Senate legislation would end a tax loophole that allows traders in complex derivatives to buy and sell these instruments in days or even seconds, yet claim a large portion of the resulting income as a long-term capital gain. Introduced by Senator Carl Levin (D-Mich) the Closing the Derivatives Blended Rate Loophole Act, S 2033, would end a tax subsidy that allows people who make short-term investments in certain derivatives to treat much of their earnings as long-term capital gains.
Generally speaking, taxpayers are allowed to claim the lower capital gains tax rate on earnings only if those earnings come from the sale of assets that they have held for more than a year. In this way, the federal tax code encourages the long-term investment that helps the economy grow.
But under Section 1256 of the Internal Revenue Code, traders in covered derivatives can claim 60 percent of their income as long-term capital gains, no matter how briefly they hold the asset. This blended tax rate applies if the trader holds the asset for 11 months or 11 hours. According to Sen. Levin, the derivatives blended tax rate is an example of how the complexities of the tax code can grant breaks for the few at the expense of the many
He noted that in December of 2011 the American Bar Association Tax Section called for ending the loophole, telling lawmakers in a letter that, whatever the merits of extending preferential rates to derivative financial instruments generally, there is no policy basis for providing those preferential rates to taxpayers who have not made long-term investments.