the operating profit or loss based upon the factors 
that uncontrolled taxpayers would consider. The regulations do not 
prescribe specific factors to be used in the formula since the 
appropriateness of any one factor will depend on all the facts and 
circumstances associated with the global dealing operation. However, 
the regulations require that the multi-factor formula take into account 
all of the functions performed and risks assumed by a participant, and 
attribute the appropriate amount of income or loss to each function. 
The IRS also solicits comments concerning which factors may be 
appropriate (for example, initial net present value of derivatives 
contracts) and the circumstances under which specific factors may be 
appropriately applied.
    The purpose of the factors is to measure the relative value 
contributed by each participant. Thus, adjustments must be made for any 
circumstances other than the relative value contributed by a 
participant that influence the amount of a factor so that the factor 
does not allocate income to a participant based on circumstances that 
are not relevant to the value of the function or activity being 
measured. For example, if trader compensation is used to allocate 
income among participants, and the traders in two different 
jurisdictions would be paid different amounts (for example, due to cost 
of living differences) to contribute the same value, adjustments should 
be made for the difference so that the factors accurately measure the 
value contributed by the trading function. The IRS solicits comments 
regarding the types of adjustments that should be made, how to make 
such adjustments, and the need for further guidance on this point.
    The total profit split method entails a one step process whereby 
the operating profit is allocated among the

[[Page 11182]]

participants based on their relative contributions to the profitability 
of the global dealing operation. No distinction is made between routine 
and nonroutine contributions. The total profit split method may be 
useful to allocate income earned by a highly integrated global dealing 
operation where all routine and nonroutine dealer functions are 
performed by each participant in each location. Accordingly, total 
profit or loss of the global dealing operation may be allocated among 
various jurisdictions based on the relative performance of equivalent 
functions in each jurisdiction.
    The residual profit split method entails a two step process. In the 
first step, the routine functions are compensated with a market return 
based upon the best transfer pricing method applicable to that 
transaction. Routine functions may include, but are not limited to, 
functions that would not give rise to participant status and which 
should be evaluated under Secs. 1.482-3 through 1.482-6. After 
compensating the routine functions, the remaining operating profit (the 
``residual profit'') is allocated among the participants based upon 
their respective nonroutine contributions.
    It should be noted that, while in appropriate cases a profit split 
method may be used to determine if a participant is compensated at 
arm's length, use of the profit split method does not change the 
contractual relationship between participants, nor does it affect the 
character of intercompany payments. For example, if a controlled 
taxpayer provides solely trading services to a global dealing operation 
in a particular jurisdiction, any payment it receives as compensation 
for services retains its character as payment for services and, under 
the regulations, is not converted into a pro rata share of each item of 
gross income earned by the global dealing operation.
J. Unspecified Methods
    Consistent with the principles underlying the best method rule, the 
regulations provide the option to use an unspecified method if it is 
determined to be the best method. The IRS solicits comments on the 
extent to which the variety of methods on which specific guidance has 
been provided is adequate.
    Guidance on the use of a comparable profits method has specifically 
not been included as a specified method in the proposed regulations 
because use of that method depends on the existence of arrangements 
between uncontrolled taxpayers that perform comparable functions and 
assume comparable risks. Global dealing frequently involves the use of 
unique intangibles such as trader know-how. Additionally, anticipated 
profit is often influenced by the amount of risk a participant is 
willing to bear. Accordingly, the IRS believes it is unlikely that the 
comparability of these important functions can be measured and adjusted 
for accurately in a global dealing operation.
K. Source of Global Dealing Income
    Under current final regulations in Sec. 1.863-7(a), all of the 
income attributable to a notional principal contract is sourced by 
reference to the taxpayer's residence. Exceptions are provided for 
effectively connected notional principal contract income, and for 
income earned by a foreign QBU of a U.S. resident taxpayer if the 
notional principal contract is properly reflected on the books of the 
foreign QBU. Attribution of all of the income from a notional principal 
contract to a single location has generally been referred to as the 
``all or nothing'' rule. The current final regulations do not provide 
for multi-location sourcing of notional principal contract income among 
the QBUs that have participated in the acquisition or risk management 
of a notional principal contract and therefore do not recognize that 
significant activities, including structuring or risk managing 
derivatives, often occur through QBUs in more than one jurisdiction.
    Recognizing the need for multi-location sourcing of income earned 
in a global dealing operation, the proposed regulations provide a new 
rule under Sec. 1.863-3 which sources income from a global dealing 
operation in the same manner as the income would be allocated under 
Sec. 1.482-8 if each QBU were a separate entity. However, the rules 
must be applied differently to take into account the economic 
differences between acting through a single legal entity and through 
separate legal entities.
    Accordingly, income from a single transaction may be split-sourced 
to more than one location, so long as the allocation methodology 
satisfies the arm's length standard. The all or nothing rule of 
Sec. 1.863-7(a) continues to apply to notional principal contract 
income attributable to activities not related to a global dealing 
operation. Corresponding changes have been made in proposed Sec. 1.988-
4(h) to exclude exchange gain or loss derived in the conduct of a 
global dealing operation from the general source rules in Sec. 1.988-4 
(b) and (c).
    These special source rules apply only with respect to participants 
that perform a dealing, marketing, sales, pricing, risk management or 
brokering function. Moreover, these rules do not apply to income, such 
as fees for services, for which a specific source rule is provided in 
section 861, 862 or 865 of the Code. Accordingly, if a controlled 
taxpayer provides back office services, the amount and source of an 
intercompany payment for such services is determined under existing 
transfer pricing and sourcing rules applicable to those services 
without regard to whether the controlled taxpayer is also a participant 
in a global dealing operation.
    If an entity directly bears the risk assumed by the global dealing 
operation, it should be compensated for that function. In providing, 
however, that the source (and effectively connected status) of global 
dealing income is determined by reference to where the dealing, 
marketing, sales, pricing, risk management or brokering function that 
gave rise to the income occurred, the regulations effectively provide 
that compensation for risk bearing should be sourced by reference to 
where the capital is employed by traders, marketers and salespeople, 
rather than the residence of the capital provider. This principle 
applies where a taxpayer directly bears risk arising from the conduct 
of a global dealing operation, such as when it acts as a counterparty 
without performing other global dealing functions. A special rule 
provides that the activities of a dependent agent may give rise to 
participant status through a deemed QBU that performs its participant 
functions in the same location where the dependent agent performs its 
participant functions. The deemed QBU may be created without regard to 
the books and records requirement of Sec. 1.989-1(b).
    As indicated, accounting, back office, credit analysis, and general 
supervision and policy control functions do not give rise to 
participant status in a global dealing operation but are services that 
should be remunerated and sourced separately under existing rules. This 
principle also applies where a taxpayer bears risk indirectly, such as 
through the extension of a guarantee. Accordingly, the sourcing rule of 
Sec. 1.863-3(h) does not apply to interest, dividend, or guarantee fee 
income received by an owner or guarantor of a global dealing operation 
that is conducted by another controlled taxpayer. The source of 
interest, dividend and guarantee fee income, substitute interest and 
substitute dividend payments sourced under Secs. 1.861-2(a)(7) and 
1.861-3(a)(6), and other income sourced by section 861,

