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JPMorgan Chase & Co. v. Commissioner of Internal Revenue

July 1, 2008


Appeal from the United States Tax Court. Nos. 5759-95 & 5956-97-David Laro, Judge.

The opinion of the court was delivered by: Flaum, Circuit Judge

ARGUED MAY 29, 2008

Before FLAUM, MANION, and EVANS, Circuit Judges.

This case concerns the taxation of JPMorgan's income from swap transactions. JPMorgan tried to carve out and defer a part of this income for certain costs and expenses associated with the swaps. The Commissioner of the Internal Revenue Service ("Commissioner"), and ultimately the Tax Court, concluded that these income deferrals were not proper, and that JPMorgan's valuation methodology did not clearly reflect income. JPMorgan then appealed the Tax Court's decision to this Court, and we remanded the case so that the Tax Court could apply a more deferential standard of review to the Commissioner's valuation methodology. After the proceedings below were again decided in the Commissioner's favor, JPMorgan now appeals here for a second time. On this appeal, JPMorgan does not contest the income deferral and valuation issues-it only disputes certain computations regarding the amounts of these carve-outs. Because we find no error in the Tax Court's acceptance of the Commissioner's computations, we affirm.

I. Background*fn1

JPMorgan Chase & Company ("JPMorgan")*fn2 is one of the largest dealers of a set of contracts known as "swaps." While the mechanics are not especially relevant in this case, these are essentially contracts between two parties designed to serve as protection against fluctuations embedded in an investment. These fluctuations can come from a number of sources, such as interest rates, commodities, or currencies. The two parties to a swap contract agree to exchange payments at specified intervals. The value inherent in a swap is a function of the difference between the amount of money that one party takes in from and gives out to the other party (i.e., the "counterparty"). To clarify, in the context of an interest rate swap, the magnitude of payments in both directions is determined by multiplying the relevant interest rate by some constant referred to as the "notional amount."*fn3 Usually, one party multiplies this notional amount by a fixed interest rate, and the other party multiplies this amount by a floating interest rate (e.g., the London Interbank Offered Rate). These payments are then exchanged, or swapped, periodically. If the floating rate is, for instance, below the fixed rate, the party paying out the floating rate takes in money, and the other party loses money on the swap.

In 1993, JPMorgan had at least 100 billion dollars worth of swaps on its books. Valuing these instruments even independent of this vast quantity can be difficult.*fn4 Even so, JPMorgan had to do so on an annual basis in order to report income accurately and pay taxes. At first, JPMorgan deferred a portion of this income for (1) administrative costs associated with handling the swaps, and (2) risk associated with counterparties who may default on their obligations. It is the latter portion of these deferrals-the credit risk-that is at issue in this appeal. Specifically, JPMorgan used two different methods to calculate the annual income deferrals associated with credit risk. The amount that it deferred was then "amortized," or put back, into income in some future year. The deferrals, known as "swap fee carve-outs," were designed to prevent the full valuation of a swap from being recognized up front.

In the Commissioner's view, JPMorgan's deferral accounting method did not clearly reflect income. Accordingly, JPMorgan received notices of deficiency from the Internal Revenue Service ("IRS") that, in essence, required it to add back the deferrals taken for administrative and credit risk costs into income for each relevant year. The amounts ranged from about $3.5 to $5.8 million each year, from 1990 through 1993. After receiving its first notice of deficiency, JPMorgan filed suit in the Tax Court arguing that its method of deferral accounting (which deferred income to match related expenses) was an accurate way to reflect income. While the case was being argued in that court, JPMorgan turned about-face and conceded that the deferral method was actually not allowed under these circumstances.

