On January 24, the U.S. House Ways and Means Committee chairman released a discussion draft on the tax treatment of financial products and derivatives.  This wide-reaching proposal, if enacted, would fundamentally change the taxation of financial products and derivatives entered into by individuals, businesses and trading firms.  The discussion draft is just that—a proposal—which means that U.S. taxpayers need to understand the implications of the proposal and to speak out about their views.



On January 24, 2013, the U.S. House Ways and Means (HW&M) Committee chairman released a financial product tax reform discussion draft to revolutionize the tax rules with respect to financial products and derivatives (the Proposal).

The Proposal is in response to the historic December 2011 joint hearing of the HW&M and the Senate Finance Committee.  McDermott Will & Emery partner Andrea Kramer was one of four guests invited to provide testimony at that hearing, where she testified that the current tax hedging provisions need to be expanded to include various risk management transactions that are not “hedges” under current tax law.

The Proposal addresses six areas:

  1. Imposing mark-to-market accounting for financial derivatives
  2. Simplifying” business hedging identification requirement
  3. Preventing “phantom” income and deductions on debt restructurings
  4. Harmonizing taxation of bonds in the secondary market traded at discounts or premiums
  5. Changing tax basis calculations for securities
  6. Expanding the scope of the wash sale rule

In the remainder of this newsletter, we summarize the Proposal’s key provisions.

Impose Uniform Mark to Market Taxation on Financial Derivatives

The Proposal seeks uniformity for the tax treatment of derivatives by requiring all non-exempt derivative positions (broadly defined as futures, forwards, options and notional principal contracts) to be marked to market at the end of each tax year so that changes in the value of derivatives result in currently taxable gain or loss.  Gains or losses from marking derivatives to market would be uniformly treated as ordinary income or loss attributable to a trade or business of the taxpayer, allowing losses to be deducted against ordinary income. 

The mark to market rules would apply to all taxpayers, including individuals, although businesses that enter into transactions that meet the tax hedge definition can qualify for an exemption.

While the Proposal would not extend to non-derivative positions (such as stock, securities or physical commodities) on a stand-alone basis, the Proposal would require mark to market taxation for any non-derivative that is part of a tax straddle with a derivative (referred to as a mixed straddle).  Under this mixed straddle rule, all positions would be marked to market as ordinary income or loss.  Any pre-straddle gains on non-derivative positions held prior to entering into the straddle would be recognized at the time the straddle is entered into.  Pre-straddle losses, however, would be deferred until the non-derivative position is disposed of in an otherwise taxable transaction.

To determine the amount of mark to market gain or loss on derivative positions, the Proposal would grant regulatory authority to allow taxpayers to rely on the fair market value of the derivatives that taxpayers report for financial or credit purposes.  Such regulatory authority, however, does not solve the problems that will likely arise in determining the value of illiquid or long-dated products.

The Proposal applies to all derivatives, as broadly defined, subject to two exceptions.  First, derivatives used by businesses as tax hedges to mitigate the risks of price, currency and interest rate changes in their business operations would be exempt from mark to market.  Another exception would be provided for certain—but not all—derivatives relating to real estate (such as options to acquire real estate).

Several tax law provisions would be repealed because of imposition of mark to market taxation and uniform ordinary income for derivatives, such as the 60/40 tax treatment currently available to Section 1256 contracts (including domestic futures contracts and non-equity options).

Debt instruments with embedded derivatives would be bifurcated into their debt and derivative components, with the derivative component being marked to market.  For example, a convertible security would be treated as a separate non-convertible debt instrument and an equity option.  A debt instrument would not be treated as having an embedded derivative, however, if it is (1) denominated in or specifies payments by reference to a nonfunctional currency, (2) a contingent payment debt instrument, (3) a variable rate debt instrument or (4) a debt with an alternative payment schedule.

This change would be effective for derivatives entered into after December 31, 2013.

Simplify Business Hedging Tax Rules

Business hedgers that meet the hedge identification rules currently match the timing and character of gains and losses on hedging transactions with the gains and losses associated with the ordinary property, ordinary obligation or borrowing being hedged.  The Proposal would exempt business hedging transactions from the tax mark to market rules discussed above.  Under current law, a business hedger must identify tax hedges on the day the hedge is entered into and the hedged property on a substantially contemporaneous basis.

Taxpayers would be permitted to meet their tax hedge identification requirement by relying on hedge identifications made for financial accounting purposes.  This would protect taxpayers from inadvertently failing to qualify for tax hedging treatment by failing to make a same-day identification.  While this would provide relief from inadvertently failing to identify a tax hedge, it does not in any way modernize or expand the tax hedging rules. 

