Sei sulla pagina 1di 15

Volume 7 Issue 1 2008

Safe Harbor or No Safe Harbor:

A First Look at the Mark-to-Market
Safe Harbor Regulations
By Richard G. Larkins, Kyle H. Klein and Jasper J. Nzedu

Richard Larkins, Kyle Klein and Jasper Nzedu describe the

shortcomings of the final mark-to-market safe harbor regulations
under Code Sec. 475 and discuss the need for clearer guidance and
a broader application of the safe harbor.

nternal Revenue Code (the Code) Sec. 475 permits dealers in securities and dealers in commodi-
requires securities dealers, and electing com- ties to elect to use the values of positions reported
modities dealers and securities and commodities on certain financial statements as the fair market
traders, to recognize
g gain or loss as if all of their values of those positions for purposes of Code Sec.
securities (or ccommodities)
mmo oditti were sold for their fair 475. Coming after requests by taxpayers for guid-
market value last
e on thee laast business
siness day o off each tax ance on valuation methods, the IRS Announcement
year. Code Sec.
ec. 475,
4775, however,
75 ow r, contains
ho ta no o method-
meth 2003-35 (in which the IRS solicited comments and
ology for determining
ng faffair
ir market value, and until
arket value submissions on possible safe harbors for valuation
recently, the Treasury and the IRS did not provide p methods under Code Sec. 475), and the proposed
guidance to taxpayers on the m matter.
ter.1 As
A a result,
esult, regulations
regu a ioons released
eas d on
rrele on May 20,
20, 2005, the safe har-
taxpayers could rely only on the historic
h i defi
d finition
ti of bor
b is i intended
i t d d to reduced the
th compliance
li burden
fair market value for federal income tax purposes2 on taxpayers and to improve the administrability of
in developing valuation methodologies, and on the the valuation requirement of Code Sec. 475 for the
Conference Agreement on Code Sec. 475 that antici- IRS. For many taxpayers, however, the safe harbor
pated that any valuation method will clearly reflect does not substantially, if at all, address the need for
income for federal income tax purposes.3 Inevitably, clarity of valuation methods under Code Sec. 475.
the absence of clarity on valuation methods has fos- Specifically, the final regulations unduly limit the
tered a contentious environment resulting in many type of taxpayer for whom the safe harbor would be
disputes between taxpayers and the IRS regarding available and the kinds of valuation methods and
the appropriate valuation methodology and, hence, securities for which a taxpayer can apply the safe
a wasting of administrative resources for both taxpay- harbor. These taxpayers will find no haven in the
ers and the government.4 safe harbor, and because the final regulations fail to
On June 11, 2007, the Treasury released final Reg. provide clear guidance on valuation methods outside
1.475(a)-4, providing an elective safe harbor that of the safe harbor, disputes on valuation methods
between taxpayers and the IRS will likely continue.
Therefore, it is improbable that the intended goals of
Richard G. Larkins is a Partner, Kyle H. Klein is an
the safe harbor will be achieved.
Executive Director and Jasper J. Nzedu is a Manager in the
Banking and Capital Markets Tax Practice of the National Tax This article discusses the need for clear guidance
Department of Ernst & Young LLP in Washington, D.C. and for making the safe harbor as broad as possible

2008 R.G. Larkins, K.H. Klein and J.J. Nzedu
Mark-to-Market Safe Harbor Regulations

if the Treasury is to achieve the stated goals of the taxpayers on valuation methods for more than 10
safe harborreducing the compliance burdens on years. In the absence of any guidance, taxpayers and
taxpayers and improving the administrability of the IRS frequently disagreed on the appropriate valu-
the valuation requirement of Code Sec. 475 for the ation methodology for marking securities to market at
IRSand reduce unnecessary controversy and dis- the end of the year for federal income tax purposes.6
putes between taxpayers and the IRS. The first part The disagreements culminated in litigation in 2001
of the article discusses the events leading up to the in the Bank One case.7
regulations. Specifically, it addresses the issues and After the Bank One litigation commenced, the
concerns faced by taxpayers and the IRS in comply- Securities Industry Association (SIA) petitioned the
ing with and administering Code Sec. 475 and the Treasury for regulations that would grant dealers a
policy goals underlying conclusive presumption
the regulations. The sec- The proposed regulations safe that the values they as-
ond part discusses the sign to their derivatives
scope and limitations of harbor was to be available only constitute fair market
the final regulations and if (and to the extent that) an value for Code Sec. 475
argues that (i) the final eligible taxpayer uses an eligible purposes so long as: (i)
regulations fail to provide the values are the same as
a substantial safe harbor method for the valuation of an those used in their appli-
to taxpayers given that eligible position on its applicable cable financial statement
dealers of securities and financial statement and elects to and (ii) the dealer makes
commodities may not use significant use of these
valuations that are near
apply the safe harbor. values in the management
bid or ask prices for secu- of its dealer business.8
rities that are not exchange traded; (ii) the safe harbor The SIA submitted a draft regulation to the Trea-
is not available for valuations that do not flow through sury and contended that there can be only one
the income statement; (iii) the safe harbor only ap- applicable financial statement for a dealer so that
plies to financial statements
ciaal sstate
eme e prepared in accordance both the taxpayer and the IRS need look to only one
with U.S. Generally
ne Accepted
erally Acc
A cep d AccoAccounting Principles
unting Princi statement, and that there is no potential for select-
(GAAP); and (iv)(iv) the
t safe
saffe harbor
rb is notn available
vailab to ing among financial statements to achieve a desired
securities and commodities
c mmo
commmo oditties traders,
t aders, even if
i their valu-
v result.9 In determining what should constitute an
ation methodologies i are consistent with Code Sec. applicable financial statement, the draft regulation
475. Finally, the article discusses es tthe Bank
e Ban
nk OOne
ne case gavee the
gav t e highest
highest priority
iori y to a statement
statemment that must be
and argues that the failure of the finall regulationsl ti to
t filed
fil dbby th
the d
dealer iin securities
i i withith a government
provide substantial guidance to taxpayers makes the regulatory authority (e.g., the Securities and Ex-
case more important than practitioners and the courts change Commission or a State or foreign regulatory
originally assumed. agency maintaining comparable standards) that has
primary responsibility for supervision of the dealer,
Background or with an examining authority designated by that
government regulatory agency (e.g., the National
Code Sec. 475 was added to the Code by Section Association of Securities Dealers, which is now the
13223(a) of the Omnibus Budget Reconciliation Act Financial Industry Regulatory Authority). The SIA
of 19935; Code Sec. 475(g) provides that the Secretary argued that such regulatory filings should be viewed
shall prescribe regulations as may be necessary or ap- as most reliable because significant consequences
propriate to carry out the purposes of Code Sec. 475. would arise if an inaccurate filing were made with
The legislative history of Code Sec. 475 indicates that, a securities regulatory agency.10
under this authority, the Secretary may issue regula- The SIA further contended that the commercial
tions to permit the use of valuation methodologies importance of an assigned valuation is established by
that reduce the administrative burden of compliance the requirement that the dealer make significant use of
on the taxpayer but clearly reflect income for federal the same values in the management of its dealer busi-
income tax purposes. Despite this authority, the IRS ness.11 The SIA asserted that to satisfy this requirement,
and the Treasury did not provide any guidance to the dealer must make significant use of those valua-

