Safe Harbor for Valuation Under Section 475, 29663-29671 [05-10167]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 99 (Tuesday, May 24, 2005)]
[Proposed Rules]
[Pages 29663-29671]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-10167]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-100420-03]
RIN 1545-BB90


Safe Harbor for Valuation Under Section 475

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document sets forth an elective safe harbor for dealers 
in securities, dealers in commodities, and traders in securities and 
commodities that permits these taxpayers to make an election pursuant 
to which the values of positions reported on certain financial 
statements are the fair market values of those positions for purposes 
of section 475 of the Internal Revenue Code. This safe harbor attempts 
to reduce the compliance burden upon taxpayers and to improve the 
administrability of the valuation aspect of section 475 for the 
Internal Revenue Service. This document also provides a notice of a 
public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by August 22, 
2005. Outlines of topics to be discussed at the public hearing 
scheduled for September 15, 2005 at 10 a.m. must be received by August, 
23, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-100420-03), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
100420-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the IRS 
Internet site at https://www.irs.gov/regs or via the Federal eRulemaking 
Portal at https://www.regulations.gov (IRS-REG-100420-03).

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments, 
the hearing or to be placed on the building access list to attend the 
hearing, Treena Garrett at (202) 622-7180; concerning the proposals, 
Marsha A. Sabin or John W. Rogers III (202) 622-3950 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer of the 
Department of Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collection of information should be received by 
July 25, 2005. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of the 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec.  1.475(a)-4(f)(1)and Sec.  1.475(a)-4(k). This

[[Page 29664]]

information is required by the IRS to avoid any uncertainty about 
whether a taxpayer has made an election and to verify compliance with 
section 475 and the safe harbor method of accounting described in Sec.  
1.475(a)-4(d). This information will be used to facilitate audits and 
to determine whether the amount of tax has been calculated correctly. 
The collection of the information is required to properly determine the 
amount of income or deduction to be taken into account. The respondents 
are sophisticated dealers or traders in securities or commodities.
    Estimated total annual recordkeeping burden: 49,232 hours.
    Estimated average annual burden per recordkeeper: 4 to 6 hours.
    Estimated number of recordkeepers: 12,308.
    Estimated frequency of recordkeeping: Annually.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may be material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 475 of the Internal Revenue Code (Code). Section 475 was added 
to the Code by section 13223(a) of the Omnibus Budget Reconciliation 
Act of 1993 (Pub. L. 103-66, 107 Stat. 312). Section 475(a) generally 
provides that the securities held by dealers in securities shall be 
valued as of the last business day of the year at fair market value. 
Section 475(g) provides that the Secretary shall prescribe regulations 
as may be necessary or appropriate to carry out the purposes of section 
475. The legislative history of section 475 indicates that, under this 
authority, the Secretary may issue regulations to permit the use of 
valuation methodologies that reduce the administrative burden of 
compliance on the taxpayer but clearly reflect income for federal 
income tax purposes. On May 5, 2003, the Treasury Department and the 
IRS published in the Federal Register an Advance Notice of Proposed 
Rulemaking (Safe Harbor for Satisfying Certain Statutory Requirements 
for Valuation under Section 475 for Certain Securities and 
Commodities)(REG-100420-03)[68 FR 23632](the ANPRM); Announcement 2003-
35, 2003-1 C.B. 956 (see Sec.  601.601(d)(2)). The ANPRM solicited 
comments on whether a safe harbor approach using values reported on an 
applicable financial statement for certain securities may be used for 
purposes of section 475. The ANPRM set forth a possible safe harbor for 
valuing these securities and asked for comments on various aspects of 
such a safe harbor.

Explanation of Provisions

Overview

    Section 475(a) requires dealers in securities to mark their 
securities to market. Sections 475(e) and (f) allow dealers in 
commodities and traders in securities or commodities to elect similar 
treatment for their securities or commodities. If the security or 
commodity is inventory, it must be included in inventory at its fair 
market value, and if it is not inventory and is held at the end of the 
taxable year, gain or loss is recognized as if the security or 
commodity had been sold for its fair market value on the last business 
day of the taxable year.
    Although the term ``fair market value'' has a long-standing and 
well-established meaning within the tax law, it is sometimes difficult 
to determine the fair market value of certain securities and 
commodities, particularly those that have no comparable sales. This has 
impeded the efficient administration of the mark-to-market system under 
section 475. Consequently, with a view to improving the 
administrability of the valuation requirements of section 475, the 
Treasury Department and the IRS issued the ANPRM, which set forth some 
principles upon which a safe harbor for valuation could be constructed. 
Using these principles, and incorporating a number of comments received 
from the public, these proposed regulations set forth a safe harbor for 
valuing securities and commodities under section 475.

Safe Harbor

    The safe harbor generally permits eligible taxpayers to elect to 
have the values that are reported for eligible positions on certain 
financial statements treated as the fair market values reported for 
those eligible positions for purposes of section 475, if certain 
conditions are met. The safe harbor is based upon the principle that if 
the mark-to-market method used for financial reporting is sufficiently 
consistent with the mark-to-market method required by section 475, then 
the values used for financial reporting should be acceptable values for 
purposes of section 475, even if those values are not fair market 
values under general tax principles. To ensure minimal divergence from 
fair market value under tax principles, these proposed regulations 
impose certain restrictions on the financial accounting methods and 
financial statements that are eligible for the safe harbor and also 
require certain adjustments to the values of the eligible positions on 
those financial statements that may be used under the safe harbor.
    The safe harbor requires that financial statement values be 
adjusted to comply with the requirements of section 482 or section 482 
principles when applicable. For example, section 482 principles may 
require the revision of estimates of future cash flows used in valuing 
certain financial instruments to reflect the appropriate arm's length 
pricing of inter-branch transactions as of their origination date. In 
addition, these proposed regulations do not alter the treatment of 
interest expense. See sections 861 and 882 and regulations thereunder.

