International Finance and Accounting Handbook

The formula would be reflected as follows:

Worldwide Location A Location B Return on Investment

(b) Severing Transfer Pricing Transactions from Non-Transfer Transactions. The first
step in the functions employed method implicitly treats transfer pricing transactions
in the same manner as transactions that are not subject to the transfer pricing provi-
sions. The second step in the functions employed method would be to sever the trans-
fer pricing transactions from transactions that are independent from the scope of the
transfer pricing regulations. Economic adjustments would then provide the third step.
The concept underlying the severing process is that a business has limited flexi-
bility to arrange nontransfer transactions. In contrast, the business has extensive ver-
satility in adjusting, or attempting to adjust transactions that are subject to the trans-
fer pricing regulations.
This second step in the functions employed method has three substeps:

1.The IRS (or the taxpayer) would sever for tax accounting purposes the assets

used for transfer pricing purposes from assets that are used for other than trans-

fer pricing purposes.

2.The IRS (or the taxpayer) would then divide dual use assets on a pro rata basis.

3.The IRS (or the taxpayer) would then sever for tax accounting purposes the in-

come for transfer pricing purposes from the income for other than transfer pric-

ing purposes. Total income or profits is determined on a deemed basis, based on

the first step of the analysis; income not subject to transfer pricing is the actual

amount; income subject to transfer pricing is the residual amount.

Return to our example in which Location A has assets of $2 billion and is deemed
to have income of $300 million. In this scenario, assets subject to transfer pricing are
$1 billion and assets not subject to transfer pricing are $1 billion, taking dual-use as-
sets into account. Now let us assume that income not subject to transfer pricing is
$200 million. This amount would be determined on the actual records of the business.
The income subject to transfer pricing analysis is the deemed total income of $300
million, less the income of transactions not subject to transfer pricing of $200 mil-
lion, or $100 million in total.
The return on investment data for Location A would appear as follows:

Transactions Not Subject Transactions Subject

to Transfer Pricing to Transfer Pricing Total

Income $200 million $100 million $300 million

Assets $1 billion $1 billion $2 billion

Return 20% 10% 15%

Now we turn to our example in which Location B has assets of $4 billion and is
deemed to have income of $600 million. In this scenario, assets subject to transfer
pricing are $1 billion and assets not subject to transfer pricing are $3 billion, taking
dual-use assets into account. Now let us assume that income not subject to transfer

900 million

6 billion

300 million

2 billion

600 million

4 million

15%

29 • 24 TRANSFER PRICING FOR INTERCOMPANY TRANSACTIONS