In June of 2007, the IRS finalized regulations providing a "safe harbor" for valuation for dealers that mark their securities to market under section 475 for purposes of determining their taxable income. I had written extensively about the issue to note my concerns with the industry's proposals for book-tax conformity--i.e., for using their financial accounting income and loss determinations as their tax determinations. See Book-Tax Conformity and the corporate Tax Shelter Debate: Assessing the Proposed Section 475 Safe Harbor. My concerns stem from the importance of a coherent interpretation of the tax code and worries about dealers' ability to manipulate values to achieve financial and tax goals. Although the IRS did adopt regulations providing for a book-tax safe harbor, those final regulations did include a number of provisions that at least helped to counter those concerns.
Now, less than a year after the finalization of the safe harbor regulations, the securities industry is pressing for broadening of the safe harbor along the lines that the industry originally proposed (basically a "trust our business judgment" approach). See Larkins et al, Safe Harbor or No Safe Harbor: A First Look at the Mark to Market Safe Harbor Regulations, 7 Journal of Taxation 57 (2008) (available on CCH at this link). The authors assert review the workings of the regulatory safe harbor, and point out the verification and consistency requirements that impose limitations, asserting that the regulations "unduly limit" the kind of taxpayer, valuation methods and securities to which the safe harbor can apply. They argue instead that the "compliance burdens" will only be addressed if the IRS makes the safe harbor "as broad as possible".
The article reiterates the old industry rationale of regulatory reliability in support of a broad safe harbor. The claim is that the IRS need onlly look to a financial statement (selected according to priority criteria as already provided in the final regulations): since the financial statement is (deemed) reliable for securities reporting, bank regulatory or other regulatory reasons, the IRS should treat it as appropriate for determining taxable income, without imposing any further limitations.
Reliability may well be an insufficient criterion, however, as I argued in my article. What is reliable for a particular regulatory purpose may nevertheless be inappropriate or manipulative for determining taxable income. That is especially true if the regulatory purpose for which the statement is prepared encourages conservatism, deferral of inclusion until expenses can be booked, and other mechanisms that may understate the income as determined from the income tax's ability to pay concept.
The article also reasserts another rationale from the Securities Industry Association's original materials in support of book-tax conformity--that the "significant use" for a business purpose can insure that the right amount of taxable income would be reported. The problem is that such "significant use for a business purpose" doesn't guarantee lack of distortion for tax purposes. That is especially true in areas where businesses have proprietary software for making business determinations that permit very particularized determinations and where those determinations are adjusted further for different purposes. Further, the many recent cases of financial statement manipulation (Enron, WorldCom, and various other earnings and stock option manipulation scandals) demonstrate that the numbers can be manipulated through various means in order to achieve a particular objective, even if that runs counter to the primary objective for which the numbers are intended. Enron used off-balance-sheet vehicles and back-to-back arrangements to hide debt from those looking at its financial statements, so that it appeared to have more equity. Managers' claims that these were activities of rogues personnel didn't wash. The SIA claim that use of the mark-to-market valuations in a single activity--say, determining employee compensation for dealers--would be sufficient to ensure the appropriateness of the values is particularly suspect, since these valuations could be consistently marked down to defer income as long as the formula for determining compensation based on the numbers appropriately grossed the amount up for that purpose.
The industry complains about having to make one valuation determination for financial accounting purposes and another for tax purposes. Yet the fact is that industries have often had to make separate determinations for various regulatory agencies that govern their activities. It is not reasonable to insist that tax nonetheless is not entitled to an appropriate accounting but must follow whatever the financial accounting system allows. This is perhaps even more true today than a year ago when the safe harbor was finalized, as the accounting standards boards are now very seriously considering convergence on an international standard that would be much more "standard" based rather than "rule" based and thus allow even more room for manipulation of the final numbers.
The article restates two other complaints lodged against the regulations when they were finalized--that subsidiaries of foreign banks are not allowed to use their valuations from their call reports to the Federal Reserve of the Comptroller of the Currency, and that businesses cannot use reports that are not filed in accord with U.S. GAAP. There does not seem to be any new rationales offered against these reasonable limitations.
One thing has changed significantly since the regulations were finalized. The current credit crunch stems from banks' taking on too much risk in the loans they issued and then securitized, and at least for some banks, failures in pricing the exotic derivatives that they held. This experience suggests that the tax administration should be even more cautious about broadening the safe harbor to allow tax accounting to be tied, without limitation, to book valuations.
The article comes back again and again to the goal of reducing compliance burdens. While tax should not impose undue burdens on businesses, it is also not clear that reducing compliance burdens should drive these kinds of decisions. That is a good secondary goal for tax administrators to bear in mind whenever rules are developed, but it is problematic when it becomes the primary goal. No matter what relief is provided, taxpayers will always argue insatiably for more relief from compliance burdens, and any additional effort compared to their primary activity (satisfying other regulators, making money) will appear unreasonable to them. Tax administrators, however, have a primary goal of facilitating collection of tax revenues appropriately and fairly from taxpayers. They shouldn't turn a deaf ear to complaints about compliance burdens, but neither should they set aside reasonable constraints.
The result of the uncertainties, claim the authors, puts more importance on the outcome of the Bank One case. The tax court's opinion ruled with the government that the taxpayer's methodology did not clearly reflect income, but instead of then confirming the government's imposition of a methodology, as seems required under the section 446 provision, the court overruled the government and imposed its own valuation methodology. The Seventh Circuit on appeal made clear that the government's method must be applied in the case of a taxpayer's failure to clearly reflect income, unless the government's method is arbitrary or unlawful, because of the statutory language that puts that decision at the discretion of the Secretary.
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