[[Page 11183]]

862 or 865 continues to be governed by the source rules applicable to 
those transactions.
    The proposed regulations provide, consistent with U.S. tax 
principles, that an agreement between two QBUs of a single taxpayer 
does not give rise to a transaction because a taxpayer cannot enter 
into nor profit from a ``transaction'' with itself. See, e.g., 
Sec. 1.446-3(c)(1). The IRS believes, however, that these agreements 
between QBUs of a single taxpayer may provide evidence of how income 
from the taxpayer's transactions with third parties should be allocated 
among QBUs. It is a common practice for taxpayers to allocate income or 
loss from transactions with third parties among QBUs for internal 
control and risk management purposes. Accordingly, the proposed 
regulations specifically provide that such allocations may be used to 
source income to the same extent and in the same manner as they may be 
used to allocate income between related persons. Conversely, such 
transactions may not be used to the extent they do not provide an arm's 
length result.
L. Determination of Global Dealing Income Effectively Connected With a 
U.S. Business
    After determining the source of income, it is necessary to 
determine the extent to which such income is ECI. Under current law, 
the general rule is that all of the income, gain or loss from a global 
dealing operation is effectively connected with a U.S. trade or 
business if the U.S. trade or business materially participates in the 
acquisition of the asset that gives rise to the income, gain or loss, 
or property is held for use in the active conduct of a U.S. trade or 
business, or the business activities conducted by the U.S. trade or 
business are a material factor in the realization of income, gain or 
loss. As noted above, the current final regulations do not permit the 
attribution of income, gain or loss from a global dealing operation 
that is allocated and sourced to a U.S. trade or business under 
Sec. 1.863-3(h) shall be effectively connected. In this regard, an 
asset used in a global dealing operation is treated as an asset used in 
a U.S. trade or business to the extent that an allocation is made to a 
U.S. QBU. Similarly, the U.S. trade or business is also treated as a 
material factor in the realization of income, gain or loss for which an 
allocation is made to a U.S. QBU. A special rule for U.S. source 
interest and dividend income, including substitute interest and 
substitute dividends, earned by a foreign banking or similar financial 
institution in a global dealing operation treats such income as 
attributable to a U.S. trade or business to the extent such income 
would be sourced to the United States under Sec. 1.863-3(h). Any 
foreign source income allocated to the United States under the 
principles of Sec. 1.863-3(h) is also treated as attributable to the 
U.S. trade or business.
    The proposed regulations also limit an entity's effectively 
connected income from a global dealing operation to that portion of an 
item of income, gain or loss that would be sourced to the U.S. trade or 
business if the rules of Sec. 1.863-3(h) were to apply. These rules are 
intended to ensure that income for which a specific source rule is 
provided in section 861, 862 or 865 does not produce effectively 
connected income unless it was earned through functions performed by a 
U.S. QBU of the taxpayer.
    With respect to notional principal contract income and foreign 
exchange gain or loss, proposed Secs. 1.863-3(h) and 1.988-4(h) also 
provide that such income, gain or loss is effectively connected with 
the conduct of a U.S. trade or business to the extent that it is 
sourced to the United States under Sec. 1.863-3(h).
    In certain circumstances, the global dealing activities of an 
entity acting as the agent of a foreign taxpayer in the United States 
may cause the foreign taxpayer to be engaged in a U.S. trade or 
business. Any income effectively connected with the U.S. trade or 
business must be reported by the foreign corporation on a timely filed 
U.S. tax return in order for the foreign corporation to be eligible for 
deductions and credits attributable to such income. See Sec. 1.882-4. 
In addition, the agent must also report any income earned in its 
capacity as agent on its own tax return. The provisions governing the 
time and manner for foreign corporations to make elections under 
Secs. 1.882-5 and 1.884-1 remain in force as promulgated. Under current 
rules, these formalities must be observed even if all of the global 
dealing income would be allocated between a U.S. corporation and a 
foreign corporation's U.S. trade or business. The IRS believes that 
these requirements are justified because of potential differences that 
might occur with respect to the realization of losses and between 
actual dividend remittances of a U.S. corporation and deemed dividend 
remittances under the branch profits tax. The IRS, however, solicits 
comments regarding whether these filing requirements can be simplified, 
taking into consideration the policies underlying the filing 
requirements of Sec. 1.882-4.
    The Business Profits article contained in U.S. income tax treaties 
requires the United States to attribute to a permanent establishment 
that portion of the income earned by the entity from transactions with 
third parties that the permanent establishment might be expected to 
earn if it were an independent enterprise. Because the proposed 
regulations contained in this document allocate global trading income 
among permanent establishments under the arm s length principle of the 
Associated Enterprises article of U.S. income tax treaties, such rules 
are consistent with our obligations under the Business Profits article. 
Accordingly, a proposed rule under section 894 provides that, if a 
taxpayer is engaged in a global dealing operation through a U.S. 
permanent establishment, the proposed regulations will apply to 
determine the income attributable to that U.S. permanent establishment 
under the applicable U.S. income tax treaty.
M. Relationship to Other Regulations
    The allocation rules contained herein do not apply to the 
allocation of interest expense. As discussed in the preamble to 
Sec. 1.882-5 (TD 8658, 1996-1 CB 161, 162, 61 FR 9326, March 5, 1996), 
the rules contained in Sec. 1.882-5 are the exclusive rules for 
allocating interest expense, including under U.S. income tax treaties.
    Proposed regulations have been issued under sections 882 and 884 
(INTL-0054-95, 1996-1 CB 844, 61 FR 9377, March 5, 1996) for purposes 
of allocating interest expense and determining the U.S. assets and/or 
liabilities reflected on the books of a foreign corporation s U.S. 
trade or business that are attributable to its activities as a dealer 
under section 475. The proposed regulations (and similar final 
regulations) under section 884 address the treatment of assets which 
give rise to both effectively connected and non-effectively connected 
income. Those rules thus address a situation analogous to the split-
sourcing situation addressed in these proposed regulations. The IRS 
anticipates issuing proposed regulations under section 861 that provide 
a similar rule for purposes of allocating interest expense of a U.S. 
corporation that has assets that give rise to split-sourced income. 
Comments are solicited on the compatibility of the proposed regulations 
contained in this document with the principles of the proposed 
regulations that address a foreign corporation s allocation of interest 
expense, including its computation of U.S. assets included in step 1 of 
the Sec. 1.882-5 formula and

