Current issues related to mark to market taxation for derivatives dealers
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Current Issues Related to Mark-to-Market Taxation for Derivatives Dealers. Presentation for IIB Conference June 24, 2008 Todd Tuckner, UBS Bill McRae, Cleary Gottlieb Steen & Hamilton LLP Jeff Maddrey, PricewaterhouseCoopers LLP. Agenda. Valuation A Bit of Historical Perspective

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Current Issues Related to Mark-to-Market Taxation for Derivatives Dealers

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Current issues related to mark to market taxation for derivatives dealers

Current Issues Related to Mark-to-Market Taxation for Derivatives Dealers

Presentation for IIB Conference

June 24, 2008

Todd Tuckner, UBSBill McRae, Cleary Gottlieb Steen & Hamilton LLP Jeff Maddrey, PricewaterhouseCoopers LLP



  • Valuation

    • A Bit of Historical Perspective

    • Valuation Safe Harbor Regulations

    • Current Credit/Liquidity

  • Everything Else

    • Overview of Section 475(a)

    • CCA 200817035

    • Best Practices/Common Issues

History of mark to market controversy

History of Mark-to-Market Controversy

  • Even prior to the adoption of Section 475 in 1993, dealers using derivatives as hedging tools had elected to use mark-to-market tax accounting as the method most consistent with their books and records and with economic reality. In 1920, the IRS first allowed commodities dealers to mark positions to market. (A.R.M. 100, 3 C.B. 66; updated in Rev. Rul. 74-223).

  • For physicals, dealers valued inventory at lower of cost or market, and there was relatively little to argue over, but the explosion of over-the-counter (“OTC”) derivatives created valuation issues because of the lack of secondary trading and complexity of models involved.

  • Generally, the adjusted mid-market method has been applied with ever-increasing complexity and sophistication, and different firms use different proprietary models.

History of mark to market controversy1

History of Mark-to-Market Controversy

  • The IRS had two initial responses to the issue of how to deal with adjusted mid-market valuations:

    • Try to audit the “black box.” In, 1995 the IRS tried to develop its own valuation software using scientists at the Los Alamos National Laboratory, and the project turned out to be cost-prohibitive.

    • Deny all adjustments to mid-market valuations, on the grounds that they front-load deductions that are attributable to future periods. This position was ultimately litigated in the Bank One case.

History of mark to market controversy bank one

History of Mark-to-Market Controversy (Bank One)

  • Summary of the Bank One case:

    • Issues involved proper valuation of interest-rate swaps.

      • IRS argued for unadjusted mid-market valuations.

      • Taxpayers argued for a “business judgment” rule.

      • Amici, including most major industry associations, argued for book/tax conformity.

    • The Tax Court held as follows:

      • “Fair market value” under Section 475 is a tax-specific standard requiring its own set of normative rules.

      • Based on testimony of various experts, the Tax Court generated several substantive requirements for a tax-sufficient valuation model, some of which were not consistent with established market practice (e.g., requirement to take taxpayer’s own credit quality into account when valuing liabilities).

History of mark to market controversy bank one aftermath

History of Mark-to-Market Controversy (Bank One Aftermath)

  • Parties were directed to come up values consistent with the Tax Court’s standards, and were unable to come to agreement.

  • On appeal, 7th Circuit held that the Tax Court should have determined whether the IRS’s actions were “arbitrary or unlawful,” and if not, whether the Tax Court “has the authority to craft its own method.” (“In addressing these issues, the tax court and the parties may consider any lessons gleaned from the computational proceedings.”)

  • On the same day that Bank One was issued, the IRS issued Announcement 2003-35, announcing the beginning of a project to create a book/tax conformity safe harbor, which project has now resulted in Treasury regulation section 1.475(a)-4.

Book tax conformity safe harbor

Book/Tax Conformity Safe Harbor

  • Applies for an eligible taxpayer using an eligible method on its applicable financial statement.

  • Eligible taxpayer: Only for dealers in securities and OTC derivatives and electing commodities dealers – not for traders electing under Section 475(f).

    • Traders were excluded, according to preamble, because of a lack on information about their business model.

Book tax conformity safe harbor part 2

Book/Tax Conformity Safe Harbor, Part 2

Eligible Method:

  • General Requirements: The book accounting must:

    • Require marking to market at least annually;

    • Require recognition of gain or loss upon marking to market on the income statement (OCI and balance sheet not good enough);

    • Reference “fair value” (determined under US GAAP); and

    • Take actual realization events, such as disposition of position or receipt or making of a payment, into account.)

Book tax conformity safe harbor part 3

Book/Tax Conformity Safe Harbor, Part 3

Eligible Method (Cont’d):

  • Substantive Limitations:

    • “Nearer to mid than bid”: valuations cannot be “at or near the bid or ask value.”

      • There is an exception for a de minimis amount of positions. Safe harbor if positions are valued at closer mid-market value than to bid or ask.

      • There is also an exception for physicals traded on a “qualified board or exchange” within the meaning of Section 1256(g)(3). So exception not available for OTC securities, including Treasuries and other debt securities, and equities traded on OTC markets.

      • Valuations must be based on present value of projected cash flows (i.e., can’t take into account cash flows attributable to prior period).

      • No double countingin adjustments (apparently based on concern that credit adjustments take into account default risks already reflected in the discount rate).

