Sunday, October 30, 2011

GAO Report Urges IRS, SEC and CFTC to Develop Information-Sharing Arrangements on Financial Derivatives

Noting that financial derivatives are particularly difficult for the US tax code to timely address, the GAO urged the development of a collaborative information-sharing working relationship between the IRS and the SEC and CFTC. IRS officials told the GAO that they are developing plans to have regular meetings with the SEC to discuss new products and emerging issues related to financial derivatives. The GAO urged the IRS to also develop a working relationship with the CFTC. The GAO report noted that the IRS has occasionally received information from the SEC on financial derivatives that were suspected of being used for abusive tax purposes. Such information, however, is received only on an ad hoc basis, either. through requests initiated by the IRS or referrals from the SEC.

The growth in the complexity and use of financial derivatives presents a particular challenge for the IRS, which sometimes identifies new financial derivative products or new uses for existing products long after they have been introduced into the market. Moreover, the tax code’s current approach to the taxation of financial derivatives is characterized by many experts as the “cubbyhole” approach under which the code establishes broad categories for financial instruments, such as debt, equity, forwards, and options, each with its own rules governing how and when gains and losses are taxed.

As new financial derivatives are developed, the IRS attempt to fit them into existing tax categories by comparing the new instrument to the most closely analogous instruments for which tax rules exist. However, said the GAO, a new financial instrument could be similar to multiple tax categories, and therefore the IRS and taxpayers must choose between alternatives, resulting in inconsistent tax consequences for a transaction that produces the same economic results. Consequently, the IRS is not always able to quickly identify and prevent potential abuse.

The GAO suggested that one way to timely identify new products or new uses of products would be through increased information sharing with the SEC and CFTC, given their oversight role of the financial derivative markets. Similarly, there may also be opportunities for bank regulators to share with the IRS any knowledge of derivatives that they gain. This would be consistent with the IRS’s goal of strengthening partnerships across government to ensure that taxpayers meet their obligations to pay taxes.

The GAO recommended a number of best practice that can inform an IRS-SEC-CFTC working relationship, including defining a common outcome, establishing mutually reinforcing strategies, leveraging resources, establishing cross-agency policies, and setting up joint agency and individual accountability.

Although financial derivatives enable companies and others to manage risks, noted the GAO, some taxpayers have used financial derivatives to take advantage of the current tax system, sometimes in ways that courts have later deemed improper or Congress has disallowed. Without changes to the approach to how financial derivatives are taxed, concluded the GAO, the potential for abuse continues.

Currently, the IRS does not systematically or regularly communicate with the SEC or CFTC on financial derivatives. The IRS’s 2009-2013 Strategic Plan lists strengthening partnerships across government agencies to gather and share additional information as key to enforcing the law in a timely manner to ensure taxpayers meet their obligations to pay taxes. The SEC and CFTC told the GAO that opportunities may exist to share additional information on financial derivatives with the IRS.

However, the ability of the IRS to share taxpayer information with other federal agencies is limited under Section 6103 of the Internal Revenue Code, which governs the confidentiality of taxpayer data. IRS officials say that the lack of reciprocal information sharing is an impediment to effective collaboration with the SEC and CFTC.

SEC officials told the GAO that when potential tax abuses have been identified and shared with the IRS, the SEC examiner involved in the case typically had some tax expertise or had worked with the IRS in the past. For example, in 2008, SEC examiners discovered a strategy employed by hedge funds to structure short-term capital gains into long-term capital gains through the use of options. This information was referred to the IRS because SEC staff believed that the IRS may conclude that the structuring of transactions in this manner may result in an incorrect treatment of capital gains. The IRS said that this information was essential to the eventual development and issuance of related guidance. However, IRS officials also said that SEC and CFTC examiners often do not have tax expertise. As a result, potential tax abuses may not be identified and shared with the IRS.

The IRS typically uncovers new financial derivative abuses during a tax audit, said the GAO, meaning by the time IRS identifies the financial derivative product, and issues guidance, the market for that product can be relatively large and developed. The SEC may identify new products and emerging trends in financial derivatives trading before the IRS because new products on exchanges must be approved by the Commission before they can be traded, and others may be disclosed in financial statements. According to IRS officials, improved collaboration could help the IRS more quickly identify and analyze emerging financial trends and new products in the financial derivatives market before taxpayers even file their tax returns.

The IRS said that a regular avenue for obtaining information about sales reported to the SEC in disclosures of insider trading could have sped the IRS’s identification of the use of VPFCs with share-lending agreements. When taxpayers deferred income recognition by not considering a VPFC and share-lending agreement as constituting a sale on their tax return, some taxpayers reported the transaction as a sale for SEC purposes. IRS officials obtained this information, but had they been regularly and systematically communicating with other agency officials on financial derivatives, problems with these transactions may have been identified earlier.

The IRS believes that because information on financial derivatives may be reported for +both regulatory and tax purposes, reviewing certain types of transactions collaboratively with the SEC and CFTC could help the IRS better identify abuse. For example, the IRS said that information on financial derivatives from SEC Form 4s, which relate to insider trading, and Form 10-Ks have been useful for identifying new financial derivative products and potential tax issues.

Federal banking regulators also have information on financial derivatives. Although federal banking regulators do not oversee derivatives markets, their oversight of banking institutions includes evaluations of risks to bank safety and soundness from derivatives activities. For example, reported the GAO, their oversight captures most credit default swap activity because banks act as dealers in the majority of transactions and because they generally oversee credit default swap dealer banks as part of their ongoing examination programs. Similarly, since OCC-regulated banks may only engage in activities deemed permissible for a national bank, the agency periodically receives requests from banks to approve new financial derivatives activities. Information collected during these reviews may provide the IRS with information on financial derivatives.

No comments: