The IIB was also extremely concerned about the income statement limitation, specifically with regard to the call reports of US branches of foreign banks. A call report is prepared in accordance with US GAAP but does not contain an income statement. Despite the fact that a call report does not contain an income statement of a complete balance sheet, the IIB contends that the call report qualifies as an “applicable financial statement”, and that the method under which mark-to-market values shown on the call report were computed, qualifies as an eligible method.
Arguments discussed in the IIB submission include the following: The preamble to the Proposed Regulations specifically acknowledges that call reports are included in the second category of the definition of applicable financial statement. Further, the IIB asserts that mark-to-market fair values for securities and derivatives that are prepared in accordance with GAAP for the purposes of the call report of a US branch will almost invariably be the same values that are used by the bank to prepare its worldwide financial statements with regard to those securities and derivatives that must be marked to market under its applicable financial reporting standards. There is no reason to believe balance sheets are any less reliable than income statements. The Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation require only call reports (absent income statements) to monitor the safety and soundness of a branch. Like the SIA, the IIB would like the IRS to clarify that a call report qualifies as an applicable financial statement and that the method under which the mark-to-market values shown on the call report were computed qualifies as an eligible method.
The issue of OCI valuations was also addressed during the hearing on Proposed Regulations in comments made by Edward Kleinbard, on behalf of the SIA. Mr. Kleinbard argued that the OCI valuation are supported by regulatory authorities who already police these values, as well as by the internal tension that tends to favor higher valuations due to compensation concerns. The IRS response was that based on “anecdotal evidence”, OCI does not provide the same kind of healthy tension provided by the income statement. Mr. Kleinbard then argued that it is easy to demonstrate that the exact methodologies are applied to security on a trading book or in OCI and that the location (in the trading book or OCI) depends on the bank’s intention with regard to the security. Therefore, as long as the same valuation engine is being used, the values derived should be respected.
Similarly, according to the ABA, the definition of an eligible method should not limit the application of the safe harbour to those mark-to-market adjustments which are recognized through the income statement until a future event, the prior mark-to-market adjustments are transferred from the balance sheet to the income statement. There would be readily auditable information available to support the taxpayer’s mark.
5.2 Bid/Ask limitation
The Proposed Regulations require that except for eligible positions traded on a qualified board or exchange as defined in Sec 1256(g)(7), the valuation method may not result in values that are “at or near” the bid or ask price.
5.2.1 Issue 1
One major objection to this requirement is that it is too broadly applied, in that it does not provide an adequate exception for dealer positions in physical securities. The submissions describe the widespread practice with regard to physical securities in which long positions are marked to bid and shorts to ask. A distinction is drawn between a dealer holding a derivative and one holding a physical security. A derivative dealer intends to hold the derivative indefinitely, while a physical is held for resale to customers. Because of the rapid turnover of dealer inventory in physical securities, the practice of marking long positions to the bid side of the market and short position to the ask side does not lead to significant deferrals of income or loss. The submission also asserts that marking longs to bid and shorts to ask is consistent with inventory valuations under Sec. 471 and consistent with the manner in which the majority of dealers value physical securities for financial accounting purposes.
As a result, the SIA takes the position that many physical securities, including most debt instruments such as US Treasury securities, are traded exclusively (or predominantly) through OTC markets and should be included in the exception for mid-market valuation. The SIA suggests that the exception utilize the broader language of “established financial market” incorporated in the Treas. Reg. Sec 1.1092(d)-1(b) definition, rather than the language of Sec. 1256(g)(7), which limits the exception to the securities traded “on a qualified board or exchange”.
5.2.2 Issue 2
The Proposed Regulation requires that the valuation come out nearer mid-market than bid/ask in order to be eligible for the safe harbour. As a general matter, the SIA submissions questions the assumptions that adjustments bringing the value nearer to bid/asl than mid-market are inappropriate. The SIA argues that disallowing bid/ask valuation is arbitrary. For example, the SIA points out that especially in the case of exotic, illiquid derivatives, a dealer would justifiably mark an unhedged position very near the bid or ask price. Further, the basic premise of the safe harbour is to achieve an administrable audit process by accepting a taxpayer’s valuation, if such values are reported consistently for both tax and important, non-tax purposes. If the methodology produces values closer to bid/ ask than unadjusted mid-market value, the inquiry should be whether these values are being used by the taxpayer for important, non-tax purposes. If they are, the presumption of the safe harbour is that the value is trustworthy.
The SIA also contends that monitoring compliance with the “nearer to mid” requirement would be difficult. First, a net value for each component of a dealer’s portfolio would have to be determined on a position-by-position basis. This would be problematic because dealers make value determinations and adjustment on a portfolio basis. Further, dealers do not retain records of bid-asl spreads for any meaningful period of time. Therefore, dealers’ internal data retention systems would have to be revised.
The ABA’s submission states that the safe harbour should allow the use of bid/ask as long as they are consistently applied. Dealers should be allowed to mark securities subjects to Prop. Reg. 1 475(a)-4, to either bid, ask, or mid-market value while requiring that the dealer mark all instruments subject to the regulation consistently. As long as all instruments are marked consistently, regardless of whether the dealer is the buyer or the seller of the swap, the value of all income attributable to the “synthetic annuity” is effectively brought into taxable income currently.