3.4 Related-party transactions
The ISDA asserts that the safe harbour can and should apply to related-party transactions. According to the ISDA, with regards to OTC derivatives contracts between related parties, dealers generally value such contracts in the same way they value third-party contracts under the adjusted mid-market method, absent credit adjustments. According to the submissions, there is no evidence that related-party transactions receive less regulatory scrutiny than third-party transactions. The ISDA suggests that if the IRS concludes that Sec. 482 is not adequate to prevent potential abuse in the related-party transactions, it could require that related-party contracts generally be valued under the same methodology as third-party contracts, but disregarding certain adjustments such as credit adjustments which will generally have the effect of increasing values.
As an initial matter, the SIA recommends that Sec. 482 be used when a taxpayer’s methodology for valuing transactions with related parties is different to that used for transactions with unrelated parties. The submission indicates the valuation methods will not change merely because the transactions valued is eliminated under GAAP consolidation rules. Requiring consistent valuation methodologies for eliminated and non-eliminated positions would be appropriate and completely consistent with current practice.
3.5 Record keeping
The ISDA is concerned that the scope of record to be retained under the safe harbour is overly broad. According to the ISDA, the IRS’ “verification should be limited to confirming book tax conformity and the presence of the required non-tax business use”. The IRS would be able to accomplish this by tracing to the ledger entries and making sure that values are properly reflected in financial statements. Verification should not require an examination of the specific techniques by which the financial statement values were determined in accordance with GAAP.
The SIA supports the three requirements for verification enumerated by the ANPRM. They strongly recommend that the IRS enter into specific information agreements with individual dealers to account for differences in operational and accounting systems of different dealers. The SIA further suggests that an Accelerated Issue Resolution (AIR) programme will be helpful in identifying appropriate procedures in identifying areas of difficulty. The submissions also addressed concerns raised by the IRS and the Treasury Department regarding pooling and deconsolidation.
According to the SIA’s submission, the unadjusted mid-market value is calculated for each individual security and derivatives position and is posted to a security sub-ledger. If security is disposed of in the following year, it would not appear in the sub-ledger and would be verifiable. Adjustments to the initial values would be made on a portfolio basis in the securities sub-ledger. The securities sub-ledger then calculates the adjusted profits and loss and trial balances for all derivatives positions, which are posted to the firm’s general ledger. The numbers are then used for all purposes, including financial reporting, risk management, and compensation, as well as tax reporting. The IRS can also verify that the procedures used take into account positions that are disposed of during the year. The IRS can also verify that the adjustments are posted to the general ledger and that no M-1 adjustments are made to these values in calculating taxable income. As each taxpayer’s operations and accounting systems are unique, the SIA suggests agreements with dealers regarding the relevant records that need to maintain and the scope of the verification process.
The ISDA makes parallel arguments and takes the position that each element of adjusted mid-market value can be verified. The IRS need not verify the computation of gain or loss on a position-by-position basis in order to administer the safe harbour. If conformity is absent, it will be reflected in a Schedule M adjustment.
Similarly, with regard to deconsolidation, the ISDA does not believe that the IRS will encounter verification difficulties. Under GAAP, fair value is still determined for transactions between entities that are consolidated for financial reporting purposes, and those values are reflected in the appropriate sub-ledgers and other supporting documentation, the IRS can identify the fair market value that should be used in order to comply with Sec. 475.
The SIA submission makes the same argument and provides additional technical details. It explains that under FAS 133, fair value is determined for each mark-to-market positions held by a dealer and is entered into a sub-ledger regardless of whether one or more of those positions will later be eliminated under the consolidation rules. The fair values of eliminated transactions are subsequently entered into a special elimination account.
Therefore, the SIA asserts, it will be possible through inspection of the relevant sub-ledgers to determine a GAAP fair value that may then serve as “fair market value” for tax purposes. Further, the SIA does not object to specific agreements between individual dealers and the IRS, but anticipates that they be used in that they be used in special cases, and the IRS should provide a set of reasonable record retention requirements.