5.3 Requirement of GAAP
There were a number of submissions that criticized the safe harbour’s limitations to financial reports prepared in accordance with US GAAP, as opposed to the GAAP of a non-US jurisdiction. The SIA asserts that insistence on a US GAAP requirement is flawed because it makes the safe harbour unavailable to foreign financial institutions which are required to pay taxed on US dealers operations, but which file their financials under the GAAP of another non-US jurisdiction. The SIA suggests that the IRS identify non-US jurisdictions with mark-to-market financial accounting that would be considered acceptable for purposes of the safe harbour. However, the SIA does not want to delay final regulations on the safe harbour, and recommends that the IRS reserve the right to identify non-US GAAP jurisdictions that employ mark-to-market financial accounting and identify those that are considered acceptable for purposes of the safe harbour. The ISDA concurs and contends that the regulations should allow the IRS to permit non-US GAAP methods that are sufficiently consistent with US GAAP.
The IIB submissions advocate drafting the regulations to eliminate the disparate treatment of US and internationally headquartered financial institutions. Mark-to-market valuations under International Financial Reporting Standards (IFRS) and other non-US GAAP financial reporting standards that have been reconciled to US GAAP in SEC filing, should be acceptable financials for purposes of the safe harbour.
The IIB contends that the safe harbour should be qualified with regard to US branches of foreign banks, as well as foreign-based financial institutions that conduct trading activities in securities and commodities which are eligible to a mark-to-market elections under Sec. 475(f) through unregulated US subsidiaries that do not prepare US GAAP financial statements. The IIB argues that several financial institutions currently file annual reports with the SEC based on non-US GAAP. Such reports require a footnote reconciliation statement. According to the IIB, the IIB is not aware of any situation in which an adjustment to conform the fair value of the marked-to-market securities and derivatives positions to US GAAP, was deemed necessary by accountants or the SEC. Therefore, the IIB argues that no reconciliation is required for securities and derivatives that are marked to market because the accounting is consistent and no adjustments need be made.
Many of the IIB’s arguments were reiterated in the Treasury Department Hearing. Because of the complexity of the issues involved, Treasury officials were reluctant to be put in the position of determining “whether a particular country’s ‘ foreign GAAP’ is similar to US GAAP and whether the implementation is similar. It was suggested that proponents of the acceptance of the use of non-US GAAP for purposes of the safe harbour, do research and comparisons and provide information to the Treasury regarding differences in the mark-to-market methodology of the various GAAP systems. The idea of having a Big Four accounting firm provide a certification or attestation that foreign GAAP is the same as US GAAP for fair value reporting was also raised.
5.4 Scope of information required
According the SIA, the scope of information to be provided is too broad. The SIA suggests that the audit not extend to review of a taxpayer’s valuation methodology, but instead should be limited to information needed to established book/tax conformity and to establish that a taxpayer’s valuations meet the requirements of the safe harbour. Therefore, a taxpayer should be able to satisfy the requirements of the safe harbour by providing information demonstrating how values are used, rather than how they are produced.
In a hearing on the Proposed Regulations, SIA representative Mr. Edward Kleinbard also argued that it is not practical to require that dealers retain a five-year old valuations engine, as valuations engines are constantly being refined and adjusted. In response, the IRS contended that it would not be an unreasonable burden to save a computer program and run it a few years later. The IRS wants a valuation engine retained so that if an issue comes up later, it will be available to prove that valuations were appropriate.
The SIA also takes issue with the requirement that taxpayers demonstrate that they could compute gain and loss with regard to each individual position. The intention of the IRS is to ensure that portfolio valuation adjustments relate to the specific terms and characteristics of the individual positions of the portfolio, and do not constitute some sort of general reserve account that could be arbitrarily applied to any collection or positions or could give rise to double counting of risks or other factors affecting the value of the portfolio. However, dealers routinely make portfolio valuation adjustments in order to take account of synergies or negative synergies that arise from a combination of positions and risks held within a given portfolio. As a result, any allocation of these adjustments to particular positions within the portfolio is arbitrary and artificial. Therefore, the SIA advocates allowing a taxpayer to document various individual elements of the portfolio that give rise to a portfolio valuation adjustment. As a result, a dealer would be required to maintain documentation establishing the economic justification of a portfolio valuation adjustment, and would not force a taxpayer to demonstrate that it can compute gain or loss attributable to the sale or other disposition of an eligible position.
The SIA requests that the 30-day period for providing information to the Commissioner be increased to 60 days. The SIA argues that much of the information requested will be too complex, and will place too great a burden on the taxpayer’s internal systems, for they taxpayers and the IRS to be assured that such information will be available within the 30-day period. The ISDA agrees with this position, as well.
6. Final Regulations
The final safe harbour regulations were reported in the Federal Register on 12 June 2007. The preamble indicates that the underlying principles of the safe harbour are based on the business model for derivatives based on comments received in response to the ANPRM and NPRM. Echoing the submission of the SIA, the preamble to the Final Regulations goes on to describe the business model of derivatives dealers. The model describes dealers seeking to enter into balanced portfolios for their derivatives, carrying offsetting positions which remain on the dealers’ books over the term of the positions. The difference between the bid and ask prices creates a synthetic annuity which is appropriately taxed in the year it is created. With regard to physical securities, except for those acquired at the end of the year, the acquisitions of a physical securities occur in the same taxable year, such that the effect of capturing a bid/ask spread also occurs entirely within that year. As a result, for securities traded on a qualified board or exchange as defined by Sec. 1256(g)(7), there is little difference between the results of realization and mark-to-market accounting, and little opportunity for manipulation.
6.1 Eligible taxpayers
The safe harbour applies only to dealers in securities and dealers in commodities. As the Treasury Department and the IRS did not receive information regarding the business model for traders and how the limitations set forth in the NPRM would apply to traders, the Treasury Department and the IRS determined that it would be unwise to include traders in the safe harbour at this time.
6.2 Eligible positions
In order to keep the Final Regulations flexible and dynamic in the future, a list of eligible securities will be issued concurrently with the final regulations. Rev. Proc. 2007-41 provides that the definition of securities includes those securities defined in Sec. 475(c)(2), and the definition of commodities is contained in Sec. 475(e)(2)