6.3 Eligible method
The four core requirements of a financial accounting method are retained (e.g mark-to-market as of the last day of the taxable year, recognize into income any gain or loss from marking eligible positions to market, recognize into income on the income statement any gain or loss on disposition of an eligible position as if a year-end mark occurred immediately before the disposition, and values must be determined using US GAAP.) In addition, the three limitations imposed by the NPRM are retained as well (method may not result in values at or near bid or ask values, method may not take into account items of income or expense attributable to a period occurring on or before the valuation date, no cost or expense may be accounted for more than once, either directly or indirectly).
According to the IRS and the Treasury, the majority of the comments received concerned the core requirements and the limitations for eligible methods.
6.3.1 Income statement requirement: Treas. Reg. Sec. 1.475(a)-4(d)(2)(ii)
Submissions suggested that the requirement that taxpayers be allowed to report change in value on their income statement, be expanded to allow values to be reported on their balance sheet because both are rigorously reviewed. The submissions also argued that because certain categories of comprehensive income do not generally appear on the balance sheet, the methodology used by many taxpayers for financial reporting would fail to be an eligible method and would not satisfy the safe harbour.
The Treasury Department and the IRS declined to allow values reported on a balance sheet to be used to satisfy the safe habrour. According to the IRS. values reported on an income statement sheet are inherently reliable because change in value reported on an income statement also appears in retained earnings and in earnings per share. Therefore, the tension created between the benefits of higher earnings for financial reporting, ensures reliability for tax purposes. As balance sheet items lack this tension, they are not as reliable as balance sheet items and are therefore not included in the safe harbour.
6.3.2 Bid/ask limitation
Comments suggested that the bid/ask limit be eliminated in order to make it easier for taxpayers to qualify for the safe harbour. It was argued that taxpayers do not retain records of spreads for meaningful period of time and that it would be burdensome to monitor the spreads. With regard to comments regarding burdensome record keeping requirements, the IRS and Treasury responded that the Final Regulations do not impose an additional record-keeping burden that is not already required by other sections of the code.
Comments also reflected a concern with whether one position running afoul of the bid/ask method or whether failing for a particular position would require the taxpayer to prove that the method consistently produces values nearer to mid-market than to bid or ask. In response, the preamble explains that the Final Regulations clearly indicated that a method may occasionally produce a value that is nearer to bid/ask than mid-market, and that this will not preclude the use of the safe harbour.
Commentators also sought a broader definition of exchange-traded positions that would encompass exchange-traded positions defined by reference to Treas. Reg. Sec. 1.1092(d)-1(b), rather than using the definition provided in Sec. 1256(g)(7). The IRS response is that the definition contained in Treas. Reg. Sec. 1.1092(d)-1(b) was part of an anti-abuse provision and was therefore intentionally broad. As a result, the IRS does not want to use the definition contained because it might “inappropriately except too many positions from the general bid-ask limitation.
With regard to the inclusion of debt instruments within the exception to mid-market valuation, the argument was made by commentators that debt instruments should be excepted from the bid/ask limitation as well. A dealer’s business model generally is to turn over debt securities very rapidly, and dealers have a strong economic incentive to do so because holding debt securities consumes balance sheet resources and poses risk management issues. The Treasury and IRS argue that they do not possess sufficient information to conclude that spreads in the OTC debt markets are de minimis. The Treasury is also concerned with debt instruments being used to lock in spreads involving other derivatives instruments which may run contrary to the tenets of the dealer business model for derivatives. In addition, there may be tax-motivated distortion in the marketplace with taxpayers seeking to lock in spreads with tax-advantaged instruments, rather than with instruments selected on the basis of their non-tax economics attributes.
6.3.3 Applicable financial statements
The main concern of commentators was that US GAAP is too narrow and that if financial statements were prepared which were substantially similar to US GAAP, they should be accepted for purposes of the safe habrour. The US GAAP requirement is retained, as it has been determined that the limitations of the safe harbour ensure sufficient consistency when applied with US GAAP. It is not clear that one would arrive at the same conclusion when looking at statements prepared under other regimes.
The IRS acknowledges the importance of making it practical for foreign banks to use the Sec. 475 safe harbour for their US branches. Therefore, the IRS and Treasury intend to resist the matter and seeks help from the industry with regard to the following issues.
First, should the safe harbour require that the values reported in the call report of the foreign bank be the same values that are reported in the income statement filed in the foreign bank’s home country? If so should the foreign bank, together with its certifies independent registered public accountant, file with the US tax return, subject to penalties of perjury, a statement to that effect? Further, must the foreign country have formally adopted International Financial Reporting Standards as published by the International Accounting Standards Board?
Second, should the valuation standards uses in a foreign bank’s home country be identical to the valuation standards under US GAAP, and if not identical, in what ways may they differ? Should the foreign bank and its certified independent registered public accountant file a statement with the US tax return describing the differences?
Third, should the income statement filed by the foreign bank be filed with the foreign bank’s home country bank regulatory authority (as distinct from a market regulatory authority like the Sec)?
Fourth, for purposes of these questions, should the term “home country” mean the country in which the foreign bank is chartered or incorporated?
The Treasury appears to have heeded the industry submissions arguing that the safe harbour should be extended to cover foreign banks without delaying the finalization of the safe harbour regulations while the issue is further studied. The extensive list of questions appears to indicate a willingness by the Treasury and the IRS to resist the safe harbour so as to broaden its application, at least to some extent, to include foreign banks, as well.