Volume 7 Issue 1 2008

tions in the financial or commercial oversight of its the IRS with the information and documents neces-
business. Thus, if a dealer uses those same valuations sary to verify the relationship between the values
as the basis of its hedging decisions, or alternatively as reported on the financial statement and the values
part of the process of determining the compensation used for purposes of Code Sec. 475.
for a group of its employees, the SIA draft regulation Under the first principle (the consistency prin-
would deem the valuations to be directly employed ciple), in order for a methodology reflected in the
in operating the dealers business.12 taxpayers financial statements to be sufficiently
Accordingly, the SIAs approach relied on nontax consistent with Code Sec. 475 principles, the
incentives to assure accuracy rather than mandating methodology must (i) value securities and com-
any particular method- modities as of the last
ology. Not surprisingly, business day of each tax
derivative dealers prefer However, the long-standing year, (ii) recognize into
this approach because it practice among securities dealers is income the gains and
does not require them to to mark long positions in physical losses arising from chang-
undertake one valuation es in value each year,
for financial accounting securities to the bid side of the and (iii) compute gain
purposes and another for market and short positions to the or loss on disposition by
tax purposes. 13 But the ask side of the market and this reference to the value at
Treasury and the IRS did
not immediately respond
practice complies with U.S. GAAP. the end of the prior year.
Announcement 2003-
to the SIAs petition for 35 also contemplated
guidance on valuation methodology and the SIA, that the valuation standard under the safe harbor
on March 28, 2002, again urged them to issue clear would be consistent with the valuation standard
regulations on Code Sec. 475.14 under Code Sec. 475, which is fair market value
In May 2003, the Tax Court filed its initial opinion the price at which property would change hands
in the Bank One case and adopted a legal standard between a willing buyer and willing seller, neither
mandating a specific
s eciffic methodology
spe m (mid-market being under any compulsion to buy or sell and both
valuation, subject
bjectt to certain
ert specified adjustments)
specified adjustme having reasonable knowledge of relevant facts.
to determine fair
air market
fa marrkett value
m v e under
er Codee Sec. 475.
4 However, the Announcement left open the question
The courts normative
orrma ativee approach
ative apppro ch contrasted
contrasted with the whether the fair value standard under U.S. GAAP
incentive-based approach recommended byy the SIA should be used as a proxy for the fair market value
two years earlier. standard
standard required
d req tax
quire for ta purposes.
xp urposes.
On the same day that the Bankk One courtt fi filled
d its
t Under
U d the
th second d principle
i (the
th incentive
i prin-
opinion, the IRS issued Announcement 2003-35 in ciple), the Announcement stated that two factors
response to the SIA and taxpayers requests.15 An- are relevant in establishing that the taxpayer has a
nouncement 2003-35 indicated that the IRS and the strong incentive to report values of the securities
Treasury were considering proposed regulations that and commodities fairly on the financial statement:
would permit taxpayers to use the valuations they (i) reporting of values on a financial statement; and
report on their financial statements for Code Sec. 475 (ii) significant use of those reported values in the
purposes upon satisfying certain conditions. The An- taxpayers business. Announcement 2003-35 con-
nouncement contemplated that eligibility for a safe templated three classes of financial statements that
harbor under the valuation requirement of Code Sec. might satisfy the financial statement requirement: (i)
475 would be guided by three broad principles. a financial statement required to be filed with the
First, any mark-to-market methodology used on a Securities and Exchange Commission (SEC) (e.g.,
financial statement submitted for financial reporting the 10-K or the Annual Statement to Shareholders);
purposes would have to be sufficiently consistent (ii) a financial statement required to be provided to
with the mark-to-market methodology used under the federal government or any of its agencies (other
Code Sec. 475. Second, the financial statement than the SEC or the IRS); and (iii) a certified audited
would have to be one for which the taxpayer has a financial statement not required to be filed with the
strong incentive to report values fairly. Third, if re- SEC or another federal agency.16 According to the
quested, the taxpayer would have to timely provide Announcement, significant uses of reported values


Mark-to-Market Safe Harbor Regulations

would include the use of valuations for purposes of (iii) certified by an independent certified public
making decisions regarding pricing, risk manage- accountant;
ment and employee compensation. (iv) given to creditors for purposes of making lend-
Under the third principle (the verification prin- ing decisions;
ciple), for purposes of the safe harbor, examinations (v) given to equity holders for purposes of evalu-
of returns would focus on how the values used in the ating their investments in the taxpayer; or
financial statements relate to gain and loss on the tax (vi) provided for other substantial non-tax purposes.
returns. Accordingly, taxpayers records would have The taxpayer must reasonably anticipate that it will
to clearly show that (i) the same value used on the be directly relied on for the purposes for which it
financial statement was used on the tax return; (ii) no se- was created.20
curity subject to Code Sec. 475 and reported under the In addition, in the case of a financial statement
required methodology on the financial statement was described in the second or third category, the val-
excluded in the application ues for eligible positions
of the safe harbor; and (iii) contained in the finan-
only securities or com- Conditioning the inclusion of cial statement must be
modities subject to Code a security in the safe harbor used by the taxpayer in
Sec. 475 had been carried most of the significant
over to the tax return under on whether or not the value is management functions
the safe harbor. reflected in the income statement of all or substantially all
Thus, Announcement abandons the underlying of its business. According
2003-35 adopted the incen- to the proposed regula-
tive based approach earlier
premise of the safe harbor might tions, [t]his use includes
recommended by the SIA. potentially make inclusion in the activities such as senior
However, the incentive safe harbor elective and can only management review of
principle was bounded by business-unit profitability,
the consistency and verifi-
lead to more controversy. market risk measurement
cation principles.
es or management, credit
After receiving
iv ing submissions
g suubm mi ons o on Advanced
n the Advan risk measurement or management, internal allocation
Notice of Proposed
oppose Rulemaking
ed Rul le ki (ANPRM),
lem AN M), the IRS of capital, and compensation of personnel, but does
and the Treasuryury released
eased proposed
rele p oposed regulations
regulation on not include either tax accounting or reporting of the
May 20, 2005, N Notice
tti of Proposed Rulemaking results of operations to other persons.21 However,
(NPRM), providing for an elective ctiv safe harbor for in
n determining
determining u use,, cconsideration
onsideration m must
us be given to
valuation under Code Sec. 475. 475 Th
The proposed d whether
h th theth taxpayers
t reliance
i on tthe
h values exposes
regulations safe harbor was to be available only if the taxpayer to material adverse consequences if the
(and to the extent that) an eligible taxpayer uses values are incorrect.22
an eligible method for the valuation of an eligible In order to qualify as an eligible method, the
position on its applicable financial statement and method was proposed to be a mark-to-market
elects to apply the safe harbor.18 Notably, an eligible method that is sufficiently consistent with the
taxpayer was proposed to be any taxpayer subject requirements of a mark-to-market method under
to the mark-to-market regime under Code Sec. 475, section 475, which requires that it satisfy certain
whether the taxpayer is a dealer in securities under requirements set forth in the proposed regulations.
Code Sec. 475(a), a dealer in commodities under First, it must mark eligible positions to market
Code Sec. 475(e), or a trader in either securities or through valuations made as of the last business day
commodities under Code Sec. 475(f).19 of each tax year. Second, it must recognize into
In order to constitute an applicable financial state- income on the income statement any gain or loss
ment, it was proposed that the financial statement from marking eligible positions to market. Third, it
must be prepared in accordance with U.S. GAAP must recognize into income on the income statement
and either be: any gain or loss on disposition of an eligible position
(i) required to be filed with the SEC; as if a year-end mark occurred immediately before
(ii) required to be provided to the federal govern- the disposition. Fourth, it must arrive at fair value in
ment or any of its agencies other than the IRS; accordance with U.S. GAAP.23

Volume 7 Issue 1 2008

The proposed regulations explain that [t]his safe keeping with the verification principle of Announce-
harbor is based on the principle that, if a mark- ment 2003-35. Under the proposed regulations,
to-market method used for financial reporting is electing taxpayers must clearly show that (i) the same
sufficiently consistent with the requirements of value used for financial reporting was used on the
section 475 and if the financial statement employ- federal income tax return; (ii) no eligible position
ing that method has certain indicia of reliability, subject to Code Sec. 475 is excluded from the appli-
then the values used on cation of the safe harbor;
that financial statement Given that many foreign financial and (iii) the fair values
should be appropriate of only eligible positions
values for purposes of institutions that are required to pay subject to Code Sec. 475
section 475.24 Thus, the taxes on U.S. dealer operations file are carried over to the
proposed regulations their primary financial statements federal income tax return
clarified that fair value under the safe harbor.27
under U.S. GAAP could under the GAAP of a non-U.S. Because they repre-
be used as a proxy for fair jurisdiction, the requirement sented efforts by the
market value for federal makes the safe harbor unavailable IRS and the Treasury to
income tax purposes. provide clarity on the
The proposed regula-
to these taxpayers. nettlesome problem of
tions, however, did place valuation under Code
certain limitations on the ability of taxpayers to Sec. 475, both Announcement 2003-35 and the
rely on their financial statement values. According proposed regulations were welcomed by taxpay-
to the preamble to the proposed regulations, these ers even though taxpayers were concerned with
limitations were to ensure minimal divergence from certain requirements in the proposed regulations
fair market value.25 Under the first limitation, which for eligibility under the safe harbor.28
applied only to securities and commodities dealers,
except for eligible positions
p that are traded on a Scope and Limitations
qualified boardrd exchange
d or exc chaan (as defined in Code Sec.
1256(g)(7)), the financial
he finnanc aaccounting
cial ac method
unting metho must not
d mus of the Final Regulations
result in values
es at or near
neaar the bid
b or ask a values,
lues, even
e On June 11, 2007, the IRS and the Treasury released fi-
if the use of bid
d or ask values
k vaalue iss perm
missib e in acaccor- nal Reg. 1.475(a)-4.29 To the dismay of many taxpayers,
dance with U.S. GAA GAAP.
G AP Under the second limitation, the final regulations adopted the proposed regulations
if the method of valuation consists sts off dete
rm ning ththe
he with
wit h some
m m modifi
ations that
that further
further limited
limi the utility
present value of projected cash flows from f an eligible
li ibl off tthe
h safe
f harbor.
b SSpecifi fically,
l ththe final regulations
position or positions, then the method must not take adopted the bid-ask limitations of the proposed regula-
into account any cash flows of income or expense tions (with the exception for valuations that are at or
that are attributable to a period or time before the near the bid-ask values for securities that are listed on
valuation date. This limitation was aimed at ensur- a qualified board or exchange), the requirement that
ing that items of income or expense would not be changes in the values of marked-to-market securities
accounted for twice, first through current realization be reflected on the income statement (which excludes
and then again in the mark. Under the third limitation, from the safe harbor the partial financial statements of
no cost or risk may be accounted for more than once, U.S.-based subsidiaries of foreign banks that are gener-
either directly or indirectly. For example, a financial ally filed with U.S. regulatory agencies, even though
accounting method that allows a special adjustment the financial statements generally are prepared in ac-
for credit risk would generally satisfy this limitation. cordance with U.S. GAAP and almost invariably use
But, it would not satisfy the limitation if it computed valuation methodologies that are consistent with valu-
the present value of projected cash flows using a ation standards under Code Sec. 475), the requirement
discount rate that takes into account any amount that financial statements be prepared in accordance
of credit risk that is also taken into account by the with U.S. GAAP and the verificationrecordkeeping
special adjustment. 26
and retentionrequirements of the proposed regula-
Finally, the proposed regulations imposed certain tions. Under the final regulations, the safe harbor is
verification and record retention requirements in available only to dealers in securities and dealers in


