Proposed Treasury Regulations Offer Dealers and Traders Safe Harbor for Section 475 Mark-to-Market Valuations

Section 475 generally requires dealers in securities, and permits dealers in commodities, traders in securities and traders in commodities, to account for their dealer or trader activities for U.S. federal income tax purposes by marking to market the positions that they hold in securities or commodities (as the case may be) at the end of each relevant fiscal period. (When used in Section 475 or this article, the term securities includes derivative financial instruments as well as physical securities.) On May 20, 2005, the U.S. Treasury and the IRS released Prop. Reg. 1.475(a)-4 (the Proposed Regulations). When promulgated in final form, the Proposed Regulations will provide an elective safe harbor for dealers and traders in securities and commodities that will permit these taxpayers to use the fair values of their positions in securities and commodities, as reported on their financial statements, as the fair market values of those positions for purposes of Section 475, generally without risk of audit challenge to those valuations by the IRS. The Proposed Regulations thus implement the proposal to develop a mark-to-market valuation safe harbor based on book-tax conformity principles first outlined by the Treasury and the IRS in Announcement 2003-35, more than two years ago. This article briefly summarizes the operation of the Proposed Regulations. The next part below describes the safe harbor and the basic definitions on which it relies. The third part of the article summarizes some important limitations on the availability of the safe harbor, as well as those (relatively narrow) circumstances under which the IRS reserves the ability to challenge a taxpayer's otherwise-qualifying valuations. Finally, the last part describes how a taxpayer makes the safe harbor election, and (more important) an electing taxpayer's recordkeeping obligations. Very generally, the authors believe that the Proposed Regulations do an admirable job of balancing the competing interests of affected taxpayers and the IRS. Moreover, the Proposed Regulations are in most respects both lucid and comprehensive. The Proposed Regulations of course contain certain provisions that can and should be revised through the public comment process, but on balance, we believe that the Proposed Regulations should be welcomed by affected taxpayers.