Bank One Corporation v. Commissioner of Internal Revenue

• Decision Date: 02 May 2003
• Docket Number: Docket Nos. 5759-95, 5956-97.
• 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 <U>v</U>. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

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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.

Docket Nos. 5759-95, 5956-97.

United States Tax Court.

Filed May 2, 2003.

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.

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.

                                                      CONTENTS
                FINDINGS OF FACT .................................................  14
                     I.     Background ...........................................  14
                         A. Stipulations of Fact .................................  14
                         B. Briefs on CD-ROM With Appropriate Hyperlinks .........  14
                         C. Relevant Taxpayers ...................................  15
                             1. FCC ..............................................  15
                             2. First Chicago NBD Corp. ..........................  15
                             3. FNBC .............................................  15
                             4. Bank One Corp. ...................................  16
                    II. The Swaps Business .......................................  17
                         A. Swaps in General .....................................  17
                             1. Definition of a Swap .............................  17
                

                             2. Swaps Are Derivative Financial Products ..........  17
                             3. Types of Swaps in the Marketplace ................  19
                         B. Origin and Growth of the Swaps Market ................  19
                             1. Origin of the Market .............................  19
                             2. Growth of the Interest Rate Swaps Market .........  20
                         C. Interest Rate Swaps ..................................  21
                             1. Terms of an Interest Rate Swap Agreement .........  21
                             2. Notional Principal Amount and Related
                                Terms ............................................  21
                             3. Different Types of Interest Rates ................  23
                             4. Use of LIBOR as a Floating Interest Rate
                                Index ............................................  23
                             5. Plain Vanilla Interest Rate Swaps ................  25
                             6. Lack of Payments at Inception ....................  27
                             7. Example of an Interest Rate Swap .................  27
                         D. Currency Swaps .......................................  28
                         E. Participants in the Market ...........................  29
                             1. End Users ........................................  29
                                   a. Typical End Users ..........................  29
                                   b. End Users' Uses of Interest Rate
                                      Swaps.......................................  30
                                       i. Combat Interest Rate Changes ...........  30
                                      ii. Prosper From Market Forecast ...........  31
                                     iii. Reduce Cost of Funding .................  32
                             2. Dealers ..........................................  32
                                   a. Typical Dealers ............................  32
                                   b. Practice as to Swaps .......................  33
                                   c. Price Quotations ...........................  33
                                   d. Role in the Market .........................  34
                                   e. Need for Strong Credit .....................  35
                             3. Brokers ..........................................  35
                         F. Market for Swaps .....................................  36
                             1. Types of Markets .................................  36
                                 a. Primary Market ...............................  36
                                 b. Secondary Market .............................  36
                             2. Brokers' Dissemination of the Dealers'
                                Quotations .......................................  37
                                 a. Daily Quotations .............................  37
                                 b. No Dissemination of Actual
                                    Swap Prices ..................................  39
                                 c. Spreads Included in Quotations ...............  39
                             3. Midmarket Rate ...................................  42
                             4. Midmarket Swap Curve .............................  43
                

                             5. ISDA Form Agreements .............................  44
                             6. Assignments and Buyouts of Swaps .................  47
                         G. Risks Assumed by Dealers .............................  48
                             1. Types of Risks ...................................  48
                             2. Techniques Used To Minimize Credit Risk ..........  48
                             3. Techniques Used To Minimize Market Risk ..........  49
                         H. Dealer Spreads .......................................  50
                             1. Bid-Ask Spread ...................................  50
                             2. Bid-to-Mid Spread ................................  50
                             3. Example ..........................................  50
                             4. Significance of Spreads ..........................  51
                             5. Decline in Interdealer Spreads ...................  52
                   III. Valuing Swaps ............................................  52
                         A. Relevant Valuation Standards .........................  52
                             1. Fair Market Value ................................  53
                             2. Market Value .....................................  53
                             3. Fair Value .......................................  53
                         B. Mark-to-Market Accounting.............................  54
                         C. Devon System and the Devon (Midmarket) Value .........  54
                             1. Devon System .....................................  54
                             2. Devon (Midmarket) Value ..........................  55
                             3. Yield Curve ......................................  56
                                 a. Overview .....................................  56
                                 b. Constructing the Curve .......................  57
                                 c. Imprecise Measure ............................  58
                         D. Market Value .........................................  58
                             1. Net Present Value—-Forward Rate Pricing ....  58
                                 a. Expected Cashflows ...........................  59
                                 b. Discounting Expected Cashflows ...............  59
                            2. Floating-Rate Note Method

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