In a letter to the House Way and Means Committee as it considers an overhaul of the U.S. tax code, the Investment Company Institute focused on two areas of intense importance to the fund industry that were part of a Committee discussion draft on the taxation of derivatives and other financial instruments. The first proposal would mark all derivatives to market, while the second proposal would require investors to compute gain or loss using the average cost basis method. The ICI understands that these proposals will be included in a comprehensive legislative tax reform package.
While more uniform taxation of derivatives generally would benefit both funds and their investors, noted the ICI, the Committee draft raises concerns. If a mark-to-market approach for derivatives is advanced, the Institute suggests changes to several provisions, including the broad scope of the definition of derivative, the decision to treat marked gains and losses as ordinary, and the application of the straddle rules.
While forcing all investors onto a single basis methodology might appear to simplify gain/loss calculations, noted the ICI, the proposal raises significant complexities and would not improve tax compliance. Because of these concerns, the ICI urged that Congress drop the mandatory average cost proposal from any reform legislation.
Derivatives. Funds and their investors generally would benefit from more uniform tax treatment of derivatives, acknowledged the ICI, since this area of tax law is particularly complex and the Internal Revenue Code has not kept pace with financial product development, which means that new financial products must be pigeon-holed into existing tax regimes that were not designed for them.
The lack of clear and cohesive rules for the taxation of derivatives also complicates accounting compliance for regulated investment companies under SEC rules requiring them to follow FIN 48 (now FASBAccounting Standards Codification Topic 740). This has increased the resources that funds must spend to support accounting for the tax effects of their investments in derivatives. Working with their outside legal advisors and accounting firms, funds must document that their tax treatment of derivatives will be sustained upon examination, based on a more-likely-than-not standard. Meeting the FASB standard would be considerably easier if the rules for taxing derivatives were clarified.
But the draft’s broad definition of “derivative” is expansive enough to encompass a number of instruments and transactions that are not typically thought of as derivatives, noted the ICI, including securities loans and repos. The Institute asked the Committee to narrow the definition to exclude such instruments and transactions, which are frequently used both by funds and by ordinary investors. The ICI also asked Congress to exempt embedded derivatives, such as the option component in a convertible bond, from a mark-to-market regime. It is difficult to see how the Internal Revenue Service could fairly and efficiently administer the proposed rules regarding embedded derivatives, opined the ICI.
The derivatives draft proposal would treat any mark-to-market gains or losses as ordinary. The ICI urged the Committee instead to treat any mark-to-market gains or losses as having the same character as the underlying security. In most cases, the assets underlying derivatives are capital assets. There are some assets, however, that are ordinary, such as currency. Thus, although mark-to-market gains and losses from most derivatives should be treated as capital, it would be appropriate to treat mark-to-market gains from derivatives such as currency forwards as ordinary.
Ordinary income treatment would also create unique difficulties for regulated investment companies. One such difficulty arises because funds cannot carry forward net operating losses (NOLs). As most funds typically have ordinary income in excess of their ordinary losses and expenses, noted the ICI, the absence of carryforward treatment has not been particularly problematic. If mark-to-market losses were ordinary, however, funds would be more likely to experience NOLs more frequently and in greater dollar amounts.
Funds therefore would need the ability to carry forward NOLs indefinitely to prevent fund investors from being unfairly whipsawed. Mutual funds also would be subject to an additional whipsaw in that they would not be able to offset capital losses on their portfolio securities, such as stocks or bonds, with ordinary gains on their derivatives.
Mandatory Average Cost. The Institute strongly urged the Committee to drop the proposal to require all investors to compute gain or loss using the average cost basis method. This proposed change to current law would provide little, if any, benefit, said the ICI, but substantial burdens would be imposed on funds, their shareholders, and reporting brokers. Importantly, average cost basis is not nearly as simple to apply as it may appear and would result in additional locked-in investment.
The mutual fund industry has substantial experience with reporting cost basis to investors, noted the ICI. Most of the industry began providing this information voluntarily about twenty years ago. For the past five years, because of federal legislation mandating cost basis reporting, funds and brokers have spent considerable time and resources addressing cost basis reporting requirements. The expended effort has included revising cost basis reporting systems to, among other things, accommodate shareholder elections to choose any available cost basis method and educating shareholders about the methods available to them. The ICI warned that changing the rules now will create additional confusion for shareholders and negate much of the work done already. Investors should retain their ability to choose their cost basis methodology for all securities.
The ICI rejected the argument that the average cost method is appropriate because securities are fungible. All tax attributes in the Code, such as holding periods and adjustments for wash sales and market discount, are calculated at the lot level. The lots therefore are not fungible for tax purposes, reasoned the ICI, different lots may have very different tax. attributes associated with them. Moreover, investors certainly do not view their lots as fungible, as different lots may have been purchased at different times for different amounts. It has long been a fixture of the federal tax system that taxpayers are able to control the timing of their gains and losses by choosing which lots to sell. It is not clear why this tenet of the U.S. tax code should be replaced by such a fundamental change.