DEALER MARK-TO-MARKET RULES--NEW GUIDANCE FROM THE INTERNAL REVENUE SERVICE

By Viva Hammer, Esq.,
Price Waterhouse LLP

One of the most significant changes made to the tax law in the 1993 Tax Act was the introduction of the requirement that "dealers" mark their securities to market for tax purposes. Although the concept of a "dealer" has existed for many years under many different U.S. Federal income tax code sections, the rules introduced in 1993 significantly broadened that definition. Very soon after the passing of the dealer mark-to-market rules under IRC section 475, the IRS came out with several sets of proposed and temporary regulations to aid taxpayers and practitioners in interpreting the new code provisions, which in many cases were radically new. Even with the guidance, there were still significant parts of the new rules which were subject to widely varying interpretations. The IRS attempted to fill some of these gaps with proposed and further temporary rules, and received extensive comments from taxpayers and practitioners on this guidance. Gratifyingly, the IRS took heed to many of the comments in the final regulations which were issued just before the holidays in December 1996. The rules make significant changes to the prior regulations, and much of the change is fairly favorable to taxpayers.

Certain Operating Rules on
Mark-to-Market Accounting

On January 4, 1995, the IRS proposed regulations concerning certain operating rules for dealers in securities. The proposed regulations included rules, which were very controversial, for marking debt instruments to market. The IRS indicated in the preamble to the final regulations that it plans to revise these rules substantially in the future. For reasons not explained in the preamble, the IRS also reserved on rules requiring a dealer to mark securities immediately before disposition.

Observation: The rules regarding the requirement to mark securities to market immediately before disposition were proposed to be effective for dispositions occurring on or after January 4, 1995. The proposed regulations remain substantial authority for the IRS; thus, taxpayers disposing of securities in certain nonrecognition transactions should consider disclosure if no mark is performed.

The final regulations adopt unchanged rules in the 1995 proposed regulations addressing the treatment of a dealer who acquires a security with substituted basis. The final regulations provide that the mark-to-market provisions apply only to changes in the value of a security occurring after the acquisition. In addition, the character and timing of recognition of any built-in gain or loss on the security is determined without regard to the mark-to-market rules. The regulations also affirm that the fact that a security has a substituted basis does not affect the ability of the dealer to identify the security as held for investment.

Observation: Thus, for example, a security acquired in a carryover basis transaction may be identified by the acquiring dealer on the date of the carryover basis transaction.

Exemptions from Marking to Market

Under the statute, the mark-to-market rules do not apply to any security held for investment. In interpreting this exception, the final regulations adopt the same language as was used in the temporary regulations and provide that a security is held for investment if it is not held primarily for sale to customers in the ordinary course of a trade or business. The preamble states that the IRS wanted to keep the IRC section 475(b) definition consistent with the concept of "held for investment" under IRC section 1236(a).

Similar to the temporary and proposed regulations, the final regulations provide a list of types of securities that are deemed held for investment. In final form, the rules provide that a taxpayer is deemed to have identified an investment in a corporation, partnership, publicly-traded partnership, or trust if it is considered related to such entity under IRC sections 267(b) or 707(b), taking into account the attribution rules of IRC sections 267(c) and 707(b). However, to address the concerns of securities dealers who acquire related party interests in the ordinary course of business, the final regulations provide that the deemed identification rules do not apply to a security if (i) the security is actively traded on a national securities exchange or interdealer quotation system established pursuant to the Securities Exchange Act, (ii) less than 15% of all of the outstanding shares (or interests in the same class) are held by the taxpayer or a related party, and (iii) the security was acquired from a related person, at least one business day has passed since the acquisition, and there has been significant trading of the security by persons not related to the taxpayer.

The regulations finalize, without change, the rules concerning the appropriate accounting for a security that has been exempt from marking to market when the exemption ceases to apply. A new example illustrates these rules in light of the actively-traded exception outlined above and the parent stock loss disallowance provisions of Treas. Reg. section 1.1502-13(f)(6).

Dealers in Notional Principal Contracts

The final rules essentially eliminate the ability of a dealer in notional principal contracts (NPCs) or other derivatives to identify those securities as held for investment (or not held for sale). Such a dealer is not eligible to identify its NPCs and derivatives as held for investment, unless the commissioner explicitly determines otherwise, for example, through a revenue ruling or private ruling. Because it represents a substantial departure from the previous regulations, the rule only applies to NPCs and derivatives acquired or entered into on or after January 23, 1997. For those acquired or entered into before this date, the taxpayer can avoid mark-to-market treatment if it establishes unambiguously that the NPC or derivative security was acquired other than in the taxpayer's capacity as a dealer in such securities.

Observation: The final regulation, consistent with the temporary regulations, does not prevent a dealer in NPCs from identifying a NPC or other derivative out of the regime on the basis of its use as a hedge of a nonmarked security. As a practical matter, this is the more common situation a dealer is likely to encounter. Moreover, the final regulations clarify that the character of gain or loss on NPCs or other derivatives that are ineligible for exemption will not be affected by possible capital characterization under section 475(d)(3)(B)(ii).