Mark-to-Market Safe Harbor Regulations

commodities, notwithstanding that Announcement U.S. GAAP. In fact, U.S. GAAPs definition of fair
2003-35 and the proposed regulations had contem- value appears to be closer to bid and ask prices32 and
plated the inclusion of traders in the safe harbor. permits using mid-market prices only as a practical
The preamble to the final regulations appropriately expedient.33 The safe harbor makes an exception for
recognizes that it is sometimes difficult to determine positions that are traded on a qualified board or ex-
the fair market value of certain securities and com- change. But many physical securities, such as regularly
modities, and that [t]his has impeded the efficient traded equity and debt securities, are not traded on a
administration of the mark-to-market system under qualified board or exchange and instead are traded on
section 475.30 The preamble, therefore, states that the over the counter (OTC) market.34 Therefore, taxpay-
the regulations are issued with a view to improving ers electing to use bid-ask prices permitted by U.S.
the administrability of the valuation requirements of GAAP for valuing positions, would not be in compli-
section 475.31 But the final regulations are unnec- ance with the safe harbor, at least with respect to their
essarily restrictive and appear to abandon the three positions in physical securities. The failure to include
broad guiding principles for a safe harbor under Code physical securities within the exception to the bid-ask
Sec. 475 set out in Announcement 2003-35. limitation will operate to increase, rather than reduce
Unless its application is broadened, it is doubtful controversy between taxpayers and the IRS.
that the safe harbor will operate to reduce the con- The safe harbor lumps together, and thus fails to
troversy and contentious environment between the distinguish between physical securities that are traded
IRS and taxpayers with regard to valuation issues in on the OTC market and OTC-traded derivatives. But
connection with Code Sec. 475. This section dis- the business model of OTC derivatives dealers that
cusses the reasons given by the IRS and the Treasury is described in the preamble to the final regulations
for limiting the availability of the safe harbor and indicates that for purposes of income recognition by
why certain of the restrictions may not serve the best dealers, the bid-ask spreads of OTC derivatives are
interests of taxpayers or the IRS. very different from the bid-ask spreads of physical se-
curities traded in the OTC market.35 As the preamble
Bid-Ask Limitation points out, dealers seek to capture and profit from
Reg. 1.475(a)-4(d)(3)
) 4(d)(3
3) rre
requires that in order to be bid-ask spreads in the marketplace by entering into
eligible for thee safe
s e harbor,
haarboor a dealers
or, dealer s valuation
valuation meth-
m balanced portfolios for their derivatives, i.e., positions
odology may not not permit
p mitt values
per v es for positions
po ns that
tha are that offset each other, either individually or in the
at or near thee bidd or askk prices
pric s of the
p the market.
market Specifi
Spe - aggregate. Although dealers may have some open
cally, Reg. 1.475(a)-4(d)(3)(i)
5( ) 4 provides as follows: positions, they seek to have balanced portfolios with a
A. General rule. Except for eligible ig le popositions
sitions that majority
ma orityy of positions
pos tions offsetting
offsett ng each
h other.
oth The offset-
are traded on a qualified b board d or exchange,
h ting
i positions
i generally
ll remain on ddealers
l books over
as defined in section 1256(g)(7), or eligible the terms of the positions. The spread between bid
positions that the Commissioner designates and ask values compensates the dealer for his risks
in a revenue procedure or other published and expenses and, therefore, contains the dealers
guidance, the valuation standard used must profit. Therefore, the creation of a balanced portfolio
not, other than on a de minimis portion of a gives rise to a synthetic annuity that has a value that
taxpayers positions, permit values at or near is largely immune from market-related changes in
the bid or ask value. Consequently, the valua- the values of the component positions.
tion method described in 1.471-4(a)(1) fails When a dealer enters into an offsetting position
to satisfy this paragraph (d)(3)(i)(A). and creates a synthetic annuity, all steps required to
B. Safe harbor. The restriction in paragraph (d)(3) earn the income from the synthetic annuity have been
(i)(A) of this section is satisfied if the method completed. Therefore, it is appropriate to recognize
consistently produces values that are closer to the present value of the income attributable to the
the mid-market values than they are to the bid bid-ask spread in the tax year the synthetic annu-
or ask values. ity is created. Nonetheless, using bid or ask values
However, the long-standing practice among securities only approximates (it does not accurately represent)
dealers is to mark long positions in physical securities realization accounting for a matched book of eligible
to the bid side of the market and short positions to the positions, such as a dealers portfolio of interest rate
ask side of the market and this practice complies with swap contracts. Therefore, the bid or ask values of

Volume 7 Issue 1 2008

derivatives would not recognize in income the pres- clear reflection of income, the limitation may have
ent value of a synthetic annuity in the tax year that unwittingly introduced a potential distortion into
the synthetic annuity is created. the marketplace. Because the limitation requires
By contrast, as one commentator has pointed out, a dealer to recognize in income on a current basis
for physical securities, dealers rapidly turn over the dealer spreads in connection with the purchase
securities that are traded on qualified boards or of a physical security into inventory, a dealer can
exchanges or on liquid over-the-counter markets. capture the credit from mark-to-market income
Therefore, except for those acquired at the end of the merely by bulking up a position in physical secu-
tax year, the acquisition and disposition of a physi- rities at year-end. By contrast, in those situations
cal security occurs within a single tax year, so that where a dealer in fact captures a spread in respect
the effect of capturing a bid-ask spread also occurs of a physical security without actually selling the
entirely within that year.36 security (for example, by using the security as a
Accordingly, a dealer enters into a derivative hedge of an offsetting derivatives position), the
position with a view to retaining that position on rule suggested above will require the dealer to
its books indefinitely, but buys physical securities recognize in income the net present value of that
into inventory for the purpose of near-term resale spread on a current basis.
to customers. In addition, the bid-ask limitation undermines the
The amount of income is easily determined regard- underlying premise of the safe harbor. The fundamen-
less of the valuation methodology if the turnover is tal premise underlying the safe harbor is that the IRS
rapid; therefore, the values of physical securities will accept taxpayer valuations, provided that the
can be easily determined, given that the spread taxpayer can demonstrate the trustworthiness of its
between the bid and ask values almost invariably valuations by showing that it uses the same values for
is captured in income in the same year that the tax purposes as it does for important nontax purposes.
dealer purchases the physical securities. Hence, it That is why Announcement 2003-35 articulated
would appear that requiring physical securities to three guiding principlesthe consistency, incentive
be marked closer to mid-market will not make their and verification principlesthat would provide a
values any moreore reliable.
r ablle
reli framework for the safe harbor. The final regulations
s ththe
he IRSS aand the Tr
Treasury assert the
easury asser presume that a positions actual value could not in
following: (i) they
hey do
th o not
ot possess
no p se suffi
ufficientt informa-
infor fact be closer to the bid or ask side of the market than
tion, based onn thee comments
coommmen received,
received, to conclude
conc to an unadjusted mid-market value. However, in the
that spreads in the h over-the-counter debt markets
th case of illiquid exotic derivatives, for example, it
are de minimis; (ii) debt instruments
um nts may be use used
ed iss entirely
en irely possible
oss b that a dealer
po dealer could
ould incur various
to lock in spreads with respectt to open positions iti risks
i k ini connection
t with
h an O
ith OTC
TC d derivatives
i posi-
in other instruments, such as derivatives; and (iii) tion that are either very difficult or very expensive to
excepting debt instruments from the bid-ask limita- hedge, so that the dealer quite appropriately could
tion might introduce a tax-motivated distortion into mark the unhedged position, for all relevant com-
the marketplace, as taxpayers may decide to lock mercial and financial accounting purposes, very near
in spreads with tax-advantaged instruments rather the bid or ask price.
than with instruments that are selected on the basis The limitation makes the safe harbor unavailable
of their non-tax economic attributes.37 Thus, the to a taxpayer having values that are at or near bid
IRS and the Treasury appear to be focused on not or ask values, even if the taxpayer can demonstrate
compromising the clear reflection of income. that the same values are used for both tax and
However, if the intention in fact is to allow financial statement purposes. Given the underly-
dealers to benefit from the safe harbor without ing principles of the safe harbor, the appropriate
compromising the clear reflection of income, the inquiry should be whether a taxpayer is employ-
concerns expressed by the IRS and the Treasury ing the values in question for financial accounting
could easily have been addressed by a rule that purposes (and, in appropriate cases, satisfying the
permits within the safe harbor all debt instru- significant business use standard of the regula-
ments except for debt instruments with embedded tions). The final regulations approach of regulating
derivatives and debt instruments that are part of adjustments to mid-market values at a substantive
a derivative position. Rather than enhancing the level abandons the underlying premise of the safe