Eligible Taxpayers and Eligible Positions

    The safe harbor is available to any taxpayer subject to the mark-
to-mark regime under section 475, whether the taxpayer is a dealer in 
securities under section 475(a), a dealer in commodities under section 
475(e), or a trader in either securities or commodities under section 
475(f). The Commissioner will issue a revenue procedure that lists the 
types of securities and commodities that are subject to the safe 
harbor. It is anticipated that the revenue procedure will apply to 
every security position and every commodity position subject to mark-
to-market under section 475. Comments are requested as to whether any 
types of securities or commodities should be excluded from the safe 
harbor.
    It is important to note, however, that the valuation methodology 
under the safe harbor applies only for positions that are properly 
marked under section 475. The safe harbor only addresses valuation and 
does not expand or contract the scope of application of section 475. 
For example, if a security is not marked under section 475 because it 
has been identified as held for investment, then under the safe harbor 
it may not be marked for Federal income tax purposes even though it is 
properly marked on the financial statement in accordance with U.S. 
Generally Accepted Accounting Principles (U.S. GAAP). Similarly, if a 
security is not marked on the applicable financial

[[Page 29665]]

statement because it is a hedge but section 475(a) applies because the 
security was not identified as a hedge, then the security must still be 
marked under section 475.

Eligible Method

    To qualify for the safe harbor, a financial accounting method must 
satisfy certain basic requirements. First, it must mark eligible 
positions to market through valuations made as of the last business day 
of each taxable year. Second, it must recognize into income on the 
income statement any gain or loss from marking eligible positions to 
market. Third, it must 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. Fourth, it must 
arrive at fair value in accordance with U.S. GAAP.
    In addition to the basic requirements, the safe harbor also imposes 
certain limitations that ensure minimal divergence from fair market 
value. Under the first limitation, which applies only to securities and 
commodities dealers, except for eligible positions that are traded on a 
qualified board or exchange (as defined in section 1256(g)(7)), the 
financial accounting method must not result in values at or near the 
bid or ask values, even if the use of bid or ask values is permissible 
in accordance with U.S. GAAP. This limitation is based upon the 
business model for derivative contracts held by dealers in those 
derivatives, the model underlying most of the public comments received 
in response to the ANPRM.
    According to the comments, dealers seek to capture and profit from 
bid-ask spreads by entering into positions that, in the aggregate, 
offset each other. The bid-ask spread contains the dealer's profit and 
compensates the dealer for all risks and expenses. The origination of 
such a balanced portfolio may, therefore, be seen as creating a 
synthetic annuity, with a value that is largely immune from market-
related changes in the values of the component securities. For these 
eligible positions, such as interest rate swap contracts, use of bid or 
ask values approximates realization accounting and, therefore, fails to 
cause recognition of the present value of the synthetic annuity in the 
taxable year that the annuity is created. Consequently, the valuation 
method described in Sec.  1.471-4(a)(1) generally fails to satisfy the 
limitation set forth in paragraph (d)(3)(i) of these proposed 
regulations.
    The Treasury Department and the IRS request comments on whether 
dealers in commodities and traders in either securities or commodities 
operate under different business models and on how the rules set forth 
in these proposed regulations should be modified, if at all, to 
accommodate those business models.
    Under the second limitation, if the method of valuation consists of 
determining the present value of projected cash flows from an eligible 
position or positions, then 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 limitation ensures that items of 
income or expense will not be accounted for twice, first through 
current realization and then again in the mark.
    Under the third limitation, no cost or risk is accounted for more 
than once, either directly or indirectly. For example, a financial 
accounting method that allows a special adjustment for credit risk 
generally satisfies this limitation. It would not satisfy this 
limitation, however, if it computed the present value of projected cash 
flows using a discount rate that takes into account any amount of 
credit risk that is also taken into account by the special adjustment. 
Thus, if a dealer in securities enters into an interest rate swap 
contract with a counterparty with a AA/aa rating, taking credit 
enhancement and netting agreements into account, then the dealer cannot 
take a special adjustment to the value of the contract for all of the 
risk between a counterparty with a risk-free rating and the actual 
counterparty if the dealer determines the present value of projected 
cash flows from the contract using a mid-market swap curve based upon 
the LIBOR AA rate. The Treasury Department and the IRS understand, 
however, that there may be degrees of credit quality within an 
established rating level, such as AA/aa, and that valuation 
methodologies used currently may reflect these nuances in credit 
quality. Accordingly, a credit adjustment reflecting these nuances may 
satisfy this limitation.

Election and Revocation

    The election to use the safe harbor is made by filing a statement 
with the taxpayer's timely filed Federal income tax return for the 
taxable year for which the election is first effective. The statement 
must declare that the taxpayer makes the safe harbor election for all 
of its eligible positions. In addition to any other information that 
the Commissioner may require, the statement must describe the 
taxpayer's applicable financial statement for the first taxable year 
for which the election is effective and must state that the taxpayer 
agrees to timely provide upon the request of the Commissioner all 
information, records, and schedules required by the safe harbor. The 
election continues to be in effect for all subsequent taxable years 
unless it is revoked.
    A taxpayer cannot revoke the election without the consent of the 
Commissioner. The Commissioner, however, can revoke the election if the 
taxpayer fails to comply with any of the recordkeeping and production 
requirements and cannot show reasonable cause for the failure, the 
taxpayer ceases to use an eligible method, the taxpayer ceases to have 
an applicable financial statement, as described below, or the taxpayer 
holds a de minimis quantity of eligible positions that are subject to 
the safe harbor. No revocation is necessary if the taxpayer ceases to 
qualify as an eligible taxpayer, or section 475 does not otherwise 
apply, because the safe harbor may only be used to determine values and 
cannot be used unless section 475 applies. Once revoked by either the 
Commissioner or the taxpayer, neither the taxpayer nor any of its 
successors may make the election for any taxable year that begins 
before the date that is six years after the first day of the earliest 
taxable year affected by the revocation without the consent of the 
Commissioner.