Definition of Dealer in Securities

The final regulations retain the general rule contained in the proposed regulations that the existence of a dealer-customer relationship is determined on the basis of facts and circumstances. A number of examples are added to the final regulations illustrating typical fact patterns. The regulations also retain the rule that any taxpayer who, in the ordinary course of its business, holds itself out as willing and able to enter into either side of a derivative transaction is a dealer in such derivatives. The examples contrast a taxpayer entering into either side of foreign currency forwards in the interbank market (dealer) with a taxpayer taking foreign currency forward positions only its own purposes of adjusting its position in particular currencies. Because the latter taxpayer has no other indicia of dealer status, the example concludes such taxpayer is not a dealer.

Transactions with Related Parties

Although the regulations retain the general rule that transactions with related persons may be treated as transactions with customers, the regulations add a new special rule for consolidated group members. The special rule generally disregards a member's intragroup transactions for purposes of determining whether a taxpayer is a "dealer in securities" subject to the mark-to-market requirements.

The preamble states the intention of the IRS to provide additional guidance on whether this special rule should be applied for other purposes under section 475, for example, in determining the applicability of certain exemptions to the mark-to-market rules.

Observation: For taxpayers that are dealers in securities, for example, a mortgage banking subsidiary of a bank or thrift that sells both to third parties and to its parent, it remains unclear whether intragroup transactions may be identified as not held for sale to customers. Even if such an identification is possible, care must be taken with respect to making an identification if the securities are ultimately disposed of in a securitization transaction that is treated as a tax sale.

In conjunction with this new intragroup sales rule, which ignores transactions with consolidated group members for determining dealer status, the final regulations contain an election allowing a consolidated group not to apply this special rule. Under this election, a consolidated group member effectively elects to determine dealer status by taking into account its transactions with other members of its group. Thus, a member may be a dealer in securities even if its only customer transactions are with other members of its consolidated group. The election continues for all subsequent years and is revocable only with consent of the commissioner.

Observation: The new intragroup sales rule appears to address many of the concerns of taxpayers who might not have viewed themselves as "dealers," but who, nevertheless, could have been treated as dealers under earlier proposed rules solely because of their transactions with other members of their consolidated groups. Additionally, the election out of the intragroup sales rule may provide certain taxpayers with book-tax conformity in their treatment of certain securities transactions.

The intragroup sales rule (and the election out of the general rule) applies to taxable years beginning on or after December 24, 1996. The preamble to the regulations states that the IRS will not challenge a taxpayer's treatment of intragroup transactions as customer or noncustomer transactions for prior years, provided the taxpayer had a reasonable basis for its treatment of the transactions and consistently applied that treatment from year to year.

Negligible Sales Rule Clarified

Under the temporary regulations, taxpayers selling securities acquired from customers were exempted from dealer status if those sales were negligible. The final regulations clarify the meaning of "negligible" and provide rules to coordinate with the intragroup sales rules described above.

Sales of Life Insurance Products

Under the literal language of the statute, many life insurance companies would become dealers in securities because the contracts they sell to their customers fall within the definition of security. The temporary regulations clarified this issue by stating that a life insurance company does not become a dealer in securities merely because its sells annuities, endowments, or life insurance contracts to customers. The final regulations adopt this rule unchanged. The preamble clarifies, however, that a life insurance company will not be able to avoid dealer status under this regulation if its activities encompass other dealer activities, for example, selling policy loans. The preamble explicitly states that section 475 casts a wide net, and even taxpayers who would not previously have considered themselves dealers, for example, those who sell credit card, student or vehicle loans, or loan participations, may be covered by the statute.

Definition of a Security

The final regulations change the language as well as some of the substance of the exclusions from the definition of security for purposes of section 475. Any security on which gain or loss is not recognized under section 1032 is excluded, i.e., stock, including treasury stock, of such corporation, or an option to buy or sell such stock. Any debt instrument issued by the taxpayer (including a synthetic debt instrument, as defined in the contingent instrument regulations) is excluded from the definition of a security.

Identification of Basis for Exemption

The final regulations require that when identifying a security as being exempt from the mark-to-market regime, a taxpayer must indicate on its books and records the reason for the exemption, that is, whether the security is held for investment (or not held for sale) or whether it is a hedge of an item that is not required to be marked to market. Although originally proposed to be effective for identifications made on or after January 4, 1995, the final regulations apply only to identifications made on or after July 1, 1997.

Observation: It remains unclear how this designation is to be made in a situation in which the taxpayer wishes to designate all its securities as outside the mark-to-market regime and expressly exempting certain securities as being within the marking regime.. *

Editor:
Viva Hammer, Esq.
Price Waterhouse LLP