Mark-to-Market Safe Harbor Regulations

harbor, and values removed from the safe harbor The balance sheet is used for very critical and
will potentially give rise to the same controversy significant nontax purposes. In the case of financial
and litigation that necessitated the safe harbor in institutions, for example, the systems under which the
the first place. financial statements are prepared as well as the items
reported on those financial statements are scrutinized
Recognition of Changes in Value by internal audit departments, independent outside
into the Income Statement accountants and bank and securities regulators. For
Reg. 1.475(a)-4(d)(2)(ii) requires that, in order example, banking and securities dealer regulatory
for a valuation method to be eligible for the ben- standards provide for minimum capital requirements
efits of the safe harbor, changes in the value of a that must be satisfied by banks and securities deal-
given position recorded under the method must ers and the balance sheets of these institutions are
be reflected specifically on the taxpayers income scrutinized to know whether the institutions satisfy
statement (as opposed to its audited balance sheet the minimum capital requirements.39 In addition,
or other reliable financial reports). This requirement regulators, creditors, shareholders and the capital
reflects the view that income statement values are markets rely on the accuracy of the balance sheets.
more reliable than balance sheet and other finan- Therefore, a financial institution having irregularities
cial statement values. Hence, the preamble to the in its financial statements would expect that there
final regulations contends as follows: would be very serious consequences.
The reliability of the balance sheet is further but-
When changes in value appear on the income tressed by the fact that the Federal Reserve, the Office
statement, they also appear in retained earn- of the Comptroller of the Currency and the Federal
ings and in earnings-per-share. This creates a Deposit Insurance Corporation require U.S. branches
tension between the benefits of higher earnings of foreign banks to file only a statement of their as-
for financial reporting and the benefit of lower sets and liabilities on their call reports. These banks
income for tax reporting. This tension helps to are not required to show their income statements on
ensure the reliabilityy of values for tax purposes, a the call reports, even though the purpose of the call
fundamental concept
al connceept uunderlying the safe harbor. reports is to enable the federal bank regulators to
Balance sheet
ee items,
et it
ms ssu
ms, such as oth
other comprehen-
er com prehe monitor the safety and soundness of U.S. branches
sive income,
ee, do not
o noot hhave the
hav h samem tension.
sion.38 of foreign banks.
The call reports only show the assets and liabilities
Undoubtedly, theth tension
t between maximizing of the banks in accordance with U.S. GAAP, and
income for financial reporting purposes
urp ses and
annd reducing
ng do not
no contain n income
m statements.
i come sta ements. In fact, a call
income for income tax purposes might ht encourage a reportt does
d nott even contain
t a complete balance
taxpayer to more accurately value its securities posi- sheet because it does not include an equity capital
tions. But this tension is not the only, or indeed the section (given that the U.S. branch of a foreign bank
most important, source of reliability for valuations. is not completely separate from its parent). Instead,
Depending on a particular taxpayers situation, the to equalize total assets and total liabilities, the call
two opposing interests may not always offset one reports rely on the net due to/due from head office
another, and a taxpayer, determined to achieve a par- and other related depository institutions entries.40
ticular result, may not be deterred by the tension. That the Federal Reserve and other government agen-
There is no reason to believe that the balance cies place confidence in the values that are reported
sheet is fundamentally less reliable than the income in the balance sheet indicates that the balance sheet
statement. The balance sheet statement is rigorously is a reliable financial statement.
reviewed by both internal and external stakeholders Additionally, it is not as though the income state-
so that taxpayers have no less need to demonstrate ment can stand independent of the balance sheet.
that they are using valuations in the balance sheet On the contrary, the income statement and the bal-
consistently both for financial statement and tax ance sheet are interrelated. The net profit and loss
purposes. More importantly, taxpayers have a on the income statement is derived by comparing
strong incentive to report values accurately if their the opening and closing balance sheets and adjust-
financial statements are filed with the SEC or other ing for asset purchases and disposals and changes in
regulatory agencies. liabilities and equity. Thus, the changes in fair value

Volume 7 Issue 1 2008

of marked-to-market securities and derivatives (i.e., in the safe harbor. Nevertheless, the premise of the
the net gain or loss in respect of such instruments) safe harbor is that if a taxpayer uses the same valu-
that are reported on the income statement are derived ation methodology consistently for both financial
from the balance sheet.41 statement and tax purposes and there are strong
The changes in value of securities reflected in the incentives for the taxpayer to report values accu-
balance sheet that do not flow through the income rately, then the values should be accepted as fair
statement are generally recorded in other compre- market values for tax purposes. Accordingly, it is
hensive income (OCI) and include available for only proper that where a taxpayer employs the same
sale securities,42 cash flow hedges43 and derivatives valuation methodology for securities whose values
contracts entered into to hedge exposure to equity are reflected in the income statement and securities
investments in non-U.S. subsidiaries (e.g., certain cur- of the same class whose values are reflected only
rency hedges).44 These are relatively straightforward in the balance sheet, the taxpayer should have the
and uncomplicated instruments and their market benefit of the safe harbor. Conditioning the inclu-
prices are readily available.45 Given that they are the sion of a security in the safe harbor on whether or
least likely to cause controversy in valuation between not the value is reflected in the income statement
the IRS and taxpayers, there is no benefit to the IRS or abandons the underlying premise of the safe harbor,
taxpayers in not including them in the safe harbor. might potentially make inclusion in the safe harbor
Furthermore, there is no theoretical or practical elective and can only lead to more controversy.
reason for excluding a security from the safe harbor Moreover, the requirement that changes in the
on the basis that its value is not recognized in income values of securities be specifically recognized in the
into the income statement when securities of the same income statement effectively makes the safe harbor
class receive the benefit of the safe harbor. As noted unavailable to U.S. subsidiaries of foreign banks. As
previously, the safe harbor does not apply to avail- noted, these U.S. subsidiaries of foreign banks are
able for sale securities because their values do not required to file call reports on a quarterly basis with
flow through the income statement but rather through the Federal Reserve or the Office of the Comptroller of
OCI, while the safe harbor applies to trading securi- the Currency. The reports are prepared in accordance
ties because their values
heir val uess are reflected in the income with U.S. GAAP, are audited by outside accountants,
statement. This creates
eatees tthe
is cre he situation
uation in whwhich securi-
ich sec and effectively are standalone balance sheets for the
ties in the same
am cclass
me clas ss mmay be distinguished
ma in solely
hed so U.S. subsidiaries. But the reports are not complete
by reason of where
wh re they
herre th
heyy are
a refl ected
eflect d in a taxpayers
taxpa financial statements given that they do not contain
financial statementt and not because they are valued statements of income or earnings. Therefore, in the
using different valuation methodologies.
hod logies. T This will
his w ill view
vie w of
of the IRS
IRS and
an the
the Treasury,
Treasury the
the call
cal reports lack
be the result if a taxpayer classifi ifies some securities
iti the tension
h t i necessary tto makek a financial statement
as available for sale and others in the same class reliable and the valuations appearing on the call
as trading securities. It would appear that, at least reports do not qualify for the safe harbor.
in such a case, a taxpayer should be able to use the The safe harbor is unavailable to U.S. subsidiaries
safe harbor if the taxpayer can demonstrate that the of foreign banks filing call reports, even though An-
valuation methodology is used consistently (for both nouncement 2003-35 and the proposed regulations
securities whose values are reflected in the income had contemplated that call reports would be appli-
statement and those whose values are reflected only cable financial statements. Under the preamble to the
in the balance sheet) and the taxpayer has the records proposed regulations, the second category of finan-
to verify the values. cial statementsi.e., those required to be provided
Presumably, the IRS would prefer that the safe to the federal government or any of its agencies other
harbor applied to both to prevent game-playing. than the IRSincluded statements filed by foreign-
Therefore, arguably, a taxpayer has no need to be controlled financial institutions engaged in trade or
concerned if the taxpayer is using a single valua- business within the United States who report their
tion methodology for the same class of securities, mark-to-market results to the Federal Reserve or the
because IRS agents are not likely to challenge such Office of the Comptroller of the Currency.46 These
methodology if the taxpayer can demonstrate that statements are the call reports discussed above.
the methodology used for valuing available for The notion that a U.S. subsidiary of a foreign bank
sale securities is also used for valuing securities would understate the value of its portfolio to the