Applicable Financial Statements

    Not all financial statements qualify under the safe harbor. 
Consequently, these proposed regulations set forth a system that 
enables a taxpayer to determine which one of its financial statements, 
if any, may be used when applying the safe harbor.
    Three categories of financial statements qualify under the safe 
harbor and are set forth in order of priority, from highest to lowest. 
In the first and highest category are those financial statements that 
must be filed with the Securities and Exchange Commission (SEC), such 
as the 10-K and the Annual Statement to Shareholders. In the second 
category are those financial statements that must be provided to the 
Federal government or any of its agencies other than the IRS. In this 
category are statements filed by foreign-controlled financial 
institutions engaged in trade or business within the United States who 
report their mark-to-market results to the Federal Reserve or the 
Office of the Comptroller of the Currency. In the third category are 
certified audited financial statements that are provided to creditors 
to make lending decisions, that are provided to equity holders to 
evaluate their

[[Page 29666]]

investment, or that are provided for other substantial non-tax purposes 
and are reasonably anticipated to be directly relied on for the 
purposes for which the statements were created. For a financial 
statement described in any of the three categories above to qualify as 
an applicable financial statement, it must be prepared in accordance 
with U.S. GAAP. If a taxpayer has two statements in the same category, 
each of which would qualify under the safe harbor, then the statement 
that results in the highest aggregate valuation of eligible positions 
is the only financial statement that may qualify for the safe harbor.
    Statements filed with the SEC provide a high degree of confidence 
that the values used on those statements reflect reasonable 
approximations of fair value. Consequently, there are no additional 
business use requirements for those statements. For the second category 
(statements filed with other agencies of the Federal government) and 
the third category of statements (the other certified audited financial 
statements), this degree of confidence is ensured by requiring some 
substantial non-tax use in the taxpayer's business. This determination 
of use must take into account whether the taxpayer's reliance on the 
values exposes the taxpayer to material adverse consequences if the 
values are incorrect. Accordingly, the safe harbor requires that the 
values for eligible positions contained in these financial statements 
be used by the taxpayer in most of the significant management functions 
of all or substantially all of its business. This use includes 
activities such as senior management review of business-unit 
profitability, market risk measurement or management, credit risk 
measurement or management, internal allocation of capital, and 
compensation of personnel but does not include either tax accounting or 
reporting the results of operations to other persons. Significance of 
use is tested by examining all the facts and circumstances in light of 
the stated purpose of the business use requirement.
    The IRS and Treasury understand that some dealers maintain internal 
books of account, not prepared in accordance with U.S. GAAP, for 
separate segments of their business and that these internal books of 
account may include a charge to each operating segment of an internal 
``cost of carry'' calculated in the manner of interest (and the 
derivatives dealer book may be treated as a separate business segment 
for that purpose). The purpose of this cost-of-carry charge is to 
assess profitability or to reflect the cost of capital in maintaining 
the positions held in that business segment. The amounts so charged do 
not reduce the fair value of eligible positions on a balance sheet 
prepared in accordance with U.S. GAAP. The maintenance of these 
segmented accounts, which may apply an accounting approach that does 
not qualify as an eligible accounting method, does not prevent some 
other financial statement prepared in accordance with U.S. GAAP from 
qualifying as the taxpayer's applicable financial statement.

Record Retention and Production; Use of Different Values

    The safe harbor can be administrable only if the IRS can readily 
verify that the values used on financial statements are also 
appropriately used on the Federal income tax return. Consequently, 
recordkeeping and record production are critical to the safe harbor. 
These proposed regulations provide specific requirements for the types 
of records that must be maintained and provided to enable ready 
verification. In general, electing taxpayers must clearly show: (1) 
That the same value used for financial reporting was used on the 
Federal income tax return; (2) that no eligible position subject to 
section 475 is excluded from the application of the safe harbor; and 
(3) that only eligible positions subject to section 475 are carried 
over to the Federal income tax return under the safe harbor. These 
proposed regulations outline what records must be retained and 
produced, including certain forms and schedules filed with the Federal 
income tax return, such as the Schedule M-1, ``Net Income(Loss) 
Reconciliation for Corporations With Total Assets of $10 Million or 
More,'' Schedule M-3, ``Net Income(Loss) Reconciliation for 
Corporations With Total Assets of $10 Million or More,'' and Form 
1120F, ``U.S. Income Tax Return of a Foreign Corporation.'' These 
proposed regulations also provide that the Commissioner may enter into 
an advance agreement with a taxpayer on how records are to be 
maintained and how long the records are to be retained. All of the 
necessary records must be retained as long as their contents may become 
material in the administration of any internal revenue law.
    To encourage rapid examinations of the Federal income tax returns 
of electing taxpayers, these proposed regulations require that all 
necessary records be produced within 30 days after the Commissioner 
requests them. If the required records are not provided as required, 
the regulations permit the Commissioner to use his discretion to: (1) 
Extend the 30-day period; (2) excuse minor or inadvertent failures to 
provide the requested records; (3) require use of values that clearly 
reflect income but which are different from those used on the 
applicable financial statement; or (4) revoke the election (as 
described under ``Election and Revocation'' above) if a taxpayer does 
not demonstrate reasonable cause for the failure to maintain and 
produce the required records.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that it is 
anticipated that the safe harbor will be used primarily by dealers in 
securities that are financial institutions with a sophisticated 
understanding of the capital markets. Because section 475 is elective 
for traders in securities or commodities or dealers in commodities, 
some small businesses could qualify for the safe harbor if they make 
two voluntary elections: (1) An election to mark to market securities 
or commodities under section 475 and (2) an election to apply the safe 
harbor. Because both elections are voluntary, it is unlikely any small 
business taxpayer who thinks the reporting and recordkeeping 
requirements are too burdensome will make these elections. Furthermore, 
the total average estimated burden per taxpayer is small, as reported 
earlier in the preamble. This is because most of the recordkeeping 
requirements do not require taxpayers to generate new records, but 
instead require records used for financial reporting purposes to be 
kept for tax reporting purposes. For all of these reasons, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. Pursuant to section 7805(f) of the Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and the Treasury Department

