## Facts

- A bank holding company and its affiliates operated as a dealer in interest-rate swaps and other derivatives, commonly entering offsetting positions and managing market and credit risks.
- For the taxable year ending December 31, 1993, the first year it applied I.R.C. § 475 to relevant dealer positions, the taxpayer marked its dealer swaps to market and reported ordinary gain or loss based on year-end “fair market value.”
- The taxpayer determined swap values using an internal model that produced “mid-market” present values derived from market data (bid/ask-based yield curve inputs), discounted expected future cash flows, and generally did not price explicitly at a dealer bid-ask spread.
- The taxpayer’s reported values included adjustments intended to account for counterparty credit risk and for administrative costs associated with originating and maintaining swap positions.
- The Commissioner determined deficiencies, asserting the taxpayer’s swap income recognition and year-end valuation approach did not clearly reflect income under I.R.C. § 446(b), and proposed alternative accounting/valuation methods.
- The taxpayer petitioned the Tax Court to redetermine the asserted deficiencies.

## Issues

1. Whether the mark-to-market rule and valuation requirement for dealer swaps under I.R.C. § 475 constitute a “method of accounting” subject to I.R.C. § 446(b).
2. Whether the taxpayer’s method for recognizing swap-related income and valuing swaps at year-end clearly reflected income under § 446(b).
3. Whether the Commissioner’s proposed method clearly reflected income under § 446(b).
4. What valuation approach best measures “fair market value” of dealer interest-rate swaps for § 475 purposes, including treatment of credit risk and administrative costs.

## Decision

- The Tax Court held that § 475’s mark-to-market rule and the associated valuation approach for dealer swaps are a “method of accounting” governed by § 446(b)’s clear-reflection-of-income standard.
- The court held the taxpayer’s method did not clearly reflect income under § 446(b).
- The court also held the Commissioner’s proposed method did not clearly reflect income under § 446(b).
- The court required a valuation framework that uses mid-market value as the baseline, with adjustments that (i) reflect credit risk dynamically and bilaterally and (ii) reflect only incremental administrative costs.
- The case proceeded for recomputation consistent with the court’s valuation framework.

## Legal Principles

- The timing and manner of recognizing income under § 475 mark-to-market, including how fair market value is determined at year-end, constitute a “method of accounting” subject to § 446(b).
- Under § 446(b), the Commissioner may reject a taxpayer’s method that does not clearly reflect income, but any substitute method must also clearly reflect income.
- For dealer interest-rate swaps under § 475, a mid-market present-value approach may be an acceptable baseline for fair market value when appropriately implemented.
- Credit risk adjustments must be dynamic and must consider the creditworthiness of both parties to the swap, not solely the counterparty.
- Administrative cost adjustments are limited to incremental costs directly attributable to maintaining the swap positions; allocations of general overhead are not part of fair market value.

## Conclusion

The Tax Court treated § 475 swap mark-to-market valuation as an accounting method reviewable under § 446(b), rejected both the taxpayer’s and the Commissioner’s approaches as failing to clearly reflect income, and required mid-market valuation with dynamic bilateral credit adjustments and incremental (not overhead) administrative cost adjustments.


Bank One Corp. v. Comm’r, 120 T.C. 174 (2003)