The Tax Court then issued its ruling and concluded that neither party's method for calculating income was appropriate. Understanding these various methods for valuing swaps is not specifically relevant to the issue in this appeal, but we mention and summarize them for completeness. Overall, the Tax Court agreed with the Commissioner that JPMorgan could not defer swap-related income associated with administrative costs and credit risk. But it also determined that these amounts should not be fully added back into income for the years 1990 through 1993. Instead, it advocated an "adjusted midmarket valuation" which would essentially allow for no deferrals and exclude the income associated with administrative costs and credit risk. The Commissioner agreed with this methodology in theory, but believed that JPMorgan's method for calculating administrative cost and credit risk deferrals was flawed. From the Commissioner's perspective, JPMorgan's poor recordkeeping made it difficult to ascertain the extent to which the midmarket value should be adjusted for credit risk-related expenses.

Regardless, the Tax Court then ordered the parties to compute JPMorgan's deficiency given this new valuation methodology pursuant to Tax Court Rule 155.*fn5 JPMorgan and the Commissioner came to an agreement regarding administrative costs for each year and for credit risk in 1993, but they could not reach an agreement on the amount of credit risk deferrals taken from 1990 to 1992. The Commissioner calculated this amount to be approximately $14.4 million total from 1990 to 1993. It relied primarily on the notices of deficiency for arriving at this value because, in its view, JPMorgan did not keep the statutorily mandated records that would be needed to arrive at a more precise estimate. In contrast, JPMorgan capped this amount at approximately $3.6 million total over the 1990-1993 period, and relied on a disputed summary chart (prepared for this litigation) to arrive at this result. The Tax Court was not pleased with either result, and ordered both parties to submit supplemental computations. Nothing new surfaced in these additional proceedings. The Tax Court then entered its decision in favor of the Commissioner's computations.

JPMorgan then appealed the decision to this court and challenged both the Tax Court's valuation methodology and the Rule 155 computations. We did not reach the substance of this issue because we remanded back to the Tax Court on the grounds that it should apply a deferential standard of review to the Commissioner's method of accounting for the swap valuations. In that decision, we concluded that deference to the Commissioner's method was due "particularly . . . given the peculiar record and circumstances of this case," including "taxpayer's failure to keep or provide records." JP Morgan, 458 F.3d at 571. At the same time, however, we expressed "concern about the perfunctory adoption of the Commissioner's computations" and requested "[g]reater explanation" regarding the computations. Id. at 572.

On remand, the Tax Court did provide a more robust account of why it agreed with the Commissioner's computations. It found that JPMorgan had failed to demonstrate that the cumulative effect of removing its improper credit risk deferrals was capped at $3.6 million for the years at issue, rather than the $14.4 million advocated by the Commissioner and reflected in its previous decisions. The Tax Court chose this route*fn6 because JPMorgan's computations were not supported by the record and violated the principle of annual accounting (i.e., it only gave a total amount for the three years, as opposed to a year-by-year breakdown). It also refused to adopt the numbers contained in JPMorgan's summary chart, Exhibit 149-P. JPMorgan then filed a motion to vacate and both parties reiterated the same arguments made above. The Tax Court denied this motion for similar reasons: there was no credible evidence of the credit risk deferrals. Given the deficiencies in the record, the Tax Court did not know whether the actual amount of JPMorgan's credit risk deferrals was the amount computed by the Commissioner, the amount computed by JPMorgan, or whether the actual amount was closer to one or the other. In sum, the Tax Court found that it did not want to "reward[ ] [taxpayer] and its successors for their lack of recordkeeping or, in other words, allow[ ] [taxpayer] to escape taxation."

II. Discussion

In this second appeal, JPMorgan does not challenge the Tax Court's valuation methodology; it only disputes its acceptance of the Commissioner's Rule 155 computations. We review the Tax Court's adoption of computations submitted by one or the other of the parties pursuant to Tax Court Rule 155 for an abuse of discretion. Chimblo v. Commissioner, 177 F.3d 119, 127 (2d Cir. 1999). Rule 155 proceedings are limited to purely computational items that must, by the terms of the rule, be consistent with the findings and conclusions of the Tax Court's opinion. Tax Ct. R. 155(b). If the parties disagree as to the amount to be entered as the decision, then each party ...

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