[[Page 29667]]

specifically request comments on the clarity of these proposed 
regulations and how they may be made easier to understand. All comments 
will be available for inspection and copying.
    A public hearing has been scheduled for September 15, 2005 
beginning at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restriction, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.

Drafting Information

    The principal authors of these proposed regulations are Marsha A. 
Sabin and John W. Rogers III, Office of the Associate Chief Counsel 
(Financial Institutions and Products). However, other personnel from 
the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.475(a)-4 also issued under 26 U.S.C. 475(g). * * *

    Par. 2. Section 1.475-0 is amended by:
    1. Revising the introductory text.
    2. Adding entries to the table for Sec.  1.475(a)-4.
    The revision and addition reads as follows:


Sec.  1.475-0  Table of contents.

    This section lists the major captions in Sec. Sec.  1.475(a)-3, 
1.475(a)-4, 1.475(b)-1, 1.475(b)-2, 1.475(b)-4, 1.475(c)-1, 1.475(c)-2, 
1.475(d)-1 and 1.475(e)-1.
* * * * *

Sec.  1.475(a)-4 Safe harbor for valuation under section 475.

    (a) Overview.
    (1) Purpose.
    (2) Summary of paragraphs.
    (b) Safe harbor.
    (1) General rule.
    (2) Scope of the safe harbor.
    (c) Eligible taxpayer.
    (d) Eligible method.
    (1) Sufficient consistency.
    (2) General requirements.
    (i) Frequency.
    (ii) Recognition at the mark.
    (iii) Recognition on disposition.
    (iv) Fair value standard.
    (3) Limitations.
    (i) Bid-ask method.
    (ii) Valuations based on present values of projected cash flows.
    (iii) Accounting for costs and risks.
    (4) Examples.
    (e) Compliance with other rules.
    (f) Election.
    (1) Making the election.
    (2) Duration of the election.
    (3) Revocation.
    (i) By the taxpayer.
    (ii) By the Commissioner.
    (4) Re-election.
    (g) Eligible positions.
    (h) Applicable financial statement.
    (1) Definition.
    (2) Primary financial statement.
    (i) Statement required to be filed with Securities and Exchange 
Commission.
    (ii) Statement filed with a Federal agency other than the IRS.
    (iii) Certified audited financial statement.
    (3) Example.
    (4) Financial statements of equal priority.
    (5) Consolidated groups.
    (6) Supplement or amendment to a financial statement.
    (7) Certified audited financial statement.
    (i) [Reserved]
    (j) Significant business use.
    (1) In general.
    (2) Financial statement value.
    (3) Management of a business as a dealer or trader.
    (4) Significant use.
    (k) Retention and production of records.
    (1) In general.
    (2) Specific requirements.
    (i) Reconciliation.
    (A) In general.
    (B) Values on books and records with supporting schedules.
    (C) Consolidation schedules.
    (ii) Instructions provided by the Commissioner.
    (3) Time for producing records.
    (4) Retention period for records.
    (5) Agreements with the Commissioner.
    (l) [Reserved]
    (m) Use of different values.
* * * * *
    Par. 3. Section 1.475(a)-4 is added to read as follows:


Sec.  1.475(a)-4  Safe harbor for valuation under section 475.

    (a) Overview--(1) Purpose. This section sets forth a safe harbor 
that under certain circumstances permits taxpayers to make an election 
pursuant to which the values of positions reported on certain financial 
statements are the fair market values of those positions for purposes 
of section 475. This safe harbor is based on the principle that, if a 
mark-to-market method used for financial reporting is sufficiently 
consistent with the requirements of section 475 and if the financial 
statement employing that method has certain indicia of reliability, 
then the values used on that financial statement should be appropriate 
values for purposes of section 475. If other provisions of the Code or 
regulations require adjustments to fair market value, use of the safe 
harbor does not obviate the need for those adjustments. See paragraph 
(e) of this section.
    (2) Summary of paragraphs. Paragraph (b) of this section sets forth 
the safe harbor. To determine who may use the safe harbor, paragraph 
(c) of this section defines the term ``eligible taxpayer'' for purposes 
of the safe harbor. Paragraph (d) of this section sets forth the basic 
requirements for determining whether the method used for financial 
reporting is sufficiently consistent with the requirements of section 
475. Paragraph (e) of this section describes adjustments to the 
financial statement values that may be required for purposes of 
applying section 475. Paragraph (f) of this section describes how to 
make the safe harbor election and the conditions under which the 
election may be revoked. Paragraph (g) of this section provides that 
the Commissioner will issue a revenue procedure that lists the types of 
securities and commodities that may qualify as ``eligible positions'' 
for purposes of the safe harbor. Using rules for determining priorities 
among financial statements, paragraph (h) of this section defines the 
term ``applicable financial statement'' and so describes the financial 
statement, if any, whose values may be used in the safe harbor. In some 
cases, as required by paragraph (j) of this section, the safe harbor is 
available only if the taxpayer's operations make significant business 
use of financial statement values. Paragraph (k) of this section sets 
forth requirements for record retention and record production. 
Paragraph (m) of this section provides that the Commissioner may use 
fair market values that clearly reflect income, but which differ from 
values used on the applicable financial statement, if a taxpayer fails 
to comply with the recordkeeping and record production requirements of 
paragraph (k) of this section.
    (b) Safe harbor--(1) General rule. Subject to any adjustment 
required by paragraph (e) of this section, if an eligible taxpayer uses 
an eligible

