On 12 June 2007, the Internal Revenue Service (IRS) published long-anticipated final safe harbour rules for the valuation of securities and commodities for Sec. 475 mark-to-market accounting purposes. The final regulations are a culmination of a process that formally began in 2003 and involved significant industry participation. This article explores the rule-making process by examining the original stated objective of the IRS and the Treasury Department.
This article will also examine industry input regarding the business and accounting practices of the taxpayers involved. The final regulations implementing the original objectives, as defined by public comments, are discussed as well.
Prior to the enactment of Sec. 475, a securities dealer was allowed to value its inventory of securities based on the cost of the securities, the lower of coast or market (LCM) value of the securities, or the market value of the securities. According to the legislative history of Sec. 475, mark-to-market treatment was required for dealers in securities because “[t]he committee believes that the cost method and the LCM method generally understate the income of securities dealers and that the mark-to-market method most clearly reflects their income. Additionally, the House Report states that inventories of securities are easily valued at year-end and are currently valued at market by securities dealers in determining their income for financial statement purposes.
Sec. 475(a) requires dealers in securities to mark their securities to market. Sec 475(e) and (f) allow dealers in commodities and traders in securities or commodities to elect similar treatment for their securities or commodities. If the security or commodity is held as inventory, it must be included in inventory at its fair market value. If it is not inventory and is held at the end of the taxable year, gain or loss is recognized as if the security or commodity has been sold at its fair market value on the last business day of the taxable year
When Code Sec. 475 was enacted in 1993, the House-Senate Conference Report stated that:
“The conference agreement does not provide any explicit rules mandating valuation methods that are required to be used for purposes of applying the mark-to-market rules. However, the conferees expect the Treasury Department will authorize the use of valuation methods that will alleviate unnecessary compliance burdens for taxpayers and clearly reflect income for tax purposes.”
As many in the securities industry have argued, a simplified method of valuation was anticipated that would serve as guidance for valuation of securities and commodities that would reduce the administrative burdens on those marking to market.
While such guidance may been anticipated, it was not immediately forthcoming. In 1995 the IRS announced that it had undertaken a project in conjunction with the Los Alamos National Laboratory to create software models capable of calculating values for over-the-counter derivatives positions. In the 1997 the IRS indicated that its project was put on hold, and the valuation model was never completed. Concerned by the continuing lack of valuation guidance, major players in the securities industry urged the IRS and Treasury to issue guidance under Sec. 475 to permit securities dealers to value derivatives the same way for both accounting and tax purposes. For example a 1999 ISDA submission stated:
“ISDA believes that rules permitting reasonable methods of valuing derivatives are necessary to effect Congressional intent, as expressed in the legislative history of Sec. 475. As Congress recognized, the absence of guidance will result (and already has resulted) in unnecessary compliance burdens for taxpayers and the IRS; these burdens include disputes on audit about the values of particular positions or the property of particular approaches to valuation.”