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Letter Ruling 9836002, March 28, 1998

Uniform Issue List Information:
UIL No. 0475.00-00
Mark to market accounting method for dealers

Code Sec. 475

ISSUE

Is Taxpayer required to mark to market its accounts receivable that are transition securities ( "Transition Receivables") under §475 of the Internal Revenue Code?

CONCLUSION

Based on the facts presented, Taxpayer must mark to market its Transition Receivables under §475 .

FACTS

Taxpayer is the parent of a consolidated group of companies that files a consolidated income tax return.

Taxpayer manufactures and sells lumber and building materials. As part of its business, Taxpayer extends credit to the purchasers of its lumber and building materials at the time of the purchase in order to finance the purchase, generating accounts receivable. To date, Taxpayer has not sold any of these receivables.

On Date 1 (prior to the issuance of Rev. Proc. 97-43 , 1997- 39 I.R.B. 12), Taxpayer filed amended returns for the taxable years ending Year 1, Year 2, and Year 3. On its Year 1 amended return, Taxpayer made an election under §1.475(c)-1(b)(4)(i) of the Income Tax Regulations for that year and for all subsequent years. This election required Taxpayer to change its method of accounting for securities to the mark-to-market method under §475 .

On its amended returns, Taxpayer marked to market its Transition Receivables under §475(a) , claiming losses of $a and $b for Year 1 and Year 3, respectively. These losses resulted in a refund due Taxpayer for those years. Taxpayer also claimed additional mark-to-market gain of $c for Year 2, resulting in an increase in the Taxpayer's tax liability for that year.

Taxpayer's books and records contain a policy statement, dated Date 2 (on or before October 31, 1997), which identifies transition securities (securities acquired on or before October 31, 1997) that are subject to identification under Holding 15 of Rev. Rul. 97-39 , 1997-39 I.R.B. 4. In the policy statement, Taxpayer identifies all transition securities held in itsInvestments subgroup of accounts (nomenclature actually used in the contemporaneous books and records) as held for investment or not held for sale under §475(b)(1)(A) or (B) . The policy statement further provides that accounts receivable and all other transition securities not listed in the Investment subgroup of accounts (i.e., the Transition Receivables at issue) are not identified as exempt under §475(b)(1)(A) or (B) as either held for investment or not held for sale.

Taxpayer represents that its books and records do not contain any statements affirmatively indicating that its Transition Receivables are held for investment or not held for sale. For general ledger and financial statement purposes, Transition Receivables are described as "Accounts ReceivableTrade" and "Notes and Other Receivables."

On Date 3 (on or before October 31, 1997), Taxpayer filed a Form 3115, Application for Change in Accounting Method, under sections 4.02 and 4.03 of Rev. Proc. 97-43 to change to the mark to market method of accounting for its securities for Year 1 and for all subsequent years. Pursuant to section 4.05 of Rev. Proc. 97-43 , Taxpayer filed the Form 3115 with the Commissioner of Internal Revenue and the examining agent. Taxpayer represents that it plans to attach the Form 3115 to its first federal income tax return filed after October 31, 1997, in accordance with section 4.04 of Rev. Proc. 97-43 .

In a 30-day letter, dated Date 4, the examining agent disallowed the Taxpayer's mark-to-market gains and losses relating to the election.

LAW AND ANALYSIS

Section 475 generally requires a dealer in securities to account for its securities on a mark-to-market method of accounting. Section 475(a) . Section 475(c)(1) defines a dealer in securities as a taxpayer who either: (1) regularly purchases securities from or sells securities to customers in the ordinary course of its trade or business; or (2) regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. The term security includes a note, bond, debenture, or other evidence of indebtedness. Section 475(c)(2)(C) .

Section 1.475(c)-1(b) generally excludes from the dealer definition a taxpayer who would not be a dealer in securities but for its purchase and sale of debt instruments that are customer paper. A debt instrument is customer paper with respect to a person at a point in time if: (1) the person's principal activity is selling nonfinancial goods or providing nonfinancial services; (2) the debt instrument was issued by a purchaser of the goods or services at the time of the purchase of those goods or services in order to finance the purchase; and (3) at all times since the debt instrument was issued, it has been held either by the person selling those goods or services or by a member of the same consolidated group as that person. Section 1.475(c)-1(b)(2) .