[[Page 11184]]

component liabilities included in steps 2 and 3 of the Sec. 1.882-5 
formula.
    The IRS believes that the transfer pricing compliance issues 
associated with a global dealing operation are substantially similar to 
those raised by related party transactions generally. The IRS also 
believes that the existing regulations under section 6662 adequately 
address these issues. Accordingly, amendments have not been proposed to 
the regulations under section 6662. Section 6662 may not in certain 
circumstances, however, apply to the computation of effectively 
connected income in accordance with proposed regulations under section 
475, 863, 864 or 988 contained in this document. The IRS will propose 
regulations under section 6038C regarding the information reporting and 
recordkeeping requirements applicable to foreign corporations engaged 
in a global dealing operation. It is anticipated that these regulations 
will coordinate the application of sections 6662 and 6038C where 
necessary.
    No inference should be drawn from the examples in these proposed 
regulations concerning the treatment or significance of liquidity and 
creditworthiness or the effect of such items on the valuation of a 
security. The purpose of the proposed regulations under section 482 is 
not to provide guidance on the valuation of a security, but rather to 
determine whether the prices of controlled transactions satisfy the 
arm's length standard. Section 475 and the regulations thereunder 
continue to govern exclusively the valuation of securities.
N. Section 475
    A dealer in securities as defined in section 475 is generally 
required to mark its securities to market. Securities are exempt from 
mark-to-market accounting if the securities are held for investment or 
not held for sale to customers and are properly identified on the 
taxpayer's books and records. Additionally, securities that hedge 
positions that are not subject to mark-to-market accounting are exempt 
from mark-to-market accounting if they are properly identified.
    Under the current regulations, a taxpayer may not take into account 
an agreement between separate business units within the same entity 
that transfers risk management responsibility from a non-dealing 
business unit to a dealing business unit. Moreover, such an agreement 
may not be used to allocate income, expense, gain or loss between 
activities that are accounted for on a mark-to-market basis and 
activities that are accounted for on a non-mark-to-market basis. In 
contrast, the regulations proposed in this document under sections 482, 
863, 864, 894, and 988 allow a taxpayer to take into account records of 
internal transfers when allocating global dealing income earned from 
third parties for purposes of determining source and effectively 
connected income. This may cause a mismatch in the timing of income, 
expense, gain, or loss.
    For example, if a taxpayer s lending desk enters into a third-party 
transaction that exposes the lending desk to currency or interest rate 
risk, the lending desk may transfer responsibility for managing the 
risk for that particular transaction to another business activity that 
can manage the risk more efficiently (e.g., the desk that deals in 
currency or interest rate derivatives). The dealing desk then, in the 
ordinary course of its business, may enter into a transaction such as a 
swap with a third party to hedge the aggregate risk of the dealing desk 
and, indirectly, the risk incurred by the lending desk with respect to 
the original transaction. Where, as is generally the case, the dealing 
desk has a large volume of transactions, it is not possible as a 
practical matter to associate the aggregate hedge with the risk of the 
lending desk. Since the transactions entered into by the dealing desk 
must generally be marked to market, the third-party transaction that 
hedges the aggregate risk of the dealing desk (which includes the risk 
transferred from the lending desk) must generally also be marked. To 
the extent that a portion of the income, expense, gain, or loss from 
the aggregate hedging transaction is allocated to the lending desk 
under the proposed global dealing regulations, the potential timing 
mismatch described above will occur if the lending desk accounts for 
its positions on a non-mark-to-market basis. This mismatch could occur 
because the portion of the income, expense, gain, or loss from the 
hedging transaction, although allocated to the lending desk for 
sourcing and effectively connected income purposes, will be accounted 
for on a mark-to-market basis under the dealing desk's method of 
accounting. Entirely exempting the aggregate hedging transaction from 
mark-to-market accounting does not adequately solve this problem, 
because it results in the portion of the income, expense, gain or loss 
from the aggregate hedging transaction that is allocated to the dealing 
desk being accounted for on other than a mark-to-market method.
    As the example shows, respecting records of internal transfers for 
purposes of sourcing without respecting these same records for purposes 
of timing could produce unpredictable and arbitrary results. 
Accordingly, the proposed regulations permit participants in a global 
dealing operation to respect records of internal transfers in applying 
the timing rules of section 475. Because the need to reconcile sourcing 
and timing exists only in the context of a cross-border operation, the 
proposed regulations have a limited scope. In particular, for the 
proposed regulations to apply, income of the global dealing desk must 
be subject to allocation among two or more jurisdictions or be sourced 
to two or more jurisdictions.
    The purpose of the proposed regulations under section 475 is to 
coordinate section 475 with the proposed global dealing regulations and 
to facilitate identification of the amount of income, expense, gain or 
loss from third party transactions that is subject to mark-to-market 
accounting. This rule is not intended to allow a shifting of income 
inconsistent with the arm's length standard.
    Under the proposed section 475 regulations, an interdesk agreement 
or ``risk transfer agreement'' (RTA) includes a transfer of 
responsibility for risk management between a business unit that is 
hedging some of its risk (the hedging QBU) and another business unit of 
the same taxpayer that uses mark-to-market accounting (the marking 
QBU). If the marking QBU, the hedging QBU, and the RTA satisfy certain 
requirements, the RTA is taken into account for purposes of determining 
the timing of income allocated by the proposed global dealing 
regulations to the separate business units of a taxpayer.
    The proposed amendments to the section 475 regulations require that 
the marking QBU must be a dealer within the meaning of proposed 
Sec. 1.482-8(a)(2)(iii) and that its income must be allocated to at 
least two jurisdictions under proposed Sec. 1.482-8 or sourced to at 
least two jurisdictions under proposed Sec. 1.863-3(h). Additionally, 
the RTA qualifies only if the marking QBU would mark its side of the 
RTA to market under section 475 if the transaction were with an 
unrelated third party. Thus, if the marking QBU were to identify the 
RTA as a hedge of a position that is not subject to mark-to-market 
accounting (such as debt issued by the marking QBU), the RTA would not 
qualify. The IRS requests comments on whether the marking QBU should 
ever be able to exempt its position in the RTA from mark-to-market 
treatment and account for its position in the RTA.