This change would be effective for hedging transactions entered into after December 31, 2013. 

Expansion of Wash Sales Rules to Related Parties

The Proposal would expand the tax 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.  In addition, the tax basis of substantially identical stock or securities is not adjusted to include the disallowed loss in an acquisition by a related party other than the taxpayer’s spouse, disallowing such losses.

This change would be effective for sales and other dispositions occurring after December 31, 2013.

Revise Issue Price Definitions to Eliminate “Phantom” Income and Deductions to Issuers Resulting from Debt Restructurings

To eliminate phantom cancellation of indebtedness (COD) income (meaning, COD income where there is not an actual forgiveness of principal) that many issuers recognize in connection with a restructuring involving an actual exchange of debt or a modification resulting in a significant modification under the “Cottage Savings” regulations, the Proposal would alter the manner in which the issue price of the new or resulting debt is determined.  Under current law, in a debt-for-debt exchange, if either the old debt or the new debt is “publicly traded,” as defined in Treasury Regulations, the issue price of the new debt is based on either its fair market value or the fair market value of the old debt.  This fair market value issue price determination in a distressed debt setting can lead to cancellation of indebtedness income to the borrower (phantom COD income) even though the exchange or modification did not otherwise result in a reduction in the principal amount owed by the issuer.

The Proposal would alter this result by redefining the issue price of the new debt in a taxable debt-for-debt exchange (a specified debt modification) to equal the lesser of the adjusted issue price of the existing (old) debt instrument or the issue price of the modified (new) debt instrument, which would now be determined under Code § 1274 as if the debt instrument were a debt instrument to which that section applied (that is, the principal amount if there is adequate stated interest or, otherwise, the imputed principal amount).  This floor on the issue price of the modified debt instrument would be reduced, however, by any amount of actual principal that is forgiven, which forgiven amount would continue to result in COD income to the borrower.

The proposed issue price determination in a specified debt modification would also apply to holders of the debt.

The issue price determination under the Proposal would also impact an issuer’s calculation of its potential redemption premium in a debt-for-debt exchange.

This change would apply to transactions after December 31, 2013.

Market Discount and Market Premium Amendments

Under current law, when a bond is purchased in the secondary market at a discount, the purchaser is not required to include market discount in income until the bond is retired or the holder resells the bond.  An election is available allowing the holder of a market discount bond to accrue such discount into income over the life of the instrument.  While there are ancillary consequences to a holder of a market discount bond if the holder does not elect to accrue market discount, market discount accretions are not mandatory under current law.

The Proposal would, if adopted, require purchasers of bonds acquired at a discount on the secondary market to include market discount in taxable income over the remaining life of the instrument.  The amount of the market discount inclusion for any taxable year would be computed (like original issue discount) on the basis of a constant interest rate.

The Proposal would include a special rule for bonds held by a partnership.  Under this special rule, in the case of bonds held by a partnership with respect to which a transfer of a partnership interest occurs by sale or exchange or by reason of death, the market discount rules would be applied to the transferee partner as if any bond held by the partnership were acquired at the time of the transfer.

In an effort to distinguish market discount resulting from changes in interest rates from market discount resulting from deterioration of the issuer’s creditworthiness, the Proposal would limit taxable secondary market discount to the amount that reflects increases in interest rates since the loan was originally made.  Specifically, the Proposal would limit taxable secondary market discount to an amount based on the greater of the original yield on the bond plus 5 percentage points or the applicable federal rate plus 10 percentage points.

These market discount changes would apply to bonds acquired after December 31, 2013.

The Proposal also includes amendments aimed at premium bonds by allow taxpayers to claim “above-the-line” deductions for bonds acquired at a premium on a secondary market.  This market premium provision would apply to taxable years beginning after December 31, 2013.

Change the Determination of Tax Basis on Sales of Securities

The Proposal would change the rules for specifying the tax basis of securities that are sold by requiring a taxpayer who sells a portion of its holdings in substantially identical securities to determine its taxable gain or loss based on the taxpayer’s average tax basis in the securities, including both the securities sold and the securities retained by the taxpayer.  This Proposal would be coordinated with the recently enacted basis reporting requirements so that taxpayers would continue to be permitted to determine basis in their securities on an account-by-account basis.

The Proposal treats any specified security that is acquired before January 1, 2014, as being in a separate account from any security that that is acquired on or after that date.  A taxpayer determines the basis of any specified security acquired in 2014 and later by disregarding the basis of specified securities acquired before 2014.  This rule would be effective for sales of securities after December 31, 2013.