Changes to bonus calculations after the fiscal year-end result previously reported to regulators, often leads to fines.
Summary: Post year-end bonus changes prove problematic for US-regulated broker dealers whose transferring pricing competitions differ from those previously report to the regulators at year-end.
Are your year-end bonuses transfer pricing methods compliant?
Inherent conflicts between regulatory restrictions on financial services companies and certain transfer pricing methods become more apparent during times of increased market volatility and can lead to regulatory problems for taxpayers.
One of these problems revolves around timing differences and transfer pricing computations that depend on year-end bonuses. Changes to bonus calculations after the fiscal year-end result in modifications to the profit or loss previously reported to regulators, often leading to fines or other negative consequences for the US taxpayer.
The IRS released proposed regulations that contained new specified methods for global dealing operations in March 1998.1 Those regulations have not yet been finalized and thus remain in their proposed form.2
In the ensuing years, many taxpayers have adopted a transfer pricing method that reflects the method described in Example 5 of the proposed regulations. This transfer pricing method is a residual profit split in which the provision of capital is treated as a routine function and receives remuneration before the trading locations are remunerated.
Although transactions are often centrally booked, under this method, the profits and losses are split across the various trading sites based on an allocation key that reflects the contribution of each participating location. The allocation key tends to be based on compensation including bonuses because compensation is considered to be an indicator of the value contributed by each location in a trading business.3
Registered US broker-dealers must comply with various SEC requirements, including net capital rules and maintaining accurate books and records. One of these requires filing periodic FOCUS reports, which provide information on the operating status of the broker-dealer.4
To comply with this requirement, trading operations report their year-end results, calculating their profit and loss including estimated employee bonuses.
Final transfer pricing calculations rely on actual bonus amounts, which are not typically finalized until after year-end results have been reported to the SEC. The actual bonus amounts can vary substantially from projections, especially if market conditions are volatile.
Any change in the bonus calculations after the fiscal year-end results in changes to the total profit and loss allocated to that location.
As a result, timing differences have proven to be problematic for US-regulated broker-dealers whose transfer pricing computations differ from those previously reported to the regulators. This may result in fines from the regulators and other ramifications.5
The most obvious solution to this problem is to allocate residual income to the booking location or capital provider, rather than to the trading locations. This approach is in line with the economics of the transaction and is consistent with the regulatory position: the capital provider bears the risk of loss.
Methods for consistent taxpayer action
To enable taxpayers to act consistently with the proposed regulations and allocate profits and losses to the trading locations, other approaches must be added to the currently proposed specified methods to keep the taxpayer from facing regulatory violations.
One approach would involve booking profits in the broker-dealer with current losses temporarily retained by the capital provider until the losses can be offset against future profits. Under this arrangement, the risk of material fluctuations in the profit and loss as a result of transfer pricing would not be borne by the regulated broker-dealer.
If taxpayers apply transfer pricing methods that are in line with the economics of their transactions (i.e., risk is borne by the capital provider), then they are in compliance with the regulators but run the tax audit risk of not being consistent with the proposed global dealing regulations.
In contrast, applying the transfer pricing methods proposed under the global dealing regulations will likely result in regulatory violations, especially during times of market volatility.
1 Allocation and Sourcing of Income and Deductions Among Taxpayers Engaged in a Global Dealing Operation, Internal Revenue Service, p. 7.
2 These proposed rules define a global dealing operation as “an operation consisting of the execution of customer transactions including marketing, sales, pricing, and risk management in a particular financial product or line of financial products, in multiple tax jurisdictions and/or through multiple participants” (Ibid, p. 57). The operation does not need to be conducted around the world on a twenty-four hour basis; the operation need only perform one of the enumerated functions described above in more than one tax jurisdiction (Ibid, p. 13).
3 The proposed global dealing regulations provide that “...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.” (Ibid, p. 23).
4 A FOCUS report is a periodic regulatory report filed by broker-dealers with the SEC that contains detailed information about a firm’s financial and operating status, including credit and debit balances and computation of net capital. Filing accurate FOCUS reports is critical to remain in good standing with the SEC. Financial Industry Regulatory Authority (FINRA) member firms are required to compile and submit FOCUS reports to FINRA pursuant to SEC Rule 17a-5. FINRA is the largest self-regulatory organization in the securities industry and is overseen by the SEC. The FINRA coordinator assigned to each broker-dealer analyzes the FOCUS reports for accuracy and financial stability, primarily comparing the firm’s net capital to the amount of net capital that is mandated by FINRA.
5 Material inadequacy violations in accounting systems, internal controls or practices and procedures are covered by SEC Rule 17a-11(e).
