CBTM sept text 9/16/03 10:33 AM Page 17 C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting By James E. Salles In this month’s column: The issue in Bank One was how the First • The Tax Court applies tax accounting prin National Bank of Chicago (FNBC), a member of tax- ciples to inventory valuations in Bank One payer’s predecessor’s consolidated group, marked Corporation v. Commissioner ; 1 did the court swap contracts to market during 1990–1993. The change the taxpayer’s method? opinion focused on interest rate swaps, which In O’Shaughnessy v. Commissioner , 2 The • accounted for the bulk of the transactions at issue, Eighth Circuit adopts the Tax Court’s posi although FNBC also engaged in currency and com- tion that changing a property’s MACRS modity swaps. The years 1990–1992 were not sub- ject to section 475, but the taxpayer had evidently classification is not a change in accounting method elected to apply mark-to-market accounting, a com- mon practice in the industry despite technical issues about the predecessor regulations’ scope. 7 Valuations as Accounting Methods: The opinion framed the issue as whether FNBC’s Bank One valuation methods “clearly reflected income” under Tax Court Judge Laro’s long-awaited opinion in the general mandate of section 446. However, the Bank One Corporation v. Commissioner 3 made its valuation issues addressed by the court are equally appearance in May. Most prominently, Bank One is applicable under section 475. the first reported decision addressing how securi- Over time, there had grown up an active pri- ties dealers should value swaps and other deriva- mary market for swaps, particularly interest rate tive contracts under section 475’s mark-to-market swaps, at standardized terms. There was, however, regime. Of less groundbreaking importance— no real secondary market for swaps, because they although possibly of broader concern—is the court’s were rarely assigned—parties generally exited their implication that changing the taxpayer’s formula positions by entering into offsetting contracts or, less for estimating fair market value was a change in frequently, buying out their counterparty—so exist- accounting method. Space considerations do not ing swaps’ year-end market values could not be permit a detailed recapitulation of the lengthy opin- determined by direct market observation. So how ion, but the discussion below provides an overview were they to be determined? The section 475 regula- of the parties’ positions and the court’s holding on tions issued in 1996 8 do not address valuation, so the valuation issue before turning to the question of dealers have been left to rely on “common law” val- whether the court imposed a change in method. uation principles and industry accounting practice. Swap dealers used specialized software to value Background: Mark-to-Market Accounting their positions. The software analyzed market data Securities dealers have traditionally been (such as interest rate indices and swap bid-ask allowed to use “mark-to-market” accounting (that spreads) to infer market assumptions about future is, to mark up inventory based on market values as interest rates. Those rates were then used to project well as mark it down below cost, as is done under any variable cash flows under the swap agreement, the “lower-of-cost-or-market method). 4 Section 475 and then to calculate the present value of all the required them to do so, effective generally from cal- cash flows to arrive at the swap’s “mid-market endar 1993. 5 The definition of “securities” was also value,” which was commonly used for a variety of extended to include contract positions that previ- internal and control purposes. For book purposes, ously might not have been considered “securities” some dealers used published quotations for stan- or even “property” at all, such as short positions, dardized transactions and made specific adjust- and entitlements and obligations under notional ments for differences in terms. Others used the principal and other derivative contracts. 6 “mid-market values,” with or without various adjustments, which might either be made directly to the book value or disclosed separately. Jim Salles is a member of Caplin & Drysdale in Washington, D.C. S E P T E M B E R 2 0 0 3 17
CBTM sept text 9/16/03 10:33 AM Page 18 C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y the IRS has ignored Congress’ exhortation to Bank One “authorize the use of valuation methods [under sec- FNBC determined swaps’ book value by reduc- tion 475] that will alleviate unnecessary compliance ing “mid-market value” by allowances for counter- burdens for taxpayers and clearly reflect income for party credit risk and projected administrative costs, Federal income tax purposes.” 10 However, on the amortizing these adjustments and the correspon- day Bank One was released, there appeared an ding income over the lifetime of the swap. The “advance notice of proposed rulemaking” (akin to main question in the case was whether this practice the similar notice that heralded the proposed was acceptable and, if it were not, what adjust- “ INDOPCO regulations”), asking for comments on ments could properly be made to the computer- a proposed book conformity safe harbor. 11 The generated “mid-market values” in applying section advance notice stated that “three broad principles” 475. Examining the relevant pronouncements, the would apply to any such safe harbor: court concluded that the accounting “fair value” • It would have to satisfy section 475’s basic standard was broader than the tax concept of “fair mandate: to determine securities’ fair mar- market value.” Thus, a valuation method that suf- ket value at year-end; ficed for book purposes might not necessarily satis- • The same figures would have to be used for fy section 475, and the court had to make an inde- financial statements and other business pendent evaluation of the taxpayer’s methods. purposes so the taxpayer would have “a Surveying the literature and considering expert tes- timony, the court agreed with the taxpayer that strong incentive to report values fairly”; adjustments for credit risks and administrative costs and were proper. • There would have to be a satisfactory The court, however, objected to numerous mechanism for tying the book figures used aspects of the taxpayer’s calculations. For adminis- to the tax return and ensuring that con- trative convenience, FNBC was computing “mar- formity was applied consistently to all secu- ket” as of about 10 days before the actual year-end, rities. and excluding certain “nonperforming” swaps. In The IRS requested comments about on what computing credit allowances, it did not take into securities or commodities should be covered; the account offsetting swaps or negotiated “credit range of practices permitted under GAAP and enhancements” that might reduce exposure, and whether they conform to section 475; whether and did not adjust values for the effects of FNBC’s own what other methodologies might exist for determin- credit rating or fluctuations in the counterparty’s ing “fair market value”; the types of “book” figures ratings. The adjustments were calculated with a that might be acceptable; and the necessary record- one-month lag, and in some cases amortized over keeping requirements. average lives rather than each swap’s term. Finally, the court held that only the projected incremental Valuation Changes as Method Changes administrative costs should affect the swaps’ value, A secondary, but interesting, question about while the taxpayer had been including some fixed Bank One is whether the taxpayer has undergone a indirect costs. The court ordered the parties to sub- change in accounting method under the Tax Court mit revised calculations of “fair market value.” opinion. The parties may have assumed so, but that is far from a foregone conclusion. “Safe Harbor” In Sight? The IRS and the courts have consistently treated Some commentators have criticized Bank One as various arbitrary and mechanical methods of deriv- an exercise in judicial lawmaking, and noted poten- ing the “cost” and/or “market value” of inventory tial problems in applying the court’s methodology or other property as methods of accounting. to anything other than the “plain vanilla” interest Changes from one such method to another, or from rate swaps that made up most of FNBC’s portfolio. 9 such a method to calculating a true “cost” or “mar- ket value,” are changes in method. 12 The point was However, the opinion can also be seen as a straight- forward attempt to come to grips with a number of recently illustrated in Hitachi Sales Corp. v. Commissioner, 13 which involved a taxpayer that highly technical issues in the face of a persistent guidance vacuum. was supposedly on the “lower of cost or market” That vacuum may be about to end. For 10 years, method of inventory accounting but had its own S E P T E M B E R 2 0 0 3 18
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