The Mark-To-Market Rules of Section 475 (Portfolio 543)

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Peter J. Connors, B.A., Catholic University; J.D., University of Richmond; LL.M. (in Taxation), New York University School of Law; Senior Tax Accountant, Arthur Andersen & Co.; Attorney, Tax Department, Bondy & Schloss; Tax Manager, J.C. Penney & Co.; Senior Manager, KPMG; Principal and Director of International Capital Markets Tax Services, Ernst & Young LLP; Tax Partner, Baker & McKenzie; Partner, Orrick, Herrington & Sutcliffe LLP (2001 to present); CPA (New York). Vice Chair-Committee Operations, American Bar Association Tax Section; Vice President, NY Region, International Fiscal Association; Executive Committee, New York State Bar Tax Section.


Detailed Analysis

I. Introduction

II. Legislative History and Purpose of Mark-to-Market Rules

A. Pre-§ 475 Rules

B. 1993 Omnibus Budget Reconciliation Act

C. 1997 Taxpayer Relief Act

D. 1998 IRS Restructuring and Reform Act

E. 1999 Tax Relief Extension Act

III. Other Mark-to-Market Initiatives

IV. Basic Rules - Recognition Before Realization

A. Section 475 General Rules

B. Coordination with Other Provisions

C. Substituted Basis

D. Special Coordination Provisions for Debt Instruments

1. Treatment of Interest and Discount - Overview

2. Bond Premium

3. Bonds with OID

4. Bonds with Market Discount

5. Bonds with Market Discount Accruing Before Application of § 475

E. Coordination with Bad Debt Deduction Provisions

1. Deduction Provisions in General

2. 1995 Proposed Regulations – Specific Charge-off Method Taxpayers

3. 1995 Proposed Regulations – Reserve Method Taxpayers

F. Mark-to-Market Upon Disposition of a Security

V. Dealer In Securities

A. “Dealer in Securities” Defined - the 1993 RRA

B. The Dealer-Customer Relationship

1. Part (A) of the “Dealer” Definition

2. Securities Traders - the 1997 TRA and the 1999 TREA

3. Part (B) of the “Dealer” Definition

4. Commodities Dealers and Traders - the 1997 TRA

5. U.S. Branches of Foreign Dealers

C. Related Parties and Dealer Status

1. General Rule

2. Special Rule for Consolidated Groups

3. Intragroup-Customer Election, Centralized Risk Management, and Separate-Entity Hedging Election

4. Dealer Status of Persons Related to Dealers

D. Negligible Sales Exception to Dealer Status

1. How Few is “Negligible”?

2. Electing Out of the Negligible Sales Exception

3. Consolidated Groups

4. Unexpectedly Failing the Test

E. “Customer Paper”

1. Pre-1998 Law – Dealer Exception for Sellers of “Customer Paper”

2. Pre-1998 Law – Retroactively Electing Out of the Dealer Exception for Sellers of “Customer Paper”

3. 1998 IRSRA – Securities Exception for Customer Paper

F. Life Insurance Companies and Products

G. Once a Dealer, Always a Dealer

VI. Change in Method of Accounting

A. General

B. Becoming a Dealer Due to Enactment of § 475

C. Becoming a Dealer Due to Changes in Circumstances

D. Becoming a Dealer by Electing Out of an Exception to Dealer Status

E. Becoming a Nondealer

VII. Securities Subject to § 475 Treatment

A. What is a “Security?”

1. Core Securities

2. Derivative Securities

3. Hedge Securities

B. Statutory Carve-Out - Contracts Subject to § 1256(a)

C. Regulatory Carve-Outs

1. Debt Instruments Issued by the Taxpayer

2. Section 1032 Securities

3. REMIC Residual Interests

D. Customer Paper

VIII. Exemptions from Mark-to-Market

Introductory Material

A. Meaning of “Held for Investment”

B. Securities Deemed Identified as Held for Investment Under the Per Se Rule

C. Changes in Per Se Investment Status

1. Onset of Prohibition Against MTM Under Per Se Rule After Failure to Identify