[[Page 11185]]

    The proposed amendments to the section 475 regulations are intended 
to address situations where the hedging QBU transfers responsibility 
for the management of risk arising from a transaction with a third 
party. Accordingly, the proposed regulations require that the hedging 
QBU's position in the RTA would be a hedge within the meaning of 
Sec. 1.1221-2(b) if the transaction were entered into with an unrelated 
entity. The IRS solicits comments on whether this requirement is broad 
enough to address the business needs of entities engaged in global 
dealing and nondealing activities. Comments suggesting that the 
requirement should be broadened (e.g., to include risk reduction with 
respect to capital assets) should address how such a regime could be 
coordinated with other relevant rules (e.g., the straddle rules). 
Additionally, if a taxpayer suggests changes to the section 475 rules 
proposed in this notice, the IRS requests additional comments 
addressing whether or not corresponding changes should be made to 
Sec. 1.1221-2(d).
    The proposed regulations also require that the RTA be recorded on 
the books and records of the QBU no later than the time the RTA is 
effective. RTAs that are not timely recorded do not qualify under the 
proposed regulations. Additionally, the RTA must be accounted for in a 
manner that is consistent with the QBU's usual accounting practices.
    If all of the requirements of the proposed regulations are 
satisfied, then for purposes of determining the timing of income, 
expense, gain, or loss allocated to a QBU under the global dealing 
regulations, the marking QBU and the hedging QBU account for their 
respective positions in the RTA as if the position were entered into 
with an unrelated third party.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory impact analysis is not required. It is 
hereby certified that these regulations do not have a significant 
economic impact on a substantial number of small entities. This 
certification is based upon the fact that these regulations affect 
entities who participate in cross-border global dealing of stocks and 
securities. These regulations affect the source of income and 
allocation of income, deductions, credits, and allowances among such 
entities. The primary participants who engage in cross-border global 
dealing activities are large regulated commercial banks and brokerage 
firms, and investment banks. Accordingly, the IRS does not believe that 
a substantial number of small entities engage in cross-border global 
dealing activities covered by these regulation. Therefore, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
Chapter 6) is not required. Pursuant to section 7805(f) of the Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments that are submitted 
timely to the IRS (a signed original and eight (8) copies). All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for July 9, 1998, at 10 a.m. in 
room 2615, Internal Revenue Building, 1111 Constitution Avenue NW, 
Washington, DC. Because of access restrictions, visitors will not be 
admitted beyond the Internal Revenue Building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by June 4, 1998, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic by June 
18, 1998.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Proposed Effective Date

    These regulations are proposed to be effective for taxable years 
beginning after the date final regulations are published in the Federal 
Register.

Drafting Information

    The principal authors of these regulations are Ginny Chung of the 
Office of Associate Chief Counsel (International) and Richard Hoge of 
the Office of Assistant Chief Counsel (Financial Institutions & 
Products). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.475(g)-2 also issued under 26 U.S.C. 475. * * *
    Section 1.482-8 also issued under 26 U.S.C. 482. * * *
    Section 1.863-3(h) also issued under 26 U.S.C. 863 and 26 U.S.C. 
865(j). * * * *
    Section 1.988-4(h) also issued under 26 U.S.C. 863 and 26 U.S.C. 
988. * * *
    Par. 2. Section 1.475(g)-2 is added as follows:


Sec. 1.475(g)-2  Risk transfer agreements in a global dealing 
operation.

    (a) In general. This section provides computational rules to 
coordinate the application of section 475 and Sec. 1.446-4 with rules 
for allocation and sourcing under the global dealing regulations. If 
the requirements in paragraph (c) of this section are met, a risk 
transfer agreement (RTA) (as defined in paragraph (b) of this section) 
is accounted for under the rules of paragraph (d) of this section.
    (b) Definition of risk transfer agreement. For purposes of this 
section, a risk transfer agreement (RTA) is a transfer of risk between 
two qualified business units (QBUs) (as defined in Sec. 1.989(a)-1(b)) 
of the same taxpayer such that--
    (1) The transfer is consistent with the business practices and risk 
management policies of each QBU;
    (2) The transfer is evidenced in each QBU's books and records;
    (3) Each QBU records the RTA on its books and records at a time no 
later than the time the RTA is effective; and
    (4) Except to the extent required by paragraph (b)(3) of this 
section, the entry in the books and records of each QBU is consistent 
with that QBU's normal accounting practices.
    (c) Requirements for application of operational rule--(1) The 
position in the RTA of one QBU (the hedging QBU) would qualify as a 
hedging transaction (within the meaning of Sec. 1.1221-2(b)) with 
respect to that QBU if--
    (i) The RTA were a transaction entered into with an unrelated 
party; and

[[Page 11186]]