Under §1.475(c)-1(b)(4)(i) , a taxpayer may elect to waive the customer paper exception. The waiver may be elected for a year ending on or before December 24, 1996, by attaching a statement to an amended return filed not later than October 31, 1997. An election under §1.475(c)-1(b)(4)(i) also is deemed to be an election to waive the exemption from the application of §475(a) provided by §1.475(c)-1(c) for taxpayers with negligible sales of securities. See Rev. Rul. 97-39 , Holdings 17 and 18.

Rev. Proc. 97-43 provides procedures for a taxpayer to obtain the automatic consent of the Commissioner to change its method of accounting to reflect the application of §475 as a result of making the election under §1.475(c)-1(b)(4)(i) . Rev. Proc. 97-43 became effective on September 10, 1997.

Taxpayer is treated as dealer in securities for purposes of §475 for Year 1 and for all subsequent years. Taxpayer regularly originates accounts receivable, which are evidences of indebtedness, with customers in the ordinary course of its business. Although Taxpayer fits within the customer paper and negligible sales exemptions from dealer status, it has complied with the requirements in §1.475(c)-1(b)(4)(i) necessary to waive those exemptions. Further, assuming that Taxpayer attaches the Form 3115 to its first federal income tax return filed after October 31, 1997, in accordance with section 4.04 of Rev. Proc. 97-43 , Taxpayer has complied with the automatic consent procedures in Rev. Proc. 97-43 to change its method of accounting to the mark-to-market method. Thus, Taxpayer is subject to markto-market accounting under §475 for those years.

Section 475(a) provides the general rule that a dealer in securities must mark to market all of its securities. Section 475(b)(1)(A) , (B) , and (C) provide that §475(a) does not apply to: (1) any security held for investment; (2) certain securities that are not held for sale; and (3) any security that is a hedge of an item that is not subject to the mark-to-market rules. Further, under §475(b)(2) , a security is not treated as described in §475(b)(1)(A) , (B) , or (C) unless it is clearly identified in the dealer's records as being described in such subparagraph before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe). An exception to this same-day identification rule is contained in Holding 15 of Rev. Rul. 97-39 .

Holding 15 of Rev. Rul. 97-39 provides a special identification regime for a taxpayer that: (1) made an election out of the customer paper exemption, the negligible sales exemption, or both; and (2) was not treated as a dealer in securities under §1.475(c)-1T . Taxpayer meets both of these requirements and, therefore, is subject to the special identification regime.

The special identification regime applies only to securities ( "transition securities") for which an identification would have been timely under the general rule (described in Holding 14 of Rev. Rul. 97-39 ) only if made on or before October 31, 1997. Rev. Rul. 97-39 , Holding 15. Under the special identification regime, a transition security was properly identified as exempt for the purposes of §475(b)(2) or (c)(2)(F)(iii) if the information that was contained in the taxpayer's books and records and that was entered substantially contemporaneously with the date of acquisition of the transition security supports a conclusion that the transition security was described by §475(b)(1)(A) , (B) , or (C) . Id. This rule applies even if the information in the taxpayer's books and records does not meet the specificity that Holding 5 of Rev. Rul. 97-39 generally requires for identification. Id.

Holding 15 also states that a taxpayer must, by October 31, 1997, place in its books and records a statement resolving ambiguities, if any, concerning which transition securities are properly identified under the special identification regime. Any information that supports treating a transition security as being described in §475(b)(2) or (c)(2)(F)(iii) must be applied consistently.

The information in the Taxpayer's books and records that was entered substantially contemporaneously with the date of the acquisition of the Transition Receivables does not support the conclusion that the Transition Receivables were described by §475(b)(1)(A) , (B) , or (C) . In fact, Taxpayer represents that its books and records at the time the Transition Receivables were originated did not contain any statements indicating that the Transition Receivables were either held for investment or held for sale to customers. Pursuant to Holding 15 of Rev. Proc. 97- 39, the Taxpayer resolved the ambiguity regarding whether the Transition Receivables were properly identified under the special identification regime by placing a statement in its books and records specifically stating that the Transition Receivables are not identified as exempt under §475(b)(1)(A) or (B) as either held for investment or not held for sale. Thus, based on these facts, Taxpayer is required to mark to market the Transition Receivables.

A copy of this technical advice memorandum is to be given to the Taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent. This technical advice memorandum does not address the issue of the proper valuation of the Transition Receivables for the years in issue.