Court Opinion

ID: 3001849
Source: CourtListenerOpinion
Date Created: 2015-09-24 20:21:30.638937+00
Date Added: 2024-06-11T12:17:25.333372
License: Public Domain

In the
 United States Court of Appeals
              For the Seventh Circuit
                       ____________

No. 07-3042
JPMORGAN CHASE & CO.
(Successor in interest to Bank One
Corporation, Successor in interest to
First Chicago NBD Corporation,
Formerly NBD Bankcorp, Inc.,
Successor in interest to First Chicago
Corporation) and Affiliated
Corporations,
                                          Petitioner-Appellant,
                              v.

COMMISSIONER OF INTERNAL REVENUE,
                                          Respondent-Appellee.
                       ____________
            Appeal from the United States Tax Court.
           Nos. 5759-95 & 5956-97—David Laro, Judge.
                       ____________
        ARGUED MAY 29, 2008—DECIDED JULY 1, 2008
                       ____________

  Before FLAUM, MANION, and EVANS, Circuit Judges.
  FLAUM, Circuit Judge. 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 cer-
2                                               No. 07-3042

tain costs and expenses associated with the swaps. The
Commissioner of the Internal Revenue Service (“Com-
missioner”), and ultimately the Tax Court, concluded
that these income deferrals were not proper, and that
JPMorgan’s valuation methodology did not clearly re-
flect 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 dis-
putes 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. Background1
  JPMorgan Chase & Company (“JPMorgan”)2 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 de-
signed to serve as protection against fluctuations embed-

1
  As this is the second time this case has come before this
Court, and because we are addressing a fairly narrow issue,
we will briefly restate only the relevant facts. For a more
fulsome account of the background, see JP Morgan Chase &
Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006).
2
   JPMorgan brought this suit as successor and on behalf of
its affiliated corporation, First National Bank of Chicago.
No. 07-3042                                                    3

ded 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 magni-
tude of payments in both directions is determined by
multiplying the relevant interest rate by some constant
referred to as the “notional amount.”3 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, periodi-
cally. 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.4 Even
so, JPMorgan had to do so on an annual basis in order to

3
  What this amount actually is does not directly matter, be-
cause it does not actually get paid out. It is a constant that is
usually tethered to the amount at stake in the underlying
investment that the investor is trying to hedge.
4
  JPMorgan was on both the “fixed” and “floating” side of many
of these transactions. The average of the difference between the
rate it paid out and the rate it was paid, or the bid-ask spread,
in regards to a particular swap was projected out for the term
of the swap to arrive at a “midmarket value.” This is the
value that JPMorgan used to value its swaps.
4                                              No. 07-3042

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 ac-
counting method did not clearly reflect income. Accord-
ingly, JPMorgan received notices of deficiency from the
Internal Revenue Service (“IRS”) that, in essence, re-
quired it to add back the deferrals taken for administra-
tive 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
No. 07-3042                                                    5

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 Com-
missioner’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 valua-
tion methodology pursuant to Tax Court Rule 155.5
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 agree-
ment on the amount of credit risk deferrals taken from
1990 to 1992. The Commissioner calculated this amount

5
  Tax Court Rule 155(a) provides that after the court files its
opinion “determining the issues in a case, it may withhold entry
of its decision for the purpose of permitting the parties to sub-
mit computations pursuant to the court’s determination of the
issues, showing the correct amount of the deficiency . . . to be
entered as the decision.” The parties are allowed to provide
separate computations where they do not agree on the com-
putations.
6                                               No. 07-3042

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 methodol-
ogy 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 Commis-
sioner’s method was due “particularly . . . given the
peculiar record and circumstances of this case,” in-
cluding “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 compu-
tations. 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
No. 07-3042                                                     7

years at issue, rather than the $14.4 million advocated by
the Commissioner and reflected in its previous decisions.
The Tax Court chose this route6 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, Ex-
hibit 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 Com-
missioner, the amount computed by JPMorgan, or wheth-
er 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

