Tuesday, December 13, 2011

Joint House Committees Hearing Examines Tax Code Treatment of Derivatives and Other Financial Instruments

An historic joint hearing of the House Ways and Means Committee and the Financial Services Committee examined the treatment of derivatives and other financial instruments under the federal tax code. The hearing highlighted the different treatment of financial instruments for SEC financial reporting and tax code purposes. As part of overall tax reform, the Committees are considering how to respond to the potentially inconsistent tax treatment of economically similar financial products so that such products are structured to meet economic and business purposes rather than tax planning objectives. The hearing also focused on how the tax code has responded to the evolving financial products market.

Thomas Barthold, Chief of Staff of the Joint Committee on Taxation, noted that tax considerations affect decisions related to holding, issuing, and structuring of financial instruments. The taxation of financial instruments generally depends on a categorization based on the type of instrument rather than on the economic characteristics of the instrument, though those economic characteristics affect the categorization. Because instruments with similar or identical economic characteristics may be categorized differently from one another, a taxpayer
with a particular economic goal may choose one instrument rather than another because of tax considerations. Timing, character, and source are principles fundamental to the U.S. income tax generally and, more particularly, affect the taxation of financial instruments.

In his testimony, David Miller of Cadwalader, Wickersham & Taft said that the current federal system for taxing financial instruments is a Ptolemaic system based on the equally archaic system of realization. While modern capital markets understand that true economic income is measured by the increase in the value of assets regardless of when they are sold, the tax code clings to the outdated concept that income is not earned, and therefore not taxed, until a taxpayer actually sells property for cash or exchanges it for materially different property.

Because the federal taxation of financial instruments has no basis in the reality of economics, he continued, sophisticated taxpayers are free to choose a tax treatment that minimizes their taxes. As an example, Mr. Miller cited credit default swaps, which can be structured as options for tax purposes or as notional principal contracts. If they are structured as options, the taxpayer can defer tax on the premiums. If they are structured as notional principal contracts, the taxpayer can rely on the contingent swap regulations proposed by the IRS to claim immediate ordinary losses when the risk of default increases. Some taxpayers initially took the position that credit default swaps are options and deferred the premiums, and then, after the market turned downward, changed their minds and treated the very same credit default swaps as notional principal contracts to claim immediate ordinary losses.

To replace this archaic system, Mr. Miller proposes a mark-to-market system of taxation under which the taxpayer would compare the value of the instrument at the end of year with its tax basis and pay tax on the difference, regardless of whether the instrument is sold. Specifically, he proposes a system that would require all public companies, all private companies with $50 million or more of net assets, and the highest-earning individual taxpayers to mark-to-market all of their publicly-traded property, derivatives of publicly-traded property (other than business hedges), and some publicly-traded debt and liabilities. Mark-to-market gains of individuals would be taxable at long-term capital gains rates and losses would be deductible to the extent of prior mark-to-market gains.

Noting that incremental change is also possible, Mr. Miller said that mark-to-market treatment could be applied selectively to derivatives. This selective treatment would require more line drawing, he acknowledged, but still would be an improvement over the current system.

More specifically, all publicly-traded derivatives for which there is a reasonable basis to determine fair market value would be subject to mark-to-market treatment, and all taxpayers would report mark-to-market gains as ordinary income or loss. Other derivatives would remain subject to the current rules, except that an interest charge would apply to prepaid derivatives.

Thus, non-traded derivatives could give rise to capital gains and losses and no tax would be paid by a taxpayer that receives non-traded property upon the exercise of an option or upon the maturity of a forward contract until the underlying property is sold or exchanged. It is not practical to apply mark-to-market treatment to illiquid and hard-to-value derivatives.

In Mr. Miller’s proposal, broker-dealers would be required to conduct the mark-to-market valuations. The IRS would establish or approve industry-wide valuation guidelines and would audit broker-dealer valuation methodologies, but would not challenge individual valuations that are made in good faith

Taxpayers that do not enter into mark-to-market derivatives with broker-dealers would have to designate an approved broker-dealer to value their derivatives or face a penalty. An exception to mark-to-market taxation would exist for taxpayers that use derivatives to hedge their ordinary assets and liabilities under existing regulations and for taxpayers that integrate their interest-rate and currency swaps into debt instruments under existing regulations. Thus, for example, mark-to-market taxation would not apply to a farmer that uses derivatives to hedge risk on the next crop, or to an energy company that hedges fuel costs.

Partnerships, trusts, and tracking stock can be used to create derivatives and mark-to-market derivatives can be embedded in non-traded derivatives, noted Mr. Miller. Thus, an anti-abuse rule would allow the IRS to treat any portion of a non-traded derivative, non-derivative security, or any other arrangement as a derivative potentially subject to mark-to-market treatment if a principal purpose of the arrangement is to avoid mark-to-market treatment.

Further, he proposed repeal of the 60 percent long-term/40 percent short-term capital gain treatment for Section 1256 contracts, noting that there is no policy justification for reduced rates of tax for short-term Section 1256 contracts. Similarly, mandatory mark-to-market treatment under Section 475 would apply to commodities dealers since there is no policy reason why commodities dealers should enjoy more favorable tax treatment than securities dealers. Investors would have the ability to elect mark-to-market treatment under Section 475 for all of their securities.

Columbia law professor Alex Raskolnikov testified that any reform introducing a special regime for derivatives raises a line drawing problem. If derivatives are taxed differently from everything else, he added, taxpayers must know how to distinguish a derivative from a non-derivative. In his view, a broad definition of a derivative is appropriate.

Professor Raskolnikov also noted the impact of a substantial reduction in the corporate tax rate on the taxation of derivatives. It is likely that the flaws in the taxation of derivatives will become even more costly if a substantial rate differential between individual and corporate tax rates is introduced. The top individual income tax rate and the corporate income tax rate have been fairly close since the early 1980s, he noted. But if a substantial difference develops, financial engineers could respond to a strong incentive to create derivatives that would shift deductions to high-tax individuals while shifting income to low-tax corporations.

Experience with derivatives-based tax planning suggests at least two areas where such income and deduction shifting is likely to arise, he noted, executive compensation and owner-controlled taxable C-corporations. In each case, he believes that it will be fairly easy for the corporation and the individual to agree on the goal of minimizing their joint tax liability and share the tax savings. There is every reason to expect that derivatives will be used to accomplish this goal.

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