    (ii) For purposes of determining whether the hedging QBU's position 
satisfies the risk reduction requirement in Sec. 1.1221-2(b), the only 
risks taken into account are the risks of the hedging QBU (that is, the 
risks that would be taken into account if the hedging QBU were a 
separate corporation that had made a separate-entity election under 
Sec. 1.1221-2(d)(2));
    (2) The other QBU (the marking QBU) is a regular dealer in 
securities (within the meaning of Sec. 1.482-8(a)(2)(iii));
    (3) The marking QBU would mark to market its position in the RTA 
under section 475 if the RTA were a transaction entered into with an 
unrelated party; and
    (4) Income of the marking QBU is subject to allocation under 
Sec. 1.482-8 to two or more jurisdictions or is sourced under 
Sec. 1.863-3(h) to two or more jurisdictions.
    (d) Operational rule. If the requirements in paragraph (c) of this 
section are met, each QBU that is a party to a RTA (as defined in 
paragraph (b) of this section) takes its position in the RTA into 
account as if that QBU had entered into the RTA with an unrelated 
party. Thus, the marking QBU marks its position to market, and the 
hedging QBU accounts for its position under Sec. 1.446-4. Because this 
section only effects coordination with the allocation and sourcing 
rules, it does not affect factors such as the determination of the 
amount of interest expense that is incurred by either QBU and that is 
subject to allocation and apportionment under section 864(e) or 882(c).
    Par. 3. Section 1.482-0 is amended as follows:
    1. The introductory text is revised.
    2. The section heading and entries for Sec. 1.482-8 are 
redesignated as the section heading and entries for Sec. 1.482-9.
    3. A new section heading and entries for Sec. 1.482-8 are added.
    The addition and revision read as follows:


Sec. 1.482-0  Outline of regulations under section 482.

    This section contains major captions for Secs. 1.482-1 through 
1.482-9.
* * * * *

Sec. 1.482-8  Allocation of income earned in a global dealing 
operation.

(a) General requirements and definitions.
    (1) In general.
    (2) Definitions.
    (i) Global dealing operation.
    (ii) Participant.
    (iii) Regular dealer in securities.
    (iv) Security.
    (3) Factors for determining comparability for a global dealing 
operation.
    (i) Functional analysis.
    (ii) Contractual terms.
    (iii) Risk.
    (iv) Economic conditions.
    (4) Arm's length range.
    (i) General rule.
    (ii) Reliability.
    (iii) Authority to make adjustments.
    (5) Examples.
(b) Comparable uncontrolled financial transaction method.
    (1) General rule.
    (2) Comparability and reliability.
    (i) In general.
    (ii) Adjustments for differences between controlled and 
uncontrolled transactions.
    (iii) Data and assumptions.
    (3) Indirect evidence of the price of a comparable uncontrolled 
financial transaction.
    (i) In general.
    (ii) Public exchanges or quotation media.
    (iii) Limitation on use of public exchanges or quotation media.
    (4) Arm's length range.
    (5) Examples.
(c) Gross margin method.
    (1) General rule.
    (2) Determination of an arm's length price.
    (i) In general.
    (ii) Applicable resale price.
    (iii) Appropriate gross profit.
    (3) Comparability.
    (i) In general.
    (ii) Adjustments for differences between controlled and 
uncontrolled transactions.
    (iii) Reliability.
    (iv) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Arm's length range.
    (5) Example.
(d) Gross markup method.
    (1) General rule.
    (2) Determination of an arm's length price.
    (i) In general.
    (ii) Appropriate gross profit.
    (3) Comparability and reliability.
    (i) In general.
    (ii) Adjustments for differences between controlled and 
uncontrolled transactions.
    (iii) Reliability.
    (iv) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Arm's length range.
(e) Profit split method.
    (1) General rule.
    (2) Appropriate share of profit and loss.
    (i) In general.
    (ii) Adjustment of factors to measure contribution clearly.
    (3) Definitions.
    (4) Application.
    (5) Total profit split.
    (i) In general.
    (ii) Comparability.
    (iii) Reliability.
    (iv) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (6) Residual profit split.
    (i) In general.
    (ii) Allocate income to routine contributions.
    (iii) Allocate residual profit.
    (iv) Comparability.
    (v) Reliability.
    (vi) Data and assumptions.
    (A) General rule.
    (B) Consistency in accounting.
    (7) Arm's length range.
    (8) Examples.
    (f) Unspecified methods.
    (g) Source rule for qualified business units.

    Par. 4. Section 1.482-1 is amended as follows:
    1. In paragraph (a)(1), remove the last sentence and add two new 
sentences in its place.
    2. Revise paragraph (b)(2)(i).
    3. In paragraph (c)(1), revise the last sentence.
    4. In paragraph (d)(3)(v), revise the last sentence.
    5. In paragraph (i), revise the introductory text.
    The additions and revisions read as follows:


Sec. 1.482-1  Allocation of income and deductions among taxpayers.

    (a) In general--(1) Purpose and scope. * * * Section 1.482-8 
elaborates on the rules that apply to controlled entities engaged in a 
global securities dealing operation. Finally, Sec. 1.482-9 provides 
examples illustrating the application of the best method rule.
* * * * *
    (b) * * *
    (2) * * *
    (i) Methods. Sections 1.482-2 through 1.482-6 and Sec. 1.482-8 
provide specific methods to be used to evaluate whether transactions 
between or among members of the controlled group satisfy the arm's 
length standard, and if they do not, to determine the arm's length 
result.
    (c) Best method rule--(1) In general. * * * See Sec. 1.482-9 for 
examples of the application of the best method rule.
* * * * *
    (d) * * *
    (3) * * *
    (v) Property or services. * * * For guidance concerning the 
specific comparability considerations applicable to transfers of 
tangible and intangible property, see Secs. 1.482-3 through 1.482-6 and 
Sec. 1.482-8; see also Sec. 1.482-3(f), dealing with the coordination 
of the intangible and tangible property rules.
* * * * *
    (i) Definitions. The definitions set forth in paragraphs (i)(1) 
through (10) of this section apply to Secs. 1.482-1 through 1.482-9.
* * * * *
    Par. 5. Section 1.482-2 is amended as follows:
    1. In paragraph (a)(3)(iv), revise the first sentence.
    2. Revise paragraph (d).

[[Page 11187]]

    The revisions read as follows:


Sec. 1.482-2  Determination of taxable income in specific situations.