6
  There was a three-step procedure involved here: (1) an
adjustment to reverse the annual decreases to swap income
from the initial credit risk deferrals in each year for 1990-1993;
(2) an adjustment pursuant to I.R.C. § 481 to correct for the
previously omitted income in prior years (i.e., in pre-1990 years)
and return those previously claimed deferrals to income; and
(3) an adjustment to reverse the amortization into income of
the disallowed deferrals.
8                                               No. 07-3042

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 may file with
the Tax Court a separate computation that it believes is
in accord with the court’s findings and conclusions. The
Tax Court will then enter its decision. Id.
  Crucially, the “starting point for the [Rule 155] computa-
tion is the statutory notice of deficiency from which the
parties compute the redetermined deficiency based upon
matters agreed by the parties or ruled upon by the Court.”
Home Group, Inc. v. Commissioner, 91 T.C. 265, 269 (1988),
aff’d 875 F.2d 377 (2d Cir. 1989). As a general matter, the
Commissioner’s deficiency determinations are “presump-
tively correct,” and “the taxpayer has the burden of
proving otherwise.” Zuhone v. Commissioner, 883 F.2d
1317, 1323 (7th Cir. 1989). Additionally, taxpayers are
required to keep adequate records from which their
correct tax liability may be determined. See I.R.C. § 6001;
Treas. Reg. § 1.6001-1 (26 C.F.R.). Indeed, in the
previous incarnation of this case, we noted that “the tax
court should bear in mind that the taxpayer retains the
burden of proof, and any inadequacies with the Commis-
sioner’s method that are due to taxpayer’s failure to keep
or provide records . . . may be taken into account.” JP
Morgan, 458 F.3d at 571.
  Here, the Tax Court found (as both parties had stipu-
lated) that JPMorgan had deferred $981,995 of swap in-
No. 07-3042                                               9

come for credit risk in 1993, but it did not make
specific findings for 1990-1992. The Commissioner
argues that JPMorgan failed to substantiate the amounts
of its credit risk deferrals and amortization for 1990-1992
and that, for those years, the amounts contained in the
notices of deficiency should be used because the taxpayer
bears the burden of proving error in the deficiency
notices. JPMorgan argued that the notices of deficiency
were arbitrary and excessive. The Tax Court held to the
contrary and found that (1) the notices of deficiency
were not arbitrary or excessive; (2) the taxpayer bore the
burden of disproving the deferral amounts set out in the
notices; (3) the only credit risk deferral amount that
JPMorgan established was that for 1993; and (4) the only
credit risk amortization JPMorgan established was the
stipulated amount of credit risk deferrals amortized in
1993. To get at credit risk for 1990-1992, the Commissioner
took the notices of deficiency which contained credit risk
deferrals and administrative cost deferrals for that peri-
od, and subtracted the latter quantity. The bottom line
here, from the Commissioner’s perspective, is that the
deficiency determinations are presumptively correct,
and JPMorgan did not produce countervailing evidence
(and in fact produced a dearth of evidence, which led to the
use of the deficiency determinations) to rebut its correct-
ness.
  JPMorgan argues that the Tax Court’s partial rejection
of the government’s valuation methodology negates the
presumption of correctness associated with the notices
of deficiency. This argument seems to have some sur-
face appeal, but there is not basis for it in the law. To be
sure, the Tax Court explicitly upheld the Commissioner’s
determination to disallow taxpayer’s deferral accounting
method. It is true that the Tax Court rejected the
midmarket (government) valuation approach for an
10                                            No. 07-3042