2. Termination of Prohibition Against MTM Under Per Se Rule

D. Securities Deemed Not Held for Investment – Notional Principal Contracts and Derivatives

E. Treatment of Securitization Transactions

1. Exemption of Contributed Securities

2. Exemption of Resulting Interests

F. What Is a Hedge?

1. Definition of Hedge

a. Hedge Definition Before the 1999 TREA

b. Hedge Definition After the 1999 TREA

2. Consolidated Group Issues

3. Integrated Hedges of Debt Instruments

IX. Character of Gain/Loss

A. General Rule of Ordinary Treatment

B. Exceptions - Capital Treatment

1. Statutory Exceptions to Ordinary Treatment

a. Securities Identified by Dealer as Held for Investment

b. Exceptions to Ordinary Treatment

(1) Securities that Hedge Items Not Marked to Market

(2) Securities Held in Nondealer Capacity

(3) Improperly Identified Securities

(4) Gain or Loss Allocable to Period to Which Exception Applies

2. Regulatory Exception to Ordinary Treatment

X. Identification and Misidentification

A. Identification – In General

B. How to Identify Securities and Positions

C. Time for Identifying Securities as Exempt from MTM

1. Same-Day Identification

2. Identification Issues for Electing Taxpayers

D. Interplay Between § § 1236 and 475

E. Consequences of Improper Identification

XI. Consolidated Return Issues

A. In General

B. Transfers of Securities Between Members

1. Sale by Dealer Member to Nondealer Member

2. Sale by Nondealer Member to Dealer Member

C. Notional Principal Contracts and Other Intercompany Obligations Between Members

D. Intragroup Hedging

1. In General

2. Separate-Entity Election

3. Gap in Effective Dates

4. Interdivisional Hedges

XII. Dealers and Traders in Commodities

A. Dealers in Commodities

1. General Rules

2. Commodity Defined

3. General Rule of Ordinary Treatment

4. Commodities Derivatives Dealers

B. Commodities Traders

C. Procedures for Making the MTM Elections

1. In General

2. Rev. Proc. 99-17

XIII. Valuation

A. In General

B. Approaches to Valuation of Securities

1. The Los Alamos Project

2. The Group of Thirty Report

3. Valuation of Securities for Financial Accounting Purposes

4. Safe Harbor

a. Safe Harbor

(1) Overview

(2) General Rule

b. Eligible Taxpayers and Eligible Positions

(1) Eligible Taxpayers

(2) Eligible Positions

c. Eligible Method

(1) General Requirements

(2) Limitations

(3) Examples

d. Election and Revocation

e. Applicable Financial Statements

f. Record Retention and Production

(1) Specific Requirements

(a) Reconciliation Requirements

(b) Instructions Provided by the Commissioner

(2) Time for Producing Records

(3) Retention Period for Records

XIV. The Global Dealing Regulations

XV. Rules Affecting Foreign Securities Dealers

XVI. State Tax Issues

A. State Tax Issues in General

B. State Tax Rules in the Context of Consolidated Returns

1. Both Dealer and Nondealer Included in State Combined Return

2. Dealer and Nondealer not Included in State Combined Return


Working Papers

Table of Worksheets

Worksheet 1 Mid-Market Swap Valuation Example

Worksheet 2 Omnibus Budget Reconciliation Act of 1993, P.L. 103–66, Section 13223

Worksheet 3 Preamble to Final Regulations Under Section 475

Worksheet 4 Preamble to 1999 Proposed Regulations Under Section 475

Worksheet 5 Rev. Rul. 97–39, 1997–2 C.B. 62, Mark–to–Market Accounting Requirements

Worksheet 6 Rev. Proc. 97–43, 1997–2 C.B. 494, Mark–to–Market Accounting Method Change Procedure

Worksheet 7 Mark-to-Market Accounting Method Election Procedure for Dealers in Commodities and Traders in Securities or Commodities

Worksheet 8 Sample Intragroup-Customer and Separate-Entity Hedging Elections