Mark-to-Market Safe Harbor Regulations

Federal Reserve or the Comptroller of the Currency in eligible taxpayer, or provided for other substantial
order to reduce tax income is not credible. Valuations nontax purposes) and that the taxpayer reasonably
by these banks are used for significant nontax pur- anticipates will be directly relied on for the pur-
poses. These companies also face significant penalty poses for which it was given or provided.49 Thus,
risks if they misstate the values in their call reports. only financial statements prepared in accordance
Therefore, call reports should be as trustworthy as with U.S. GAAP are eligible for the safe harbor.
financial statements that include an income statement Given that many foreign financial institutions that
and not including them as applicable financial state- are required to pay taxes on U.S. dealer operations
ments will not serve to enhance the administrability file their primary financial statements under the
of valuation under Code Sec. 475. GAAP of a non-U.S. jurisdiction, the requirement
Recognizing the utility of including call reports as makes the safe harbor unavailable to these taxpay-
applicable financial statements, the final regulations ers. As noted previously, the call reports filed by
leave open the possibility that the reports could later the U.S. subsidiaries of foreign banks are generally
be included within the safe harbor. Therefore, the prepared in accordance with U.S. GAAP. However,
final regulations solicit responses to several issues that the call reports do not contain income statements,
the IRS and the Treasury view as important in decid- and even though the valuations of securities shown
ing whether to extend the safe harbor to call reports. on the call reports are reflected in the income state-
The issues include (1) whether the safe harbor should ments filed by their parent banks using valuation
require that the values reported in the call report of standards that are essentially the same as U.S. GAAP,
the foreign bank be the same values that are reported the income statements filed by their parent banks as
in the income statement filed in the foreign banks part of their overall financial statements generally
home country; (2) whether the valuation standards are prepared in accordance with the GAAP of the
used in the foreign banks home country should be home countries. Accordingly, the final regulations
identical to the valuation standards under U.S. GAAP; fail to include U.S. subsidiaries of foreign banks in
(3) whether the income statement filed by the foreign the safe harbor by requiring that changes in values
bank should be filed with the foreign banks home of securities be shown on the income statement, and
country bankk regulator
gulaatorr (as distinct from a market
reg by requiring that the income statement be prepared
regulator likee thee SEC);
SEEC); and
a (4) whether
whether the term
w t in accordance with U.S. GAAP.
home country yy sshould
try hou mean
uld m n the co
country which
y in w No doubt the IRS and the Treasury have a legitimate
the foreign bank
an chartered
nk iiss ch incorporated.
hartered or incorporat 477 interest in ensuring that financial statements used for
the safe harbor are prepared
p under a sound set of ac-
Requirement of U.S. GA
AP counting
cou principles.
nting princ p s. HHowever,
Howwever, rather
ath than requiring
her th
The final regulations also limit th
the availability
il bil t off th
h that
h t financial
i l statements
t bbe preparedd iin accordance
safe harbor by requiring that financial statements with U.S. GAAP, it would appear that the relevant
be prepared in accordance with U.S. GAAP.48 Un- inquiry should be whether the accounting standard
der Reg. 1.475(a)-4(h), a taxpayers applicable (or the valuation standard) under which a taxpayers
financial statement for a tax year is the taxpayers financial statement is prepared is consistent with U.S.
primary financial statement for that year and GAAP, if the goal is in fact to reduce the compliance
there are three categories of primary financial state- burdens of taxpayers and minimize controversy.
ments: (i) a financial statement that is prepared in The utility of the limitation becomes even more
accordance with U.S. GAAP and that is required questionable when one considers that U.S. GAAP
to be filed with the SEC, such as the 10-K or the is converging with International Financial Reporting
Annual Statement to Shareholders; (ii) a financial Standards (IFRS), promulgated by the International
statement that is prepared in accordance with U.S. Accounting Standards Board (IASB).
GAAP and that is required to be provided to the There is an ongoing project by the SEC and IASB
federal government or any of its agencies other to achieve convergence between U.S. GAAP and the
than the IRS; and (iii) a certified audited financial IFRS.50 Indeed, the SEC recently voted unanimously
statement that is prepared in accordance with U.S. to publish a Concept Release to allow U.S. issuers
GAAP (that is given to creditors for purposes of that file on Form 10-K the option of preparing their
making lending decisions, given to equity holders financial statements in accordance with IFRS.51 The
for purposes of evaluating their investment in the SEC has also proposed to eliminate the U.S. GAAP

Volume 7 Issue 1 2008

reconciliation requirement for foreign private issuers (c) Able to transact for the asset or liability
who file financial statements prepared in accordance (d) Willing to transact for the asset or liability;
with IFRS.52 Therefore, at a time when the SEC is ac- that is, they are motivated but not forced or
knowledging the reliability and equivalence of the otherwise compelled to do so57
IFRS to U.S. GAAP, the IRS and the Treasury have The convergence of the U.S. GAAP definition of
decided to distinguish between the two standards fair value to the IFRS definition demonstrates that,
for preparing financial statements. at least with respect to fair value measurements, the
More importantly, IFRS, as promulgated by the IFRS is essentially the same as U.S. GAAP. Because
IASB (although not necessarily as adopted by all the safe harbor is unavailable to valuations that
jurisdictions),53 contains rules for marking securities are reported under IFRS, the final regulations are
and OTC derivatives to market that are essentially not likely to enhance the administrability of valu-
the same as fair value accounting under U.S. GAAP. ations under Code Sec. 475 by U.S. subsidiaries
The U.S. GAAP definition of fair value for a finan- of foreign banks.
cial instrument is materially the same as that under
the IFRS and there is no reasonable basis for not in- Unavailability of Safe Harbor to
cluding valuations of financial instruments reported Traders of Securities and Commodities
under the IFRS under the safe harbor. In fact, until Lastly, the final regulations provide that the safe har-
the Financial Accounting Standards Board (FASB), bor is available only to taxpayers who are dealers in
the body responsible for promulgating U.S. GAAP securities under Code Sec. 475(a) or who are dealers
standards, adopted Financial Accounting Standard in commodities and are subject to the election de-
(FAS) 157 (which defines fair value), the IFRS defini- scribed in Code Sec. 475(e)(1). Accordingly, securities
tion of fair value was considerably stricter than the traders and commodities traders are not eligible
U.S. GAAP standards. taxpayers for purposes of the safe harbor.
International Accounting Standard (IAS) 39, the The IRS and the Treasury contend that they do not
relevant section of the IFRS dealing with financial have a full understanding of the business model of
instruments, defines fair value as the amount for traders so that it would be unwise to include them
which an asset ett could
coould be
b exchanged, or a liability in the safe harbor at this time.58 According to the
settled, between
een knowledgeable,
know wleedg ble, willing
w lling parties
parties in
i an IRS and the Treasury, the final regulations are based
arms length transaction.
traansacttion n. On the other
n 54
o hand, FAS on the business model of dealers and the IRS and
157 defines fair vvalue
faair valu
alu a tthe
ue as
ue price
e pri that woul
ce tha would be the Treasury do not understand how, for example,
received to sell an asset or paid to transfer a liability the bid-ask limitation would apply to traders. Ap-
in an orderly transaction between en market
arket participants
part cip
pants parently,
par ent y, comments
y thee co
omments received b by
y the IRS and the
at the measurement date. 55
Treasury iin response tto A
T Announcementt 2003-35 and
Under FAS 157, an orderly transaction is a transac- the proposed regulations failed to address whether
tion that assumes exposure to the market for a period traders, like dealers, capture spreads when they
prior to the measurement date to allow for marketing enter into securities or derivatives positions so as to
activities that are usual and customary for transac- be immune to changes in value in the underlying
tions involving such assets or liabilities; it is not a securities or derivatives.
forced transaction (for example, a forced liquidation But traders are generally interested in rapidly
or distress sale).56 Also, under FAS 157, market par- turning over securities to profit from price changes.
ticipants are buyers and sellers in the principal (or Therefore, it would appear that except for securities
most advantageous) market for the asset or liability acquired at the end of the tax year, the acquisition
that are the following: and disposition of securities by a trader occurs within
(a) Independent of the reporting entity; that is, they a single tax year, so that the effect of capturing a bid-
are not related parties ask spread also occurs entirely within that year. Of
(b) Knowledgeable, having a reasonable under- course, when a trader holds a security for investment
standing about the asset or liability and the rather than for trading, the bid-ask spread may not be
transaction based on all available informa- captured within the tax year. However, in those cases,
tion, including information that might be the trader would not likely elect mark-to-market treat-
obtained through due diligence efforts that ment and the issue of the appropriate valuation for
are usual and customary the securities would not arise.


