Bank One Corp. v. Comm'r of Internal Revenue
| Decision Date | 02 May 2003 |
| Docket Number | 5956–97.,Nos. 5759–95,s. 5759–95 |
| Citation | 120 T.C. No. 11,120 T.C. 174 |
| Parties | BANK ONE CORPORATION (Successor in Interest to First Chicago NBD Corporation, Formerly NBD Bancorp, Inc., Successor in Interest to First Chicago Corporation) and Affiliated Corporations, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Taxpayer bank petitioned for redetermination of deficiencies arising from method by which it claimed expenses associated with interest rate swaps and year-end valuation of swaps, which IRS determined did not clearly reflect income. As matters of first impression, the Tax Court, Laro, J., held that: (1) mark-to-market rule and valuation requirement for swaps and financial derivatives was method of accounting, subject to clear reflection of income standard; (2) taxpayer's method of accounting for swaps income did not clearly reflect income; (3) IRS' method of accounting for swaps income did not clearly reflect income; (4) valuing each swap at its midmarket value, adjusted on dynamic basis for credit risk and administrative costs was acceptable; (5) proper credit risk adjustment would reflect creditworthiness of both parties; and (6) proper administrative costs adjustment was limited to incremental costs.
Ordered accordingly. Jay H. Zimbler, John L. Snyder, Michael A. Clark, Michael R. Schlessinger, Bradford L. Ferguson, David M. Schiffman, John Wester, Kevin R. Pryor, Michael M. Conway, Marilyn D. Franson, and Hille R. Sheppard, for petitioner.*
Marjory A. Gilbert, Marsha A. Sabin, Joseph P. Ferrick, John W. Rogers III, Charles W. Culmer, Michael O'Donnell, and William Merkle, for respondent.
F, a financial institution, enters into bilateral contracts which are a type of derivative financial product known as interest rate swaps. Most of F's swaps are of the plain vanilla type where one party (first party) agrees to pay to the other party (second party) amounts ascertained as of certain dates by applying a fixed rate of interest to a set notional amount. The second party agrees to pay to the first party amounts ascertained as of the same dates by applying a floating rate of interest (e.g., LIBOR rate) to the same notional amount. For purpose of the mark-to-market rule of sec. 475(a) (2), I.R.C., which applies to taxable years ended after Dec. 30, 1993, F reported that the fair market value of its swaps as of Dec. 31, 1993, equaled their mid-market values; i.e., the values derived through a net cashflow/ present value analysis that was based on the average of each swap's market bid and ask rates. In addition, F deferred the recognition of the difference between its valuation and the bid or ask prices which it paid or received for the swaps, treating that difference as deferred income designed to compensate it for (1) the perceived credit risks of its counterparties and (2) the estimated administrative costs to be incurred on holding and managing the swaps until maturity. F used a similar method to report its swaps income for 1990 through 1992. F ascertained the values of its swaps for each of the years 1990 through 1993 as of a date that was approximately 10 days before the last day of F's taxable year and reported that value as the swaps' fair market value as of the last day of that year. R determined that F's method of reporting its swaps income did not clearly reflect F's swaps income for any of the years from 1990 through 1993. R determined that a proper method values F's swaps as of the end of each year at the midmarket values and does not take into account any deferral for credit risk or future administrative costs. Pursuant to sec. 446(b), I.R.C., R changed F's method of accounting for its swaps income to R's “proper” method.
Held: The mark-to-market rule of sec. 475(a)(2), I.R.C., including the valuation requirement subsumed therein, is a method of accounting that is subject to the clear reflection of income standard of sec. 446(b), I.R.C.
Held, further, F's method of accounting for its swaps income does not clearly reflect its swaps income under sec. 475, I.R .C., in that F's values were not determined at the end of its taxable years and did not properly reflect adjustments to the midmarket values which were necessary to reach the swaps' fair market value.
Held, further, R's “proper” method of accounting for F's swaps income does not clearly reflect that income under sec. 475, I.R.C., in that a swap's mid-market value without adjustment does not reflect the swap's fair market value.
Held, further, to arrive at the fair market value of a swap and other like derivative products, it is acceptable to value each product at its midmarket value as properly adjusted on a dynamic basis for credit risk and administrative costs. A proper credit risk adjustment reflects the creditworthiness of both parties, with due respect to netting and other credit enhancements. A proper administrative costs adjustment is limited to incremental costs.
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¦FINDINGS OF FACT ¦14 ¦
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¦I. ¦Background ¦14 ¦
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¦ ¦A. Stipulations of Fact ¦14 ¦
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¦ ¦B. Briefs on CD–ROM With Appropriate Hyperlinks ¦14 ¦
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¦ ¦C. Relevant Taxpayers ¦15 ¦
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¦ ¦1. FCC ¦15 ¦
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¦ ¦2. First Chicago NBD Corp ¦15 ¦
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¦ ¦3. FNBC ¦15 ¦
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¦ ¦4. Bank One Corp ¦16 ¦
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¦II. ¦The Swaps Business ¦17 ¦
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¦ ¦A. Swaps in General ¦17 ¦
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¦ ¦1. Definition of a Swap ¦17 ¦
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¦ ¦2. Swaps Are Derivative Financial Products ¦17 ¦
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¦ ¦3. Types of Swaps in the Marketplace ¦19 ¦
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¦ ¦B. Origin and Growth of the Swaps Market ¦19 ¦
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¦ ¦1. Origin of the Market ¦19 ¦
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¦ ¦2. Growth of the Interest Rate Swaps Market ¦20 ¦
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¦ ¦C. Interest Rate Swaps ¦21 ¦
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¦ ¦1. Terms of an Interest Rate Swap Agreement ¦21 ¦
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¦ ¦2. Notional Principal Amount and Related Terms ¦21 ¦
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¦ ¦3. Different Types of Interest Rates ¦23 ¦...To continue reading
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