    (a) * * *
    (3) * * *
    (iv) Fourth, section 482 and paragraphs (b) through (d) of this 
section and Secs. 1.482-3 through 1.482-8, if applicable, may be 
applied by the district director to make any appropriate allocations, 
other than an interest rate adjustment, to reflect an arm's length 
transaction based upon the principal amount of the loan or advance and 
the interest rate as adjusted under paragraph (a)(3)(i), (ii), or (iii) 
of this section. * * *
* * * * *
    (d) Transfer of property. For rules governing allocations under 
section 482 to reflect an arm's length consideration for controlled 
transactions involving the transfer of property, see Secs. 1.482-3 
through 1.482-6 and Sec. 1.482-8.


Sec. 1.482-8  [Redesignated as 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:


Sec. 1.482-8  Allocation of income earned in a global securities 
dealing operation.

    (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

[[Page 11188]]

    (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.                     

[[Page 11189]]

                                                                                                                
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

[[Page 11190]]

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

[[Page 11191]]

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

[[Page 11192]]

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

[[Page 11193]]

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

[[Page 11194]]

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-

[[Page 11195]]

 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).
    Par. 7. Section 1.863-3 is amended as follows:
    1. Paragraph (h) is redesignated as paragraph (i).
    2. A new paragraph (h) is added.
    The addition reads as follows:


Sec. 1.863-3  Allocation and apportionment of income from certain sales 
of inventory.

* * * * *
    (h) Income from a global dealing operation--(1) Purpose and scope. 
This paragraph (h) provides rules for sourcing income, gain and loss 
from a global dealing operation that, under the rules of Sec. 1.482-8, 
is earned by or allocated to a controlled taxpayer qualifying as a 
participant in a global dealing operation under Sec. 1.482-8(a)(2)(ii). 
This paragraph (h) does not apply to income earned by or allocated to a 
controlled taxpayer qualifying as a participant in a global dealing 
operation that is specifically sourced under sections 861, 862 or 865, 
or to substitute payments earned by a participant in a global dealing 
operation that are sourced under Sec. 1.861-2(a)(7) or Sec. 1.861-
3(a)(6).
    (2) In general. The source of any income, gain or loss to which 
this section applies shall be determined by reference to the residence 
of the participant. For purposes of this paragraph (h), the residence 
of a participant shall be determined under section 988(a)(3)(B).
    (3) Qualified business units as participants in global dealing 
operations--(i) In general. Except as otherwise provided in this 
paragraph (h), where a single controlled taxpayer conducts a global 
dealing operation through one or more qualified business units (QBUs), 
as defined in section 989(a) and Sec. 1.989(a)-1, the source of income, 
gain or loss generated by the global dealing operation and earned by or 
allocated to the controlled taxpayer shall be determined by applying 
the rules of Sec. 1.482-8 as if each QBU that performs activities of a 
regular dealer in securities as defined in Sec. 1.482-8(a)(2)(ii)(A) or 
the related activities described in Sec. 1.482-8(a)(2)(ii)(B) were a 
separate controlled taxpayer qualifying as a participant in the global 
dealing operation within the meaning of Sec. 1.482-8(a)(2)(ii). 
Accordingly, the amount of income sourced in the United States and 
outside of the United States shall be determined by treating the QBU as 
a participant in the global dealing operation, allocating income to 
each participant under Sec. 1.482-8, as modified by paragraph 
(h)(3)(ii) of this section, and sourcing the income to the United 
States or outside of the United States under Sec. 1.863-3(h)(2).
    (ii) Economic effects of a single legal entity. In applying the 
principles of Sec. 1.482-8, the taxpayer shall take into account the 
economic effects of conducting a global dealing operation through a 
single entity instead of multiple legal entities. For example,

[[Page 11196]]

since the entire capital of a corporation supports all of the entity's 
transactions, regardless of where those transactions may be booked, the 
payment of a guarantee fee within the entity is inappropriate and will 
be disregarded.
    (iii) Treatment of interbranch and interdesk amounts. An agreement 
among QBUs of the same taxpayer to allocate income, gain or loss from 
transactions with third parties is not a transaction because a taxpayer 
cannot enter into a contract with itself. For purposes of this 
paragraph (h)(3), however, such an agreement, including a risk transfer 
agreement (as defined in Sec. 1.475(g)-2(b)) may be used to determine 
the source of global dealing income from transactions with third 
parties in the same manner and to the same extent that transactions 
between controlled taxpayers in a global dealing operation may be used 
to allocate income, gain or loss from the global dealing operation 
under the rules of Sec. 1.482-8.
    (iv) Deemed QBU. For purposes of this paragraph (h)(3), a QBU shall 
include a U.S. trade or business that is deemed to exist because of the 
activities of a dependent agent in the United States, without regard to 
the books and records requirement of Sec. 1.989(a)-1(b).
    (v) Examples. The following examples illustrate this paragraph 
(h)(3).