Mark-to-Market Safe Harbor Regulations

Under the final regulations, the safe harbor is un- tax fair market value and fair value under U.S.
available to traders whether or not their valuations GAAP, the court stated:
are consistent with Code Sec. 475, based on U.S.
GAAP, or income is recognized into the income state- We note that the proposed regulation may ren-
ment. For example, consider the case of entities that der this distinction moot in future cases, since it
are Code Sec. 475(c)(1) dealers but that have also would provide that the value that the eligible
made Code Sec. 475(f) trader in securities elections taxpayer assigns to that eligible position in its
to preserve the character of some of their speculative applicable financial statement is the fair market
activity. These traders would not be able to use the value of the eligible position for purposes of sec-
safe harbor for their trading securities, even though the tion 475, even if that value is not the fair market
safe harbor is available to the same securities in their value of the position for any other purpose of the
dealer portfolio. Also, the safe harbor is unavailable internal revenue laws.62
to traders, notwithstanding that both Announcement
2003-35 and the proposed regulations had contem- Second, with respect to the different valuation
plated their inclusion in the safe harbor. Removing methods proposed by the IRS (unadjusted mid-market
traders from the safe harbor invariably means that, values) and the taxpayer (mid-market values with
at least with respect to traders, the administrability further adjustments), the court stated:
of valuations under Code Sec. 475 will not be easier
than it was before the safe harbor project. We note again that the proposed regulations re-
garding mark-to-market accounting may render
The Bank One Case the particular application of the method disputed
here inapplicable in the future. Academic litera-
As noted, the failure of the final regulations to pro- ture has characterized the methodology at issue
vide comprehensive safe harbor to taxpayers ensures of using the unadjusted midmarket value for
that valuation controversies between taxpayers and most significant business purposes as outlying.
the IRS will continue. Specifically, traders and U.S. Linda M. Beale, Book-Tax Conformity and the
subsidiaries off fore
eign banks,
an because the safe harbor
n ba Corporate Tax Shelter Debate: Assessing the Pro-
is not availablelee to them,
ble theem,, will
em w likely continue
continue to have
h posed Section 475 Mark-to-Market Safe Harbor,
disputes with ththe
he IRIRS over
er vvaluations.
RS ove
o ua s. Dealers
ers and the 24 Va. Tax Rev. 301, 420 (2004) (emphasis omit-
IRS will continuenue to disdispute valuations
pute valuat ons oof secur
securities ted). The article further noted that the taxpayers
that are marked tto market through OCI rather than approach
p during the years at issue cannot be
the income statement. But, given en the
t e outcomeme of
outccom o the
he cconsidered
o s dered
d d il illustrative
lu rat ve of current practice,
prac sug-
Bank One case, taxpayers should
ld be concerned d th
that gesting
ti ththatt tthis
h didispute
t may h have lit
little bearing
their valuations may not be upheld by the courts. on the current market or practices. Id. at 422.63
The Bank One case involved a dispute between the
taxpayer and the IRS over the valuation methodology Finally, on the valuation of interest swaps, the
used by the taxpayer to value certain swaps entered into court stated:
by the taxpayer. The taxpayer had employed a method-
ology that valued the swaps at their mid-market values Meanwhile, the Commissioner independently
with adjustments for credit risk and administrative issued a notice of proposed rulemaking that
costs.60 The IRS contended that the appropriate valuation would affect the valuation of interest swaps. See
should be mid-market values without any adjustments Safe Harbor for Valuation Under Section 475, 70
for credit risk and administrative costs. The Tax Court Fed. Reg. 29663 (May 24, 2005). The proposed
held that both the taxpayers and the IRS methodology rule sets forth a safe harbor for valuing securities
for valuing the swaps failed to clearly reflect taxpayers such as interest swaps. Specifically, the proposed
income and, on its own, adopted a methodology that rule provides that if the valuation reported on
permitted some adjustments to mid-market values.61 certain financial statements mirrors the reported
On appeal, the Court of Appeals for the Seventh tax value, then the Commissioner will accept the
Circuit presumed that the proposed regulations and value as fair market value. Such a rule, if final-
the ANPRM would limit the cases precedential ized, would likely bear on similar cases and may
value. First, with respect to the distinction between limit this cases precedential value 64

Volume 7 Issue 1 2008

The Court of Appeals then affirmed the Tax Courts final regulations. As noted, the proposed regulations
decision as it related to the taxpayers valuation meth- and the ANPRM contemplated the inclusion of traders
odology. But the Seventh Circuit Court of Appeals also in the safe harbor and they are excluded under the
held that the Tax Court should not have rejected the final regulations. Additionally, taxpayers fair value
IRS methodology, unless the Tax Court found that the computations would be respected only if they are
methodology was arbitrary or unlawful: recognized into the income statement. Therefore,
Bank One type disputes are likely to continue for
Having rejected the taxpayers method, the tax valuations reflected outside the income statement.
court proceeded to examine the Commissioners More importantly, by holding that once a court finds
method. The tax court analyzed whether the Com- that a taxpayers valuation method does not clearly
missioners own method produced the fair market reflect income the court must adopt the IRSs proposed
value of the interest swaps. In doing so, however, methodology unless it is arbitrary or unlawful, the Court
the tax court failed to afford the Commissioner the of Appeals opinion is significant and may have longer
deference due under the statutory scheme. Section lasting impact than was originally thought to be the case.
446, provides that if the method used [by the Although the Tax Court again adopted its original ruling
taxpayer] does not clearly reflect income, such in the case, it is not clear that the Tax Court can modify
as occurred in this case in which the taxpayers the IRSs method without finding that it is unlawful or
method fails to produce a fair market value, then arbitrary.67 This is because Code Sec. 446 appears to
the computation of taxable income shall be made suggest that once the Tax Court finds that the taxpayers
under such method as, in the opinion of the Sec- method does not clearly reflect income, and that the
retary, does clearly reflect income. We observe Secretarys method is not unlawful or arbitrary, the
section 446 requires that the Commissioners meth- Secretary is free to compute taxpayers income using
od shall be followed. Following this language, the a method that in the opinion of the Secretary, does
Supreme Court instructs that the Commissioners clearly reflect income.68 The Tax Courts unpublished
interpretation may not be set aside unless clearly opinion fails to address this critical language in the
unlawful or plainlyy arbitrary. Accordingly, the tax opinion of the Secretary and merely asserts that the
court was required
q ed to
quire t defer
de to the Commissioners
d court did not find that the IRSs method clearly reflected
method of cacalculating fair market value.655
lculating fa taxpayers income. Nonetheless, in such cases, the Code
Sec. 446 standard is not clear reflection of income as
On remand, and and in
n an
a unpublished
unpublished opinion,
opinion the may be decided by a court but clear reflection of income
Tax Court held that h t the
th t Commissioners valuation in the opinion of the Secretary.
method was not arbitrary or unlawful
nlawful but insisted
ed Accordingly,
A ccordingly, w while
ile tthe nal
hee fin regulations
al regulati may not
that the method did not clearly l refl
flect ttaxpayers
h the
th administrability
d i i t bi i off valuations
l under
income.66 Accordingly, the Tax Court again adopted Code Sec. 475 because of their many limitations on
its original ruling on the case. the use of the safe harbor, the Bank One case has the
Despite the Court of Appeals presumptions, it is potential effect of forcing taxpayers to take conserva-
clear that given the narrow applicability and limited tive positions for valuation purposes or risk having
utility of the final regulations, disputes between the their methodology determined to fail to clearly reflect
IRS and taxpayers, such as was at issue in the Bank income, resulting in the IRS valuation position being
One case, will not soon disappear by reason of the upheld unless it is arbitrary or unlawful.
The absence of regulatory guidance existed de- pliance burdens of taxpayers under the bill.) purposes.) See also Dept of Treasury, General
spite the fact that both the Committee Report H.R. CONF. REP. NO. 103-213, at 616. (Valu- Explanation of the Presidents Budget Propos-
and the Conference Agreement to Code Sec. ation of securities. The conference agreement als Affecting Receipts 89-90 (Jan. 30, 1992).
475 contemplated that the Treasury will au- does not provide any explicit rules mandating (The mark-to-market method represents
thorize the use of valuation methods that will valuation methods that are required to be used the best accounting practice in the trade or
alleviate unnecessary compliance burdens for for purposes of applying the mark-to-market business of dealing in securities and is the
taxpayers. See H.R. CONF. REP. NO. 103-213, rules. However, the conferees expect that the method that most clearly reflects the income
103rd Cong., 1st Sess., at 613 (1993). (It is Treasury Department will authorize the use of of a securities dealer, proposing that dealers
expected that the Treasury Department will valuation methods that will alleviate unneces- be required to use mark- to-market accounting
authorize the use of appropriate valuation sary compliance burdens for taxpayers and for their inventories as they already do when
methods that will alleviate unnecessary com- clearly reflect income for Federal income tax preparing financial statements.)


