Interest rate swaps

Interest rate swaps

September 01, 2006 | By Keith Martin in Washington, DC

Interest rate swaps must be marked to market for tax purposes at year end by banks, but there is room for disagreement about how to value them.

A long-running dispute between JPMorgan Chase Bank and the Internal Revenue Service went back to the US Tax Court in August for still more proceedings.

At issue is how to value interest rate swaps that the bank entered into between 1990 and 1993. The trial before the tax court involved 28 witnesses, more than 10,000 pages of exhibits and another 3,300 pages of briefs from the parties. The judge ended up rejecting the approaches of both parties and instructing them to use a different valuation method. However, the new method proved too complicated. More than a year later, both parties came back to the court with new calculations and briefs, at which point the judge essentially gave up and issued a cursory order adopting the IRS approach.

The case may be moot. In May 2005, the IRS said in a proposed regulation that it will accept whatever value a taxpayer assigns swaps on its financial statements. However, the proposal has not been formally adopted.

Section 475 of the US tax code requires securities dealers to mark to market securities that they are holding at year end, meaning determine their value and then report a gain or loss based on the change in value from the year before. (If the securities were acquired during the year, then the gain or loss is calculated against the price paid for them.) This rule does not apply to securities held as inventory for sale to customers. Swaps are considered securities.

JPMorgan Chase calculated its swap values by running a computer program called the Devon derivatives software system. The Devon system assumes that both parties to the swap have the same AA credit rating. JPMorgan Chase took the mid-market values generated by the computer software and adjusted them for credit risk and administrative costs to maintain the swaps. The IRS disagreed with how the bank calculated the adjustments.

In mid-August, a US appeals court sent the case back to the tax court. The appeals judge was unimpressed with the way the tax court simply gave up, but he also said the tax court had not been fair to the IRS in the first instance. Taxpayers are required by section 446 of the US tax code to account for income in a manner that clearly reflects income “in the opinion of the [IRS].” This makes it very difficult for anyone to challenge the IRS on an issue like the proper method to value swaps. The taxpayer cannot merely show his approach makes more sense; he must show that the approach the IRS wants to use is arbitrary or unlawful.

The case is JPMorgan Chase & Co. v. Commissioner.

Keith Martin