Taking into consideration submissions regarding how dealers profit from bid/ask spreads, the IRS recognizes that as a general matter, dealers attempt to enter into positions that, in the aggregate, offset each other. The Proposed Regulations incorporate the description used by commentators characterizing the typical dealer’s balanced portfolio as “creating a synthetic annuity”. As a result, use of the bid/ask value does not cause recognition of the present value of the synthetic annuity in the taxable year the annuity is created. Thus, the regulations require that values used must be closer to mid-market to be respected and may not be at or near bid/ask values.
The Proposed Regulation provides an excerption for eligible positions that are traded on a qualified board or exchange as defined in Sec. 1256(g)(7), which may be valued at bid/ask. Recognizing the business model supplied by the industry comments, an exception is made for dealers in “physical”, as distinct from dealers in derivatives. As explained in the submissions, a dealer in physicals does not create a synthetic annuity, resulting in deferral of income. Rather, a dealer in physicals turns over its securities inventory rapidly which precludes significant deferral of income.
If the valuation method is based on the present value of projected cash flows from an eligible position or positions, the method must not take into account any cash flows of income or expense that are attributable to a period or time before the valuation date. This provisions is intended to prevent items of income or expense from being double counted, i.e through current realizations and then at the mark.
No cost or risk may be accounted for more than once, either directly or indirectly. For example, if computation of the present value of cash flows uses a discount rate that already takes into account credit risk, a special adjustment which accounts for credit risk may not then be applied. The IRS appears to be particularly concerned with redundant credit adjustments.
4.4 Financial statements and business use
An eligible taxpayer’s applicable financial statement for a taxable year is the taxpayer’s primary financial statements. In order to assist taxpayers in determining which financial statements qualify for the safe harbour, three categories of acceptable financial statements are listed, in order of priority:
- financial statements that must be filed with the SEC;
- financial statements the must be filed with the US government or any of its agencies other than the IRS. This includes statements filed by foreign-controlled financial institutions engaged in a US trade or business, which report their mark-to-market results to the Federal Reserve or the Office of the Comptroller of the Currency; and
- certified audited financial statement provided for substantial non-tax purposes.
For a financial statement in any of the above categories to qualify as an applicable financial statement, it must be prepared in accordance with US GAAP. The preamble indicates that statements filed with the SEC provide a high degree of confidence that the values used in those statements reflect reasonable approximations of fair value. Therefore, there are no additional business use requirements for such financials. However, for categories (2) and (3), the additional requirement of significant non-tax use in the taxpayer’s business is imposed. The requirement of significant business use is fulfilled if:
- the financial statement contains values for eligible positions;
- the eligible taxpayer makes significant use of financial statements values in most of the significant management functions of the business; and
- such use is related to the management of all or substantially all of the eligible taxpayer’s business.