On May 3, the U.S. Tax Court issued its decision in Bank One Corp. v. Commissioner, the first case to address the question of how an over-the-counter derivatives dealer must value open positions at year-end under the U.S. mark-to-market tax regime, which became mandatory in 1993. As discussed below, the decision is likely to create more issues for both taxpayers and the Internal Revenue Service than it resolves. The much-awaited decision was issued against a backdrop of considerable controversy--including over such basic issues as the appropriateness of an adjusted mid-market method in valuing derivatives, and the degree of deference, if any, properly afforded to an OTC derivative dealer's specific valuation model or financial accounting methodologies. The disagreements appear to have been exacerbated over the years by a considerable gap between the OTC derivatives dealers, on the one hand, which have spent substantial resources developing their valuation models and consider those models to be proprietary technology, and the IRS, on the other hand, which is imperfectly positioned to second-guess the various technical and theoretical underpinnings of a valuation model, but nonetheless has an interest in ensuring that dealer models do not systematically undervalue positions and, consequently, taxable income. One of the more striking examples of the IRS's attempts to address this gap occurred in 1995, when the IRS commissioned the Los Alamos National Laboratory to develop software for the valuation of derivatives with the intention that the software would then be used in tax audits. The project survived long enough for the Los Alamos scientists to produce a software prototype in 1997 that was unveiled to a select group of industry participants for comments, but the project was abandoned later that year, after an intense round of industry criticism, and IRS management concerns over the project's costs.
Against this background, there was much hope on the part of both taxpayers and the IRS that the Tax Court's decision in Bank One would resolve the numerous valuation disputes that had proved time-consuming and expensive in the tax audit process. The IRS's litigators had argued for a straight mid-market valuation for derivatives and took the position that industry-wide practices such as adjustments for counterparty credit risk and anticipated overhead costs give rise to an improper acceleration of deductions when used for U.S. federal income tax purposes. Bank One's litigators took the position that a reasonable business judgment rule should apply, in which the business judgment used by the bank in valuing its positions should be given deference. The court, however, rejected both of these positions, and opted instead to set normative standards for implementing an adjusted mid-market valuation method for tax purposes.
The Decision's Logic
The Tax Court's decision, which runs to 259 pages, uses the following logic to justify the judicial creation of normative standards for valuing derivatives: The mark-to-market method employed by an OTC derivatives dealer is an accounting method, and as such, will be respected if it clearly reflects the dealer's income. It is irrelevant for these purposes that the IRS may be able to produce a method that more clearly reflects income. The Court held that the unadjusted mid-market method advocated by the IRS fails to clearly reflect income, because it looks only to gross cash flows generated by positions and not to net income. An adjusted mid-market method does clearly reflect income, but only if it is designed to reach the fair market value of the relevant derivatives. For these purposes, the Tax Court held, the term "fair market value" is not the same as the term "fair value" used for financial accounting purposes, but is instead a specialized tax concept that may very well require OTC derivatives dealers to value derivatives differently for tax purposes than for financial accounting or other purposes. The distinctions the Court drew between "fair value" and the tax concept of "fair market value" were based on minor differences between the technical definitions of the two terms, and not on any fundamental difference between the concepts underlying them.
The Tax Court then went on to set out various standards that a system purporting to measure "fair market value" for tax purposes must meet. These standards were based largely on the testimony of two court-appointed experts, whom the Court found to be more credible than the experts presented by the litigants. Under the Court's standards, certain credit and administrative adjustments are appropriate. The Court further held, however, that an OTC derivatives dealer must take its own creditworthiness into account, in addition to that of its counterparty. This holding appears to be inconsistent with the tax accounting practices of many OTC derivatives dealers today. A dealer may make administrative adjustments by reference to the dealer's own costs, rather than by reference to some sort of third-party data, but marginal costs, not average costs, must be used for these purposes. It appears that other adjustments may also be allowed in appropriate circumstances, such as liquidity adjustments for "exotic" derivatives, and derivatives are to be valued on a position-by-position basis, as opposed to a portfolio basis.
Although there are many criticisms one could level at the Tax Court's valuation methodology, the larger issue is whether the court should have attempted to prescribe any valuation methodology that applies specifically for tax purposes. The Court's attempt to create normative standards for measuring value is unlikely to serve either the OTC derivatives dealer community or the IRS particularly well. First, it seems unlikely that taxpayers will have valuation models in place that are capable of implementing the Court's methodology precisely as it has been laid out. In addition, the burden on taxpayers of keeping two sets of valuations--one to match the tax standards and the other to serve non-tax functions--is likely to be substantial. Arguably the separation of tax valuations from the valuations used for a dealer's core business functions would make the tax numbers less reliable, since a taxpayer's incentives to produce lower valuations for tax purposes would not be offset by incentives, for example, to produce higher valuations for financial accounting purposes or to produce accurate valuations for risk-management purposes.
Amicus Brief
In this regard, a number of trade associations presented an amicus brief to the Tax Court in the Bank One case, in which the amicii argued that the IRS should audit the process by which an OTC derivatives dealer feeds values into its tax and accounting books and records without becoming overly concerned with the substantive technical and theoretical underpinnings of any particular valuation methodology. If a dealer uses one set of valuations for such core business functions as financial reporting, regulatory reporting, risk management and determining compensation of senior traders, then the IRS should be comfortable that the valuations do not have any inherent downward bias that would systematically understate taxable income--competing incentives created by the different purposes should remove bias from the system. Therefore, an audit process that focuses on ensuring the consistency of values across the spectrum of a dealer's non-tax core business functions should be more efficient and more reliable than a process, such as that planned in the ill-fated Los Alamos initiative, aimed at second-guessing any particular valuation methodology.
Of course, the approach taken by the Tax Court in the Bank One case is directly contrary to that advocated in the amicus brief. A few hours prior to the release of the decision in Bank One, however, the IRS issued an "Advanced Notice of Proposed Rulemaking," which appears to view the approach suggested by the amicus brief as a potential solution to the current valuation disputes that have proven so time-consuming and costly for both taxpayers and the IRS to date.
Safe Harbor
The notice proposes a safe-harbor valuation methodology, by which an OTC derivatives dealer would be allowed to use the same valuations for the mark-to-market tax regime as it uses for financial accounting purposes. The IRS appears to be willing to allow such a safe-harbor provided that three conditions are met.
First, the mark-to-market methodology used for financial statement purposes must be "sufficiently consistent" with general tax requirements. In this connection, the notice lists a considerable number of questions concerning how valuations are derived for financial accounting purposes.
Second, the notice requires an OTC dealer to make significant use of the valuations in its business--reflecting the approach advocated by the amicus brief.
Third, the notice mentions that variation and reconciliation requirements will have to be developed, presumably in order to increase the efficiency and reliability of the audit process. In order to develop these procedures, the IRS is currently in the process of beginning an "Accelerated Issue Resolution" audit program with several volunteers from the OTC derivatives dealer community; the program is intended to provide the IRS with a more detailed understanding of how valuations generated by a dealer's computer models can be traced through tax and accounting books and records.
It seems likely that both the IRS and taxpayers will have a strong incentive to turn the notice and the AIR into a workable set of tax standards and audit procedures, now that the Bank One case has made the alternative burdensome and, in many respects, unworkable.
This week's Learning Curve was written by William McRae, associate at Cleary, Gottlieb, Steen & Hamiltonin New York.