[[Page 29668]]

method for the valuation of an eligible position on its applicable 
financial statement and the eligible taxpayer is subject to the 
election described in paragraph (f) of this section, the value that the 
eligible taxpayer assigns to that eligible position in its applicable 
financial statement is the fair market value of the eligible position 
for purposes of section 475, even if that value is not the fair market 
value of the position for any other purpose of the internal revenue 
laws. Notwithstanding the rule set forth in this paragraph, the 
Commissioner may, in certain circumstances, use fair market values that 
clearly reflect income but which are different than the values used on 
the applicable financial statement. See paragraph (m) of this section.
    (2) Scope of the safe harbor. The safe harbor may be used only to 
determine values for eligible positions that are properly marked to 
market under section 475. It does not determine whether any positions 
may or may not be subject to mark-to-market accounting under section 
475.
    (c) Eligible taxpayer. An eligible taxpayer is a dealer in 
securities as defined in section 475(c)(1) and Sec.  1.475(c)-1, a 
dealer in commodities as defined in section 475(e), or a trader in 
securities or commodities as defined in section 475(f).
    (d) Eligible Method--(1) Sufficient consistency. An eligible method 
is a mark-to-market method that is sufficiently consistent with the 
requirements of a mark-to-market method under section 475. To be 
sufficiently consistent, the eligible method must satisfy all of the 
requirements of paragraph (d)(2) and paragraph (d)(3) of this section.
    (2) General requirements. The method--
    (i) Frequency. Must require a valuation of the eligible position no 
less frequently than annually, including a valuation as of the last 
business day of the taxable year;
    (ii) Recognition at the mark. Must recognize into income on the 
income statement for each taxable year mark-to-market gain or loss 
based upon the valuation or valuations described in paragraph (d)(2)(i) 
of this section;
    (iii) Recognition on disposition. Must require, on disposition of 
the eligible position, recognition into income (on the income statement 
for the taxable year of disposition) as if a year-end mark occurred 
immediately before such disposition; and
    (iv) Fair value standard. Must require use of a valuation standard 
that arrives at fair value in accordance with U.S. Generally Accepted 
Accounting Principles (U.S. GAAP) as established by the Financial 
Accounting Standards Board.
    (3) Limitations--(i) Bid-ask method. Except for eligible positions 
that are traded on a qualified board or exchange, as defined in section 
1256(g)(7), the valuation standard used for the applicable financial 
statement of an eligible taxpayer must not permit values at or near the 
bid or ask value. Consequently, the valuation method described in Sec.  
1.471-4(a)(1) generally fails to satisfy this paragraph (d)(3)(i). The 
restriction in this paragraph (d)(3)(i) is satisfied if a resulting 
value is closer to the mid-market value than it is to the bid or ask 
value.
    (ii) Valuations based on present values of projected cash flows. If 
the method of valuation consists of projecting cash flows from an 
eligible position or positions and determining the present value of 
those cash flows, the method must not take into account any cash flows 
(income or expense) attributable to a period or time prior to the 
valuation date. In addition, adjustment of the gain or loss recognized 
on the mark may be required with respect to payments on notional 
principal contracts that will occur after the valuation date to the 
extent that portions of the payments have been recognized for tax 
purposes prior to the valuation date and appropriate adjustment has not 
been made for purposes of determining financial statement value.
    (iii) Accounting for costs and risks--(A) General rule. In a 
determination of fair value, appropriate costs and risks may be taken 
into account, but no cost or risk may be accounted for more than once, 
either directly or indirectly. If appropriate, the costs and risks that 
may be accounted for, include, but are not limited to, credit risk 
(appropriately adjusted for any credit enhancement), future 
administrative costs, and model risk. In the case of credit risk, an 
adjustment is implicit in computing the present value of cash flows 
using a discount rate greater than a risk-free rate. Accordingly, a 
determination of whether any further downward adjustment to value for 
credit risk is warranted, or whether an upward adjustment is required, 
must take that implicit adjustment into consideration.
    (4) Examples. The following examples illustrate this paragraph (d).