adjusted midmarket approach, but that does not take
away from the presumption of correctness associated
with the notices of deficiency. The Tax Court determined
that the original deficiency determination should be
corrected, but that too does not diminish its value. See
Paccar, Inc. v. Commissioner, 849 F.2d 393, 400 (9th Cir.
1988) (“Where the Commissioner has conceded errors in
his original computations, and the tax court has sus-
tained the Commissioner’s corrected determination, those
errors are not a basis for overcoming the presumption of
correctness.”).
  Apart from whether there is a presumption of correct-
ness that attaches to the notices of deficiency, JPMorgan
asserts that it has presented sufficient evidence to show
that the amounts contained in the notices are not accurate.
Specifically, it relies on Exhibit 149-P, which is a sum-
mary chart that purportedly displays accumulated
credit risk reserve balances. This chart indicates that the
credit risk reserve balance at the end of 1993 was $3.6
million. The logic of JPMorgan’s argument is as follows:
we know the amount of this balance at the end of 1993,
and we know the extent of credit risk deferrals taken in
1993 (about $900,000), and so we can subtract these
values to arrive at a credit risk reserve balance for the
end of 1992. This is how JPMorgan arrives at its
$2.7 million figure, which it believes represents the
total amount of credit risk deferrals that can be added
back into income for the 1990-1992 period. How this $2.7
million is to be allocated for each year is of no moment,
JPMorgan maintains. The simple point is that the total
amount that is to be allocated for 1990-1993 cannot ex-
ceed $3.6 million, and is certainly nowhere near the
$14.4 million figure put forth by the government.
No. 07-3042                                                  11

   The fatal flaw in JPMorgan’s argument is that it assumes
that the $3.6 million figure is accurate—it is not. This is true
for at least two reasons. First, the figure is derived from
Exhibit 149-P, which purports to summarize all outstand-
ing credit risk deferrals recorded in a particular piece of
equipment known as the “Devon System.” But JPMorgan,
by its own admission, conceded that the Devon System
was not used to value all of its swaps. For instance, in
its own findings of fact in the Tax Court, JPMorgan notes
that it used “a different system to compute mid-market
values” for “commodity swaps.” Additionally, it admits
that “Devon was not used to value” a set of currency
swaps. Second, JPMorgan has not made any efforts to
demonstrate the exhibit’s accuracy in regards to those
swaps that it actually does value. The exhibit is merely
a one-page summary of over 600 pages of reports that
were not admitted into evidence. Moreover, the exhibit
is labeled as a “Summary of Monthly Devon Reports,”
but many months (e.g., January through September of 1991)
are missing. JPMorgan cannot overcome the presumption
of correctness connected with the Commissioner’s notices
of deficiency with an oversimplified, unsubstantiated, and
incomplete one-page summary chart.
  What JPMorgan had to do here was present the same
information to the Tax Court regarding its 1990-1992
swap transactions that it presented for its 1993 trans-
actions. JPMorgan complied with I.R.C. § 6001’s record-
keeping requirement that year and was able to demonstrate
that it entered into 488 swap transactions in 1993. The
anemic records prevented the Tax Court from making
similar findings for the previous years in question.
JPMorgan cites two cases, Transport Mfg. & Equip. Co. v.
Commissioner, 374 F.2d 173 (8th Cir. 1967), and Commissioner
12                                               No. 07-3042

v. Jacobson, 164 F.2d 594 (7th Cir. 1947), for the proposition
that the Tax Court should not solely rely on notices of
deficiency when making Rule 155 computations. Nobody
disagrees with this point as a general matter—the Tax
Court’s hands were tied here because of the dearth of
evidence produced by JPMorgan for 1990-1992. It is
precisely because of situations like this that we have pre-
sumptions and burdens of proof. The Tax Court even
gave JPMorgan a second chance on remand to establish
credit risk deferrals and related amortization for 1990-
1992, and it squandered this opportunity by failing to
produce additional evidence and obstinately relying on
Exhibit 149-P. We must therefore conclude that “in arriving
at the tax deficiency, the Tax Court, as the trier of the
facts, is warranted in bearing heavily against the taxpayer,
whose own failure to keep records has created the di-
lemma.” Mitchell v. Commissioner, 416 F.2d 101, 103 (7th Cir.
1969). The Tax Court is not required to take a stab in the
dark, particularly when the party asking it to do so has
turned out the lights.

                      III. Conclusion
  For the foregoing reasons, we AFFIRM the Tax Court’s
judgment.

                    USCA-02-C-0072—7-1-08