The
current tax treatment of gains and losses from entering into derivative
transactions, such as swaps and futures, is highly dependent upon the type of
derivative, the profile of the taxpayer, and other factors, which can result in
very different tax consequences for economically similar transactions. In order
to bring uniformity to the tax treatment of derivatives
and more appropriately measure income and loss, the draft would require all
derivative positions to be marked to market at the end of each tax year so that
changes in the value of the derivative result in taxable gain or loss.
Any
gains or losses from marking a derivative to market would be treated as
ordinary income or loss. For straddles, offsetting financial positions, that
include at least one derivative
position, all positions in the straddle would be marked to market with ordinary
income or loss treatment, including stock, debt and other financial
products
that otherwise would not be subject to mark-to-market treatment under this
proposal.
For
purposes of determining the amount of mark-to-market gain or loss on a derivative,
the draft would provide regulatory authority to rely upon the fair market
value of the derivative that the taxpayer reports for financial or credit purposes.
The
legislation would not apply to common transactions involving derivatives, such as
hedges used by companies to mitigate the risk of price, currency and interest
rate changes in their business operations and real estate transaction, such as options
to acquire real estate. The draft would repeal several tax law provisions that
would be superseded by general
mark-to-market tax treatment of derivatives, such as provisions that attempt to
police the inconsistent tax treatment of derivatives under current law.
The
draft would also simplify business hedging tax rules. Currently, taxpayers are
permitted to match the timing and character of taxable gains and losses on
certain hedging transactions with the gains and losses associated with the
price, currency or interest rate risk being hedged. However, taxpayers can only accomplish such
matching tax treatment if they properly identify the transaction as a hedge on
the day they enter into the transaction.
Often, taxpayers inadvertently fail to satisfy this identification
requirement, even though they have properly identified the transaction as a
hedge for financial accounting purposes. The draft would permit taxpayers to
rely upon an identification of a transaction as a hedge that they have made for
financial accounting purposes.
The
draft would eliminate phantom tax resulting from debt restructurings.
Currently, when the terms of an outstanding debt instrument are significantly
modified, the issue price of the modified debt instrument does not necessarily
equal the issue price of the debt instrument prior to modification. In particular, the issue price of the modified
debt instrument
can be substantially lower than the issue price of the debt instrument prior to
modification
if the debt instrument has lost significant value since the loan was originally made.
The
reduction in the issue price resulting from the modification of the debt
instrument constitutes
taxable cancellation of indebtedness income to the borrower, although the borrower
still owes the same actual principal amount as was owed prior to the modification.
The draft would eliminate the phantom taxable income problem associated with many
debt restructurings by generally providing that the issue price of the modified
debt instrument cannot be less then the issue price of the debt instrument
prior to modification. This floor on the
issue price of the modified debt instrument would be reduced by any amount of
actual principal that is forgiven.
The
draft would prevent the harvesting of tax losses on securities. For decades,
the wash sale tax rules have prevented taxpayers from artificially creating tax
losses on securities that have declined in value by selling the securities at a
loss and, within a short time before or after the sale, acquiring the same
securities. When these rules apply, the
loss is deferred until the replacement securities are later sold. However, many taxpayers can avoid the wash
sale rules by directing a closely related party, such as a spouse or dependent
child, to acquire the replacement securities.
The draft would close this loophole by expanding
the scope of the wash sale rules to include acquisitions of replacement
securities by certain closely related parties, including spouses, dependents,
controlled or controlling entities (such as corporations, partnerships, trusts
or estates), and certain qualified compensation, retirement, health and
education plans or accounts.