    Example 1. (i) A, a calendar year taxpayer, is a dealer in 
securities within the meaning of section 475(c)(1). A generally 
maintains a balanced portfolio of interest rate swaps and other 
interest rate derivatives, capturing bid-ask spreads and keeping its 
market exposure within desired limits (using, if necessary, 
additional derivatives for this purpose). A uses a mark-to-market 
method on a statement that it is required to file with the United 
States Securities and Exchange Commission (Securities and Exchange 
Commission or SEC) and that satisfies paragraph (d)(2) of this 
section with respect to both the contracts with customers and the 
additional derivatives. None of the derivatives is traded on a 
qualified board or exchange, as defined in section 1256(g)(7). When 
determining the amount of any gain or loss realized on a sale, 
exchange, or termination of a position, A makes a proper adjustment 
for amounts taken into account respecting payments or receipts. All 
of A's counterparties on the derivatives have credit quality ratings 
of AA/aa, according to standard credit ratings obtained from private 
credit rating agencies.
    (ii) Under A's valuation method, as of each valuation date A 
determines a mid-market probability distribution of future cash 
flows under the derivatives and computes the present values of these 
cash flows. In computing these present values, A uses an industry 
standard yield curve that is appropriate for obligations by persons 
with credit quality ratings of AA/aa. In addition, based on 
information including its own knowledge about the counterparties, A 
adjusts some of these present values either upward or downward to 
reflect A's reasonable judgment about the extent to which the true 
credit status of each counterparty's obligation, taking credit 
enhancements into account, differs from AA/aa.
    (iii) A's methodology does not violate the requirement in 
paragraph (d)(3)(iii) of this section that the same cost or risk not 
be taken into account, directly or indirectly, more than once.
    Example 2. (i) The facts are the same as in Example 1, except 
that A uses risk-free rates to discount the payments to be received 
under the derivatives. Based on information, including its own 
knowledge about the counterparties, A adjusts these present values 
to reflect A's reasonable judgment about the extent to which the 
true credit status of each counterparty's obligation, taking credit 
enhancements into account, differs from a risk-free obligation.
    (ii) A's methodology does not violate the requirement in 
paragraph (d)(3)(iii) of this section that the same cost or risk not 
be taken into account, directly or indirectly, more than once.
    Example 3. (i) The facts are the same as in Example 1, except 
that, after computing present values using the discount rates that 
are appropriate for obligors with credit quality ratings of AA/aa, 
A, based on information including its own knowledge about the 
counterparties, adjusts some of these present values either upward 
or downward to reflect A's reasonable judgment about the extent to 
which the true credit status of each counterparty's obligation, 
taking credit enhancements into account, differs from AAA/aaa.
    (ii) A's methodology violates the requirement in paragraph 
(d)(3)(iii) of this section that the same cost or risk not be taken 
into account, directly or indirectly, more than once. By using a AA/
aa discount rate,

[[Page 29669]]

A's method takes into account the difference between risk-free 
obligations and AA/aa obligations. This difference includes the 
difference between a rating of AAA/aaa and one of AA/aa. By 
adjusting values for the difference between a rating of AAA/aaa and 
one of AA/aa, A takes into account risks that it had already 
accounted for through the discount rates that it used. The same 
result would occur if A judged some of its counterparties' 
obligations to be of AAA/aaa quality but A failed to adjust the 
values of those obligations to reflect the difference between a 
rating of AAA/aaa and one of AA/aa.
    Example 4. (i) The facts are the same as in Example 1, except 
that A determines the mid-market value for each derivative and then 
subtracts the corresponding part of the bid-ask spread.
    (ii) A's methodology violates the rule in paragraph (d)(3)(i) of 
this section that forbids valuing the derivatives at or near the bid 
or ask value.

    Example 5. (i) The facts are the same as in Example 1, and, in 
addition, A's adjustments for all risks and costs, including credit 
risk, future administrative costs, and model risk, consistently 
cause the adjusted value to be at or near the bid value or ask 
value.
    (ii) A's methodology violates the rule in paragraph (d)(3)(i) of 
this section that forbids valuing the derivatives at or near the bid 
or ask value.