Mark-to-Market Safe Harbor Regulations

See Reg. 1.170A-1(c)(2) (the price at which challenges their adjustments to the mid-market from Treasury and the IRS would free up
the property would change hands between a valuation); see also Securities Industry Asso- scarce IRS audit resources and reduce tax-
willing buyer and a willing seller, neither be- ciation letter to the Assistant Secretary for Tax payer administrative burdens, consistent
ing under any compulsion to buy or sell and Policy, Department of Treasury and to the Chief with the direction of Congress.)
both having reasonable knowledge of relevant Counsel, IRS, 2002 TNT 78-18 (Mar. 28, 2002) Announcement 2003-35, IRB 2003-21,
facts); see also Reg. 1.704-4(a)(3) (similar); (urging the IRS to give priority to guidance on 956 (filed by the Office of the Federal
Rev. Rul. 59-60, 2.02; 1959-1 CB 237; TBR mark-to-market requirements: IRS examiners Register on May 2, 2003, 8:45 a.m., and
57, 1 CB 40 (1919) ([a] fair market value are increasingly challenging taxpayers section published in the issue of the Federal
that both a buyer and a seller, who are acting 475 valuation methodologies, even though Register for May 5, 2003, 68 FR 23632,
freely and not under compulsion and who are these rely on methodologies used for key and referred to as the Advance Notice
reasonably knowledgeable about all material non-tax purposes (e.g., financial reporting). of Proposed Rulemaking (ANPRM)).
facts, would agree to in a market of potential Absent clear guidance, we seem certain to see The Announcement also indicated that in
buyers at a fair and reasonable price); Hudson additional costly litigation along the lines of a certain limited circumstances, it may also be
River Woolen Mills, 9 BTA 862, 868, Dec. case now involving Bank One). appropriate to consider financial statements
3255 (same); Announcement 2003-35, IRB See Bank One Corp., 120 TC 174, Dec. 55,138 required to be filed with a state government
2003-21, 956 (the price at which property (2003). The Bank One cases involved the ap- or any of its agencies, a political subdivision
would change hands between a willing buyer propriate valuation of certain interest rate swaps of a state or possibly a foreign regulator, and
and a willing seller, neither being under any entered into by petitioners and were consoli- to consider statements provided to equity
compulsion to buy or sell and both having dated for trial. It should be noted that the cases holders or creditors.
reasonable knowledge of relevant facts). were cases about fair market value before Code 70 FR 2966371.
The Tax Court has summarized the stan- Sec. 475 was effective. In docket No. 5759- Proposed Reg. 1.475(a)-4(b)(1).
dards for fair market value as: 95, First Chicago Corp. (FCC) and its affiliated Proposed Reg. 1.475(a)-4(c).
(1) The buyer and the seller are a willing corporations, one of which was a corporation Proposed Reg. 1.475(a)-4(h)(2).
buyer and a willing seller; (2) neither formerly known as the First National Bank of Proposed Reg. 1.475(a)-4(h)(1), (j).
the willing buyer nor the willing seller Chicago (FNBC), petitioned the Tax Court to re- Proposed Reg. 1.475(a)-4(j)(4).
is under a compulsion to buy or sell the determine the IRS determination of deficiencies Proposed Reg. 1.475(a)-4(d)(1), (2).
item in question; (3) the willing buyer of $1,661,112 and $ 2,956,794 in the affiliated Proposed Reg. 1.475(a)-4(a)(1).
and the willing seller are both hypotheti- groups consolidated federal income taxes for Preamble to the proposed regulations, 70
cal persons; (4) the hypothetical willing 1990 and 1991, respectively. In docket No. FR 29663-29671.
buyer and the hypothetical willing seller 5956-97, First Chicago NBD Corp., the succes- Proposed Reg. 1.475(a)-4(d)(3)(iii), (4)
are both reasonably aware of all relevant sor in interest to FCC and affiliated corporations, (Examples 13).
facts involving the item in question; petitioned the Tax Court to redetermine the IRS Proposed Reg. 1.475(a)-4(k).
(5) the item in question is valued at its determination of a $95,156,499 deficiency See, e.g., Institute of International Bankers
highest and best use;; and (6) the item in the 1993 consolidated federal income tax Comment Letter, 2005 TNT 189-23 (Sept.
in question is valued
v ed without
value w
witho o regard return of FCC and its affiliated corporations. 13, 2005); Securities Industries Association
to events occurring
urrring afterr the va
n Ba
Bank k One w was the successor to First National Comments to Announcement 2003-35,
date to the extent
nt tha
at tho
ose su
ubs ent Bank k of Chic
Chicago. In order to avoid confusion, 2003 TNT 177-39 (July 30, 2003); and Inter-
events were notot reaso
onabbly fo
ore ble this article co
consistently refers to the taxpayer in national Swaps and Derivatives Association
on the date of va
aluattion. the Bank On One case (both in the Tax Court and in Comments to the Proposed Regulations,
Bank One Corp., 120 0 TC C 17
174, 306, Dec. the Seventh Circuit Court of Appeals) as Bank 2006 TNT 52-33 (Mar. 7, 2006).
55,138 (2003). O
One. The regulations
at apply to tax years ending on
3 8
H.R. CONF. REP. 103-213, at 616 (1993). The See
Seee LLetter
et ter from
m MaM
Marc E. Lackritz
ckritz to Hon.
Hon. or after
o fter JJune
ne 12
12,, 20
07 SeSee T.D. 9328.
Committee Report provides that fair market ket Mark
M ark A A. Wei
W b erg 2001
200 01 TN
TNT T 96
27 Preamble
P eam mble tto th
the fina
al re
g l T.D. 9328.
value will be determined by valuing each (Apr. 25, 2001) (hereinafter referred to Id.
security on an individual security basis without as the 2001 SIA letter); Letter from Saul See Statement of Financial Accounting
taking into account blockage discounts. H.R. M. Rosen and Patti McClanahan to Hon. Standards (FAS) 157, Fair Value Measure-
CONF. REP. NO. 103-213, at 613. (For purposes Mark Weinberger and Hon. B. John Wil- ments, issued by the Financial Account-
of the House bill, fair market value is generally liams, 2002 TNT 78-18 (Mar. 28, 2002) ing Standards Board, September 2006
determined by valuing each security on an (hereinafter referred to as the 2002 SIA (hereinafter referred to as FAS 157) (5,
individual security basis. Thus, if a taxpayer letter). defi ning fair value as the price that
holds a large block of securities of the same See id., 2001 SIA letter. would be received to sell an asset or paid
type, the securities should be valued without Id. to transfer a liability in an orderly transac-
taking any blockage discount into account.) Id. tion between market participants at the
4 12
The Bank One case, supra note 2, is a very Id. measurement date); see also American
prominent result of the litigious environment Id. Institute of Certified Public Accountants,
created by the lack of clarity around the ap- See 2002 SIA letter, supra note 8. (The Audit and Accounting Guide Brokers and
propriate valuation methodology. need for guidance is only increasing. IRS Dealers in Securities, 7.08 (explicitly
Act Sec. 13223(a) of the Omnibus Budget examiners are increasingly challenging permitting the use of bid and ask prices).
Reconciliation Act of 1993 (P.L. 103-66). taxpayers section 475 valuation method- See 31 of FAS 157, providing that:
See, e.g., New York State Bar Association Tax ologies, even though these rely on meth- If an input used to measure fair value
Section, Report on IRS Announcement 2003- odologies used for key non-tax purposes is based on bid and ask prices (for
35 (Safe Harbor for Valuation Under Section (e.g., fi nancial reporting). Absent clear example, in a dealer market), the price
475) (hereinafter referred to as the NYSBA guidance, we seem certain to see addi- within the bid-ask spread that is most
Report), 2003 TNT 197-18, at 13 (Oct. 9, tional costly litigation along the lines of a representative of fair value in the cir-
2003) (stating that Derivatives dealers anec- case now involving Bank One. In addition cumstances shall be used to measure
dotally report that the IRS on audit routinely to helping avoid disputes, bright-line rules fair value, regardless of where in the