    Example 1. Use of comparable uncontrolled financial transactions 
method to source global dealing income between branches. (i) F is a 
foreign bank that acts as a market maker in foreign currency through 
branch offices in London, New York, and Tokyo. In a typical business 
day, the foreign exchange desk in F's U.S. branch (USFX) enters into 
several hundred spot and forward contracts on the interbank market 
to purchase and sell Deutsche marks (DM) with unrelated third 
parties. Each of F's branches, including USFX, employs both 
marketers and traders for their foreign currency dealing. In 
addition, USFX occasionally transfers risk with respect to its third 
party DM contracts to F's London and Tokyo branches.
    These interbranch transfers are entered into in the same manner 
as trades with unrelated third parties. On a typical day, risk 
management responsibility for no more than 10% of USFX's DM trades 
are transferred interbranch. F records these transfers by making 
notations on the books of each branch that is a party to the 
transfers. The accounting procedures are nearly identical to those 
followed when a branch enters into an offsetting hedge with a third 
party. USFX maintains contemporaneous records of its interbranch 
transfers and third party transactions, separated according to type 
of trade and counterparty. Moreover, the volume of USFX's DM spot 
purchases and sales each day consistently provides USFX with third 
party transactions that are contemporaneous with the transfers 
between the branches.
    (ii) As provided in paragraph (h)(3)(i) of this section, USFX 
and F's other branches that trade DM are participants in a global 
dealing operation. Accordingly, the principles of Sec. 1.482-8 apply 
in determining the source of income earned by F's qualified business 
units that are participants in a global dealing operation. Applying 
the comparability factors in Sec. 1.482-8(a)(3) shows that USFX's 
interbranch transfers and uncontrolled DM-denominated spot and 
forward contracts have no material differences. Because USFX sells 
DM in uncontrolled transactions and transfers risk management 
responsibility for DM-denominated contracts, and the uncontrolled 
transactions and interbranch transfers are consistently entered into 
contemporaneously, the interbranch transfers provide a reliable 
measure of an arm's length allocation of third party income from F's 
global dealing operation in DM-denominated contracts. This 
allocation of third party income is treated as U.S. source in 
accordance with Secs. 1.863-3(h) and 1.988-4(h) and accordingly will 
be treated as income effectively connected with F's U.S. trade or 
business under Sec. 1.864-4.
    Example 2. Residual profit split between branches. (i) F is a 
bank organized in country X that has a AAA credit rating and engages 
in a global dealing operation in foreign currency options through 
branch offices in London, New York, and Tokyo. F has dedicated 
marketers and traders in each branch who work closely together to 
design and sell foreign currency options that meet the particular 
needs of customers. Each branch also employs general salespeople who 
sell standardized foreign currency options, as well as other 
financial products and foreign currency offered by F. F's traders 
work from a common book of transactions that is risk managed at each 
branch during local business hours. Accordingly, all three branches 
share the responsibility for risk managing the book of products. 
Personnel in the home office of F process and confirm trades, 
reconcile trade tickets, and provide ongoing administrative support 
(back office services) for the other branches. The global dealing 
operation has generated $223 of operating profit for the period.
    (ii) Under Sec. 1.863-3(h), F applies Sec. 1.482-8 to allocate 
global dealing income among its branches, because F's London, New 
York, and Tokyo branches are treated as participants in a global 
dealing operation that deals in foreign currency options under 
Sec. 1.482-8(a)(2). After analyzing the foreign currency options 
business, F has determined that the residual profit split method is 
the best method to determine an arm's length amount of compensation 
allocable to each participant in the global dealing operation.
    (iii) Under the first step of the residual profit split method 
(Sec. 1.482-8(e)(6)(ii)), F identifies and compensates the routine 
contributions performed by each participant. F determines that an 
arm's length compensation for general salespeople is $3, $4, and $5 
in New York, London, and Tokyo, respectively, and that the home 
office incurred $11 of expenses in providing the back office 
services. Since F's capital legally supports all of the obligations 
of the branches, no amount is allocated to the home office of F for 
the provision of capital.
    (iv) 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 their nonroutine 
contributions. F determines that a multi-factor formula best 
reflects these contributions. After a detailed functional analysis, 
and applying the comparability factors in Sec. 1.482-8(a)(3), 40% of 
the residual profit is allocated to the London branch, 35% to the 
New York branch, and the remaining 25% to the Tokyo branch. Thus, 
the residual profit of $200 ($223 operating profit minus $12 general 
salesperson commissions minus $11 back office allocation) is 
allocated $80 to London (40% allocation x $200), $70 to New York 
(35% x $200) and $50 to Tokyo (25% x $200).
    Example 3. Residual profit split--deemed branches. (i) P, a U.K. 
corporation, conducts a global dealing operation in notional 
principal contracts, directly and through a U.S. subsidiary (USsub) 
and a Japanese subsidiary (Jsub). P is the counterparty to all 
transactions entered into with third parties. P, USsub, and Jsub 
each employ marketers and traders who work closely together to 
design and sell derivative products to meet the particular needs of 
customers. USsub 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. However, P, Ussub, and Jsub have 
authorized a trader located in each of the other affiliates to risk 
manage its books during periods when the primary trading 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. The global dealing operation has 
generated $180 of operating profit for the period.
    (ii) Because employees of USsub have authority to enter into 
contracts in the name of P, P is treated as being engaged in a trade 
or business in the United States through a deemed QBU. Sec. 1.863-
3(h)(3)(iv). Similarly, under U.S. principles, P would be treated as 
being engaged in business in Japan through a QBU. Under Sec. 1.482-
8(a)(2), P, USsub, and Jsub are participants in the global dealing 
operation relating to notional principal contracts. Additionally, 
under Sec. 1.863-3(h)(3), the U.S. and Japanese QBUs are treated as 
participants in a global dealing operation for purposes of sourcing 
the income from that operation. Under Sec. 1.863-3(h), P applies the 
methods in Sec. 1.482-8 to determine the source of income allocated 
to the U.S. and non-U.S. QBUs of P.
    (iii) After analyzing the notional principal contract business, 
P has concluded that the residual profit split method is the best 
method to allocate income under Sec. 1.482-8 and to source income 
under Sec. 1.863-3(h).
    (iv) Under the first step of the residual profit split method 
(Sec. 1.482-8(e)(6)(ii)), P identifies and compensates the routine 
contributions performed by each participant.

[[Page 11197]]

Although the back office function does 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 a routine contribution 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 a 
routine contribution, $20 of income is allocated to USsub under step 
1 of the residual profit split method. Similarly, as the arm's 
length compensation for the risk to which P is subject as 
counterparty is $40, $40 is allocated to P as compensation for 
acting as counterparty.
    (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 ($180 gross income minus $20 
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 P, 35% of the residual 
profit to USsub, and the remaining 25% of residual profit to Jsub. 
Accordingly, under step 2, $48 is allocated to P, $42 is allocated 
to USsub, and $30 is allocated to Jsub. Under Sec. 1.863-3(h), the 
amounts allocated under the residual profit split is sourced 
according to the residence of each participant to which it is 
allocated.
    (vi) Because the $40 allocated to P consists of compensation for 
the use of capital, the allocation is sourced according to where the 
capital is employed. Accordingly, the $40 is sourced 35% to P's 
deemed QBU in the United States under Sec. 1.863-3(h)(3)(iv) and 65% 
to non-U.S. sources.
* * * * *
    Par. 8. Section 1.863-7(a)(1) is amended by revising the second 
sentence to read as follows:


Sec. 1.863-7  Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope--(1) Introduction. * * * This section does not apply to 
income from a section 988 transaction (as defined in section 988(c) and 
Sec. 1.988-1(a)), or to income from a global dealing operation (as 
defined in Sec. 1.482-8(a)(2)(i)) that is sourced under the rules of 
Sec. 1.863-3(h). * * *
* * * * *
    Par. 9. Section 1.864-4 is amended as follows:
    1. Paragraphs (c)(2)(iv), (c)(2)(v), (c)(3)(ii), and (c)(5)(vi)(a) 
and (b) are redesignated as (c)(2)(v), (c)(2)(vi), (c)(3)(iii), and 
(c)(5)(vi) (b) and (c), respectively.
    2. New paragraphs (c)(2)(iv), (c)(3)(ii), and (c)(5)(vi)(a) are 
added.
    The additions read as follows:


Sec. 1.864-4  U.S. source income effectively connected with U.S. 
business.