    (e) Compliance with other rules. Notwithstanding any other 
provisions of this section, the fair market values for purposes of the 
safe harbor must be consistent with section 482 or rules that adopt 
section 482 principles, when applicable. Thus applicable financial 
statement values must be adjusted as necessary for purposes of the safe 
harbor. For example, if a notional principal contract is subject to 
section 482 or section 482 principles, the values of future cash flows 
taken into account in determining the value of the contract for 
purposes of section 475 must be consistent with section 482.
    (f) Election--(1) Making the election. Unless the Commissioner 
prescribes otherwise, an eligible taxpayer elects under this section by 
filing with the Commissioner a statement declaring that the taxpayer 
makes the safe harbor election in this section for all its eligible 
positions. In addition to any other information that the Commissioner 
may require, the statement must describe the taxpayer's applicable 
financial statement for the first taxable year for which the election 
is effective and must state that the taxpayer agrees to timely provide 
upon the request of the Commissioner all information, records, and 
schedules required by paragraph (k) of this section. The statement must 
be attached to a timely filed Federal income tax return (including 
extensions) for the taxable year for which the election is first 
effective.
    (2) Duration of the election. Once made, the election continues in 
effect for all subsequent taxable years unless revoked.
    (3) Revocation--(i) By the taxpayer. An eligible taxpayer that is 
subject to an election under this section may revoke it only with the 
consent of the Commissioner.
    (ii) By the Commissioner. The Commissioner, after consideration of 
all relevant facts and circumstances, may revoke an election under this 
section, effective beginning with the first open year for which the 
election is effective or with any subsequent year, if--
    (A) The taxpayer fails to comply with paragraph (k) of this section 
(concerning record retention and production) and the taxpayer does not 
show reasonable cause for this failure;
    (B) The taxpayer ceases to have an applicable financial statement 
or ceases to use an eligible method; or
    (C) For any other reason, no more than a de minimis number of 
eligible positions, or no more than a de minimis fraction of the 
taxpayer's eligible positions, are covered by the safe harbor in 
paragraph (b) of this section.
    (4) Re-election. If an election is revoked, either by the 
Commissioner or by the taxpayer, the taxpayer (or any successor of the 
taxpayer) may not make the election for any taxable year that begins 
before the date that is six years after the first day of the earliest 
taxable year affected by the revocation without the consent of the 
Commissioner.
    (g) Eligible positions. Eligible positions mean those types or 
classes of securities or commodities that are marked to market under 
section 475 and are described by the Commissioner as eligible positions 
for purposes of this safe harbor in a revenue procedure or other 
published guidance.
    (h) Applicable financial statement--(1) Definition. An eligible 
taxpayer's applicable financial statement for a taxable year is the 
taxpayer's primary financial statement for that year if the statement 
is described in paragraph (h)(2)(i) of this section (concerning 
statements required to be filed with the SEC) or if the statement is 
both described in either paragraph (h)(2)(ii) or (iii) of this section 
and also meets the requirements of paragraph (j) of this section 
(concerning significant business use). Otherwise, or if the taxpayer 
does not have a primary financial statement for the taxable year, the 
taxpayer does not have an applicable financial statement for the 
taxable year.
    (2) Primary financial statement. For any taxable year, an eligible 
taxpayer's primary financial statement is the financial statement, if 
any, described in one or more of paragraphs (h)(2)(i) through (iii) of 
this section. If more than one financial statement of the taxpayer for 
the year is so described, the primary financial statement is the one 
first described in paragraphs (h)(2)(i) through (iii) of this section. 
A taxpayer has only one primary financial statement for any year.
    (i) Statement required to be filed with the Securities and Exchange 
Commission. A financial statement that is prepared in accordance with 
U.S. GAAP and that is required to be filed with the SEC, such as the 
10-K or the Annual Statement to Shareholders.
    (ii) Statement filed with a Federal agency other than the IRS. A 
financial statement that is prepared in accordance with U.S. GAAP and 
that is required to be provided to the Federal government or any of its 
agencies other than the IRS.
    (iii) Certified audited financial statement. A certified audited 
financial statement that is prepared in accordance with U.S. GAAP; that 
is given to creditors for purposes of making lending decisions, given 
to equity holders for purposes of evaluating their investment in the 
eligible taxpayer, or provided for other substantial non-tax purposes; 
and that the taxpayer reasonably anticipates will be directly relied on 
for the purposes for which it was created.
    (3) Example. A prepares a financial statement, FS1, that is 
required to be filed with a Federal government agency other than the 
SEC or the IRS, and is thus described in paragraph (h)(2)(ii) of 
this section. A also prepares a second financial statement, FS2, 
that is a certified audited financial statement that is given to 
creditors and that A reasonably anticipates will be relied on for 
purposes of making lending decisions, and that is thus described in 
paragraph (h)(2)(iii) of this section. Because FS1, which is 
described in paragraph (h)(2)(ii) of this section, is described 
before FS2, which is described in paragraph (h)(2)(iii) of this 
section, FS1 is A's primary financial statement.
    (4) Financial statements of equal priority. If two or more 
financial statements are of equal priority, after applying the rules of 
paragraph (h)(2) of this section, then the statement that results in 
the highest aggregate valuation of eligible positions being marked to 
market under section 475 is the primary financial statement.
    (5) Consolidated groups. If the taxpayer is a member of an 
affiliated group that files a consolidated return, the primary 
financial statement of the taxpayer is the primary financial statement 
of the common parent (within the meaning of section 1504(a)(1)) of the 
consolidated group.
    (6) Supplement or amendment to a financial statement. For purposes 
of

[[Page 29670]]