Volume 7 Issue 1 2008

fair value hierarchy the input falls (Level 12 (describing trading and available for sale a discussion of the European Unions position
1, 2, or 3). This Statement does not pre- securities as debt securities and equity on IAS 39, see European Commission Press
clude the use of mid-market pricing or securities with readily determinable values.) Release, Accounting Standard: Commis-
other pricing conventions as a practical (available at; sion Endorses IAS 39, IP/04/1385 (Nov. 19,
expedient for fair value measurements for a more detailed discussion of the issues 2004), available at
within a bid-ask spread. relating to amounts included in OCI, see
For a discussion of how debt securities are letter from Edward D. Kleinbard on behalf 85&format=HTML&aged=1&language=EN&
traded, see the New York State Bar Association, of the Securities Industry Association, to guiLanguage=en. See also IAS 39 Financial
Report on Definition of Traded on an Estab- Suzanne Boule, Office of the Chief Counsel, Instruments: Recognition and Measurement
lished Market Within the Meaning of Section IRS, regarding Advance Notice Regarding Frequently Asked Questions (FAQ), European
1273, 2004 TNT 159-7 (Aug. 12, 2004). Proposed Safe Harbor Under Section 475, Commission Memo/04/265, Brussels (Nov.
For more discussion of OTC derivatives dated October 30, 2003 (attached to letter 19, 2004), available at
model, see preamble to the final regulations, from Securities Industry Association, 2005
T.D. 9328. TNT 179-26 (Aug. 17, 2005)). 4/265&format=HTML&aged=1&language=E
36 46
For more discussion of OTC physical securi- Preamble to the proposed regulations, 70 N&guiLanguage=en.
ties model, see Securities Industry Associa- FR 2966371. See Technical Summary to IAS 39 Financial
tion Comments to the Proposed Regulations, See preamble to the final regulations, T.D. Instruments: Recognition and Measurement
2005 TNT 179-26 (Aug. 17, 2005). 9328. (prepared by IASC Foundation staff), www.
37 48
Preamble to the final regulations, T.D. 9328. See Reg. 1.475(a)-4(h).
38 49
Id. Reg. 1.475(a)-4(h)(2). 4401-A90D-483C63800CAA/0/IAS39.pdf.
39 50 55
For more discussion of the capital require- For a discussion of the issues raised by the Statement of Financial Accounting Standards
ments for banks, securities dealers and convergence project, see Donald T. Nico- No. 157, Fair Value Measurements, 5
other financial institutions, see Report to the laisen, Chief Accountant, SEC, A Securities (Sept. 2006).
Chairman, Committee on Banking, Hous- Regulator Looks at Convergence, 25 NW. J. Id., at 7.
ing, and Urban Affairs, U.S. Senate, and INTL L. & BUS. 3 (Spring 2005), at 661; Mary Id., at 10.
the Chairman, Committee on Banking and Tokar, Convergence and the Implementation Id.
Financial Services, House of Representatives, of a Single Set of Global Standards: The Real- See Bank One Corp., 120 TC 174, Dec.
Risk-Based Capital: Regulatory and Industry Life Challenge, 25 NW. J. INTL L. & BUS. 3 55,138 (2003).
Approaches to Capital and Risk, published (Spring 2005), at 687. Id., at 243, 315. The taxpayers valuations,
by United States General Accounting Office See, e.g., Speech by SEC Commissioner, however, were not the values on the last
(GAO) (July 1998) (available at Roel C. Campos, Remarks at the Open business day of the tax year as required by
archive/1998/gg98153.pdf). Meeting: Concept Release on Allowing U.S. Code Sec. 475.
40 61
SEC Form 2069 (Weekly Report of Assets Issuers to Use IFRS, Washington, D.C. (July Id.
and Liabilities for Large g Branches and 25, 2007), available at JPMorgan Chase & Co., CA-7, 2006-2 USTC
Agencies of Foreign e
eign Ban
nks), available at speech/2007/spch072507rcc.htm. 50,453, 458 F3d 564, 569 (note 2) JPMorgan
serrve.ggov/bboard dd port- Se
See SEC prepress release: SEC Soliciting Public Chase & Co. became the successor in interest
R_22069 9200 0707 704 df. Comment
mment on o Eliminating Reconciliation to Bank One Corporation in the Bank One case
For more discussionssio
on of
o thee relationship
relati ip be- Requirement
uiremen for IFRS Financial Statements following the merger of Bank One Corporation
tween the balance cee sheet,
sheeet,, income
i me statement
sta ment (Ju
y 3, 200
2007), available at with JPMorgan Chase & Co. in July 2004.
and statement of cash ash flow
ws, see, e.g., Larry news/press/2007/2007-128.htm. Id., at 571 (note 4).
53 64
Walther, PRINCIPLES OF ACCOUNTING, Ch. 16 The European
Th urop Union hasas adopted
ado IFRS for Id., at 5677 (emphasis added).
Financial Analysis and the Statement of all listed
al listed co
mpanies in the
he European
u opean Un
ion See JJPMorgan
PMo organ Chase
Chase & Co.,
C CA-7, 2006-2
Cash Flows (available at www.principleso- eso iin respect
respect of their
th ir consolidated
c lidated financial
i cial USTCC 50,453,
453 458 F3d
50 F3d 564,
5 569-571 (cita- statements. In that regard, the European tions and footnotes omitted).
42 66
These are generally marketable equity se- Union specifically adopted in November, JPMorgan Chase & Co., No. 5956-97, 2007
curities and debt securities that a company 2004, IAS 39. However, the European Union TNT 99-14 (Mar. 7, 2007).
may sell prior to maturity. modified the operation of IAS 39 for European As at the time of this publication, the second
E.g., a floating-to-fixed interest rate swap companies through two carve outs, which Tax Courts opinion has not been appealed
that allows a bank to convert interest on a mitigated in certain respects the application by any of the parties.
floating rate bond into a more predictable of IAS 39 to European issuers in respect of (i) See Code Sec. 446 (emphasis added); see
stream of cash flows. the rules under IAS 39 related to hedge ac- also Heilig Meyers Co., DC VA, 2007-1 USTC
The U.S. GAAP treatment of such derivatives counting, under which hedged items and their 50,509 (applying Code Sec. 446 to valua-
is addressed by Financial Accounting Stan- hedges are both marked-to-market and (ii) an tion of installment accounts receivable under
dard 52 (Foreign Currency Translation). election under IAS 39, pursuant to which an Code Sec. 475 and upholding valuation made
See e.g., FAS No. 115, Accounting for Certain entity may mark-to-market any financial asset by the IRS after finding that taxpayers valua-
Investments in Debt and Equity Securities, or liability, including the entitys own debt. For tion did not clearly reflect income).

This article is reprinted with the publishers permission from the JOURNAL OF FINANCIAL PLANNING, a
quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the
publishers permission is prohibited. To subscribe to the JOURNAL OF FINANCIAL PLANNING or other CCH
Journals please call 800-449-8114 or visit All views expressed in the articles
and columns are those of the author and not necessarily those of CCH.