Book tax conformity safe harbor part 4

Book/Tax Conformity Safe Harbor, Part 4

  • Applicable Financial Statement :

    • Only US GAAP is acceptable – International Financial Accounting Standards (“IFRS”) or GAAP of another country will not be satisfactory.

    • Creates a hierarchy of financial statements:

      • Financial statements required to be filed with the SEC (e.g., a Form 10K);

      • Financial statements required to be provided to the federal government or any federal agency other than the IRS and that serve a “significant business use”; or

      • Certified financial statements prepared for credit or other investment evaluations or for other substantial non-tax purposes that serve a “significant business use.”

Book tax conformity safe harbor part 5

Book/Tax Conformity Safe Harbor, Part 5

Significant Business Use is served by a financial statement if:

  • (i) statement contains values for eligible positions,

  • (ii) the taxpayer makes significant use of those values in most of the significant “management functions” of the business, and

  • (iii) the use is related to the management of “substantially all” of the taxpayer’s business.

  • “Management Functions” refers to financial and commercial oversight, including senior management review of business unit profitability, risk management, credit risk measurement, compensation, and internal capital allocation.

  • Book tax conformity safe harbor part 6

    Book/Tax Conformity Safe Harbor, Part 6

    Record keeping requirements:

    • Taxpayer must maintain (and be prepared to produce for the IRS upon 30 days notice) detailed book-tax reconciliation schedules, including:

      • “all supporting schedules, exhibits, computer programs, and any other information used in producing the values and schedules, including the documentation of rules and procedures governing determination of the values.”

      • The return of “black box” audits?

    • Records must break the values out on a position by position basis.

      • Some “pooling” is allowed, “if the taxpayer demonstrates that it can compute gain or loss attributable to the sale or other disposition of an individual eligible position.”

      • How to deal with synergies and portfolio effects?

    • Consolidation schedules.

    Current credit liquidity situation

    Current Credit/Liquidity Situation

    • Level 3 valuation

      • What is tax issue?

        • Subjective nature of process

        • Mark to bid for cash positions

        • Extreme illiquidity

        • Liquidity adjustments for derivatives books

      • Use of hindsight by IRS

        • Subjective numbers may be more subject to scrutiny.

    • SIFMA efforts.

    • Treasury’s recent guidance shows a sensitivity to liquidity related issues

      • Section 956/REMIC/Tax-exempt bond guidance

    • What can we expect in way of guidance prior to filing 2007 returns?

    Everything else

    Everything else

    • Overview of Section 475(a)

    • CCA 200817035

    • Best Practices/Common Issues

    Dealer overview 1

    Dealer Overview #1

    • Dealer status determined at entity level.

      • Sometimes securities booked into non-dealer entities.

      • Analysis on a per entity basis.

      • Buy OR sell.

    • Limited ability to ID out of M2M book.

      • To ID out, must be “held for investment” and same-day IDed.

      • Debt can be ID’ed out if “not held for sale”

      • Derivatives generally cannot be ID’ed out by a derivatives dealer.

        • Section 475(b)(4) and Reg. 1.475(b)-1(c) – derivatives dealer cannot ID out “such” securities.

        • What is the meaning of “such”?

    • ID’s are supposed to be done on day 1

      • What if book process is slower?

    Dealer overview 2

    Dealer Overview #2

    • Securities

      • As expected (equities, debt, swaps, certain FX derivatives).

      • Potentially unexpected:

        • Section 1256 contracts EXCLUDED unless properly identified as hedges of things in M2M book.

        • Commitments (including FAS 149 derivatives).

        • Equity in section 267/707 related entities (relevant for CDO equity)

        • Certain partnership equity.

        • Cannot mark own debt (even though can now mark for FAS 159)

        • Business contracts whose value fluctuates with prices of specific securities.

    Dealer overview 3

    Dealer Overview #3

    • Penalty for misidentification

      • If leave something in that is really “held for investment,” M2M timing but character may not be ordinary.

      • If ID something out that is really held for sale to customers, HICOM timing under section 475(d)(2).

    • Contrast with section 475(f) penalty:

      • If leave something in that is really not part of trader business, HICOM timing but ordinary character.

    Cca 200817035

    CCA 200817035

    • Taxpayer “migrated” securities into M2M book by removing tax ID-out with respect to securities.

      • Section 475(b)(3) provides mark-and-freeze mechanic for securities that cease to be “held for investment”

      • The IRS interpreted dealer activities narrowly by looking to section 471 inventory case law for line between “held for sale” and “held for investment”

    Best practices common issues

    Best Practices/Common Issues

    • Tax ID statements

      • Global ID statements fail to reflect either current systems or current intent.

    • FAS 157/159 adoption

      • Tax IDs need to be updated.

      • Migration considerations.

    • Method change considerations

      • Is change in value a change in method of accounting (necessitating 3115)?

      • Change in estimate?

      • Pros and cons?

    Best practices common issues1

    Best Practices/Common Issues

    • Per-se HFI-tax securities

      • Equity in section 267-related entities.

      • Interaction with securitization structures

    • Section 475(f) overlay

      • Does the CCA change the calculus?

    • Section 1236 interaction

      • Linked in section 475(d)(3)

    • Character

      • Ordinary under section 475(d)(3) is limited to securities “held in connection with its activities as a dealer”

    • Trade date/settlement date issues

      • Book increasingly uses “settlement date” accounting

      • If tax uses trade date, can cause a “day one” book/tax basis difference.

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