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.
June 16, 2003
