Similar sentiments were expressed by the Securities Industry Association (SIA), urging the Treasury to give priority to the issuance of guidance concerning the valuation of securities under the mark-to-market rules of Sec. 475. Organizations like the American Bar Association (ABA), as well as individuals from major accounting firms and academia, also submitted letters to the IRS urging regulations allowing for book-tax conformity under Sec. 475.
On the judicial front, the first major case to focus on the proper valuation of a derivative dealer’s portfolio was Bank On Corp. v. Commissioner. At issue in Bank One was whether the bank properly valued its derivatives portfolio for purposes of mark-to-market accounting. The developments in Bank One were closely watched by members of the securities industry, and most major players were involved in the submission of an amicus curiae brief to the court hearing the Bank One case. While the outcome of the case is still being parsed by commentators, it appears that the Tax Court relied heavily on its own witnesses and prescribed its own method of accounting that does not comport with that of the IRS or of the defendant.
In light of the increasing uncertainty regarding the definition of fair value, exacerbated by judicial involvement, the IRS indicated its intent to address the issue directly. On 5 May 2003, the same day the Tax Court issued its option in Bank One, the IRS issued an Advance Notice of Proposed Rulemaking (ANPRM). The IRS provided the Tax Court with advance knowledge of the planned notice. In the Notice, the IRS and the Treasury Department expressed their intent to publish a Notice of Proposed Rulemaking (NPRM) for valuing securities and commodities. The stated intent of the NPRM was to reduce the administrative burdens on both taxpayers and the IRS of determining fair market value under Sec. 475. To that end, the IRS and the Treasury Department were considering proposed rules that would permit values used in financial statements to be used on a tax return, and would provide an elective safe harbour for valuing securities and commodities.
2. Advance Notice of Proposed Rulemaking
According to the ANPRM, three broad principles guide eligibility for safe harbour. The mark-to-market methodology used must be sufficiently consistent with the mark-to-market methodology used under Sec. 475. The financial statement must be one that gives the taxpayer a strong incentive to report values fairly. Finally, the taxpayers, if requested, must provide information necessary to verify the relationship between the values reported on the financial statement and the values used for purposes of Sec. 475. Each of these requirements is discussed in more detail below.
2.1 Consistency requirements
As a general matter, any mark-to-market methodology used on a financial statement submitted for financial purposes would have to be sufficiently consistent with the requirements of the mark-to-market methodology used for Sec. 475. This consistency requirement was defined to mean that securities and commodities must be valued as of the last day of the taxable year, gains and losses arising from changes in value must be recognized into income each year, and gain or loss on disposition must be computed by reference to the value at the end of the prior year.
The IRS solicited comments regarding differences between mark-to-market for financial reporting and Sec. 475 and how those difference should affect the safe harbour. The IRS was also interested in whether generally accepted accounting principles (GAAP) should be used as a proxy for fair market value for tax purposes. Other areas that the Notice was specifically concerned with were the valuation of securities at the bid price and downward adjustments from mid-market values for future expenses, as well as redundant downward adjustment for credit risk. The IRS sought information on the types of adjustments currently used for financial statement purposes, and explanations of these adjustments. The authors of the Notice were also concerned with the consideration by the Financial Accounting Standard Board (FASB) of fair value reporting of derivatives, the valuation of the projected cash flows and any impact that this has on how taxpayers are reporting valuation adjustments for fair value purposes.