paragraph (b)(1) of this section and this paragraph (h), a financial 
statement includes any supplement or amendment to the financial 
statement.
    (7) Certified audited financial statement. For purposes of this 
paragraph (h), a financial statement is a certified audited financial 
statement if it is certified by an independent certified public 
accountant from a Registered Public Accounting firm, as defined in 
section 2(a)(12) of the Sarbanes-Oxley Act of 2002, Public Law 107-204, 
116 Stat. 746 (July 30, 2002), 15 U.S.C. 7201(a)(12), and rules 
promulgated under that Act, and is--
    (i) Certified to be fairly presented (a ``clean'' opinion);
    (ii) Certified to be fairly presented subject to a concern about a 
contingency, other than a contingency relating to the value of eligible 
positions (a qualified ``subject to'' opinion); or
    (iii) Certified to be fairly presented except for a method of 
accounting with which the Certified Public Accountant disagrees and 
which is not a method used to determine the value of an eligible 
position held by an eligible taxpayer (a qualified ``except for'' 
opinion).
    (i) [Reserved].
    (j) Significant business use--(1) In general. A financial statement 
is described in this paragraph (j) if--
    (i) The financial statement contains values for eligible positions;
    (ii) The eligible taxpayer makes significant use of financial 
statement values in most of the significant management functions of its 
business; and
    (iii) That use is related to the management of all or substantially 
all of the eligible taxpayer's business.
    (2) Financial statement value. For purposes of this paragraph (j), 
the term financial statement value means--
    (i) A value that is taken from the financial statement; or
    (ii) A value that is produced by a process that is in all respects 
identical to the process that produces the values that appear on the 
financial statement but that is not taken from the statement because 
either--
    (A) The value was determined as of a date for which the financial 
statement does not value eligible positions; or
    (B) The value is used in the management of the business before the 
financial statement has been prepared.
    (3) Management of a business as a dealer or trader. For purposes of 
this paragraph (j), the term management of a business as a dealer or 
trader refers to the financial and commercial oversight of the 
business. Oversight includes, but is not limited to, senior management 
review of business-unit profitability, market risk measurement or 
management, credit risk measurement or management, internal allocation 
of capital, and compensation of personnel. Management of a business as 
a dealer or trader does not include either tax accounting or reporting 
the results of operations to other persons.
    (4) Significant use. If an eligible taxpayer uses financial 
statement values for some significant management functions and uses 
values that are not financial statement values for other significant 
management functions, then the determination of whether the taxpayer 
has made significant use of the financial statement values is made on 
the basis of all the facts and circumstances. This determination must 
particularly take into account whether the taxpayer's reliance on the 
financial statement values exposes the taxpayer to material adverse 
economic consequences if the values are incorrect.
    (k) Retention and production of records--(1) In general. In 
addition to all records that section 6001 otherwise requires to be 
retained, an eligible taxpayer subject to the election provided by this 
section must keep, and timely provide to the Commissioner upon request, 
records and books of account that are sufficient to establish that the 
values used for eligible positions for purposes of section 475 are the 
values used in the applicable financial statement. This obligation 
extends to all books and records that are required to be maintained for 
any period for financial or regulatory reporting purposes, even if 
these books or records may not otherwise be specifically covered by 
section 6001. All records described in this paragraph (k) must be 
maintained for the period described in paragraph (k)(4) of this 
section, even if a lesser period of retention applies for financial 
statement or regulatory purposes.
    (2) Specific requirements--(i) Reconciliation. Unless the 
Commissioner otherwise provides--
    (A) In general. An eligible taxpayer must provide reconciliation 
schedules between the applicable financial statement for the taxable 
year and Federal income tax return for that year. The required 
reconciliation schedules include all supporting schedules, exhibits, 
computer programs and any other information used in producing the 
values and schedules, documentation of rules and procedures governing 
determination of the values. The required schedules also include a 
detailed explanation of any adjustments necessitated by imperfect 
overlap between the eligible positions that the taxpayer marks to 
market under section 475 and the eligible positions for which the 
applicable financial statement uses an eligible method. A corporate 
taxpayer subject to this paragraph (k) must reconcile the net income 
amount reported on its applicable financial statement to the amount 
reported on the applicable forms and schedules on its Federal income 
tax return (such as the Schedule M-1, ``Net Income(Loss) Reconciliation 
for Corporations With Total Assets of $10 Million or More''; Schedule 
M-3, ``Net Income(Loss) Reconciliation for Corporations With Total 
Assets of $10 Million or More''; and Form 1120F, ``U.S. Income Tax 
Return of a Foreign Corporation'') in the time and manner provided by 
the Commissioner. Eligible taxpayers that are not otherwise required to 
file a Schedule M-1 or Schedule M-3 must reconcile net income using 
substitute schedules similar to Schedule M-1 and Schedule M-3, and 
these substitute schedules must be attached to the return.
    (B) Values on books and records with supporting schedules. The 
books and records must state the value used for each eligible position 
separately from the value used for any other eligible position. 
However, an eligible taxpayer may make adjustments to values on a 
pooled basis, if the taxpayer demonstrates that it can compute gain or 
loss attributable to the sale or other disposition of an individual 
eligible position.
    (C) Consolidation schedules. The taxpayer must provide a schedule 
showing consolidation and de-consolidation that is used in preparing 
the applicable financial statement, along with exhibits and subordinate 
schedules. This schedule must provide information that addresses the 
differences for consolidation between the applicable financial 
statement and the Federal income tax return.
    (ii) Instructions provided by the Commissioner. The Commissioner 
may provide an alternative time or manner in which an eligible taxpayer 
subject to this paragraph (k) must establish that the same values used 
for eligible positions on the applicable financial statement are also 
the values used for purposes of section 475 on the Federal income tax 
return.
    (3) Time for producing records. All documents described in this 
paragraph (k) must be produced within 30 days of a request by the 
Commissioner, unless the Commissioner grants a written extension. 
Generally, the Commissioner will exercise his discretion to excuse a 
minor or inadvertent failure to provide requested documents if the 
taxpayer

[[Page 29671]]

shows reasonable cause for the failure, has made a good faith effort to 
comply with the requirement to produce records, and promptly remedies 
the failure. For failures to maintain, or timely produce, records, see 
paragraph (m) of this section (allowing the Commissioner, but not the 
taxpayer, to use fair market values which clearly reflect income, but 
which are different from those values used on the applicable financial 
statement, for eligible positions that otherwise might be subject to 
the safe harbor) and paragraph (f)(3)(ii) of this section (allowing the 
Commissioner to revoke the election).
    (4) Retention period for records. All materials required by this 
paragraph (k) and section 6001 must be retained as long as their 
contents may become material in the administration of any internal 
revenue law.
    (5) Agreements with the Commissioner. The Commissioner and an 
eligible taxpayer may enter into a written agreement that establishes, 
for purposes of this paragraph (k), which records must be maintained, 
how they must be maintained, and for how long they must be maintained.
    (l) [Reserved].
    (m) Use of different values. If the taxpayer fails to satisfy 
paragraph (k) of this section (concerning record retention and record 
production) with respect to the records that relate to certain eligible 
positions for a taxable year, the Commissioner may, for those eligible 
positions for that year, use fair market values under section 475 that 
are different from those values reported for those positions on the 
applicable financial statement and are values the Commissioner 
determines to be appropriate to clearly reflect income. See paragraph 
(f)(3)(ii) of this section concerning revocation of the election by the 
Commissioner, when a taxpayer does not produce required records and 
fails to demonstrate reasonable cause for such failure.
    Par. 4. Section 1.475(e)-1 is amended by redesignating paragraphs 
(d) through (j) as paragraphs (e) through (k), respectively and adding 
a new paragraph (d) to read as follows:


Sec.  1.475(e)-1  Effective dates.

* * * * *
    (d) Effective date. Section 1.475(a)-4 (concerning a safe harbor to 
use applicable financial statement values for purposes of section 475) 
applies to taxable years ending on or after the date on which the 
Treasury decision promulgating these regulations is published in the 
Federal Register.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-10167 Filed 5-20-05; 8:45 am]
BILLING CODE 4830-01-P