* * * * *
    (c) * * *
    (2) * * *
    (iv) Special rule relating to a global dealing operation. An asset 
used in a global dealing operation, as defined in Sec. 1.482-
8(a)(2)(i), will be treated as an asset used in a U.S. trade or 
business only if and to the extent that the U.S. trade or business is a 
participant in the global dealing operation under Sec. 1.863-3(h)(3), 
and income, gain or loss produced by the asset is U.S. source under 
Sec. 1.863-3(h) or would be treated as U.S. source if Sec. 1.863-3(h) 
were to apply to such amounts.
* * * * *
    (3) * * *
    (ii) Special rule relating to a global dealing operation. A U.S. 
trade or business shall be treated as a material factor in the 
realization of income, gain or loss derived in a global dealing 
operation, as defined in Sec. 1.482-8(a)(2)(i), only if and to the 
extent that the U.S. trade or business is a participant in the global 
dealing operation under Sec. 1.863-3(h)(3), and income, gain or loss 
realized by the U.S. trade or business is U.S. source under Sec. 1.863-
3(h) or would be treated as U.S. source if Sec. 1.863-3(h) were to 
apply to such amounts.
* * * * *
    (5) * * *
    (vi) * * *
    (a) Certain income earned by a global dealing operation. 
Notwithstanding paragraph (c)(5)(ii) of this section, U.S. source 
interest, including substitute interest as defined in Sec. 1.861-
2(a)(7), and dividend income, including substitute dividends as defined 
in Sec. 1.861-3(a)(6), derived by a participant in a global dealing 
operation, as defined in Sec. 1.482-8(a)(2)(i), shall be treated as 
attributable to the foreign corporation's U.S. trade or business, only 
if and to the extent that the income would be treated as U.S. source if 
Sec. 1.863-3(h) were to apply to such amounts.
    Par. 10. Section 1.864-6 is amended as follows:
    1. Paragraph (b)(2)(ii)(d)(3) and (b)(3)(ii)(c) are added.
    2. Paragraph (b)(3)(i) is revised by adding a new sentence after 
the last sentence.
    The additions and revision read as follows:


Sec. 1.864-6  Income, gain or loss attributable to an office or other 
fixed place of business in the United States.

* * * * *
    (b) * * *
    (2) * * *
    (ii) * * *
    (d) * * *
    (3) Certain income earned by a global dealing operation. 
Notwithstanding paragraphs (b)(2)(ii) (a) or (b) of this section, 
foreign source interest, including substitute interest as defined in 
Sec. 1.861-2(a)(7), or dividend income, including substitute dividends 
as defined in Sec. 1.861-3(a)(6), derived by a participant in a global 
dealing operation, as defined in Sec. 1.482-8(a)(2)(i) shall be treated 
as attributable to the foreign corporation's U.S. trade or business 
only if and to the extent that the income would be treated as U.S. 
source if Sec. 1.863-3(h) were to apply to such amounts. * * *
    (3) * * *
    (i) * * * Notwithstanding paragraphs (b)(3)(i) (1) and (2) of this 
section, an office or other fixed place of business of a nonresident 
alien individual or a foreign corporation which is located in the 
United States and which is a participant in a global dealing operation, 
as defined in Sec. 1.482-8(a)(2)(i), shall be considered to be a 
material factor in the realization of foreign source income, gain or 
loss, only if and to the extent that such income, gain or loss would be 
treated as U.S. source if Sec. 1.863-3(h) were to apply to such 
amounts.
    (ii) * * *
    (c) Property sales in a global dealing operation. Notwithstanding 
paragraphs (b)(3)(ii)(a) or (b) of this section, personal property 
described in section 1221(1) and sold in the active conduct of a 
taxpayer's global dealing operation, as defined in Sec. 1.482-
8(a)(2)(i), shall be presumed to have been sold for use, consumption, 
or disposition outside of the United States only if and to the extent 
that the income, gain or loss to which the sale gives rise would be 
sourced outside of the United States if Sec. 1.863-3(h) were to apply 
to such amounts.
    Par. 11. Section 1.894-1 is amended as follows:
    1. Paragraph (d) is redesignated as paragraph (e).
    2. New paragraph (d) is added.
    The addition reads as follows:


Sec. 1.894-1  Income affected by treaty.

* * * * *
    (d) Income from a global dealing operation. If a taxpayer that is 
engaged in a global dealing operation, as defined in Sec. 1.482-
8(a)(2)(i), has a permanent establishment in the United States under 
the principles of an applicable U.S. income tax treaty, the principles 
of Sec. 1.863-3(h), Sec. 1.864-4(c)(2)(iv), Sec. 1.864-4(c)(3)(ii), 
Sec. 1.864-4(c)(5)(vi)(a) or Sec. 1.864-6(b)(2)(ii)(d)(3) shall apply

[[Page 11198]]

for purposes of determining the income attributable to that U.S. 
permanent establishment.
* * * * *
    Par. 12. Section 1.988-4 is amended as follows:
    1. Paragraph (h) is redesignated as paragraph (i).
    2. A new paragraph (h) is added.
    The addition and revision read as follows:


Sec. 1.988-4  Source of gain or loss realized on a section 988 
transfer.

* * * * *
    (h) Exchange gain or loss from a global dealing operation. 
Notwithstanding the provisions of this section, exchange gain or loss 
derived by a participant in a global dealing operation, as defined in 
Sec. 1.482-8(a)(2)(i), shall be sourced under the rules set forth in 
Sec. 1.863-3(h).
* * * * *
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 98-5674 Filed 3-2-98; 1:50 pm]
BILLING CODE 4830-01-P