House Ways and Means Committee Chairman Dave Camp (R-Mich.) has proposed to tax derivatives on an annual mark-to-market basis with ordinary gain or loss treatment. This far-reaching proposal is the centerpiece of a series of tax changes for financial products set forth in a discussion draft released on January 24 as part of Chairman Camp’s ongoing effort to develop comprehensive tax reform legislation.
Copies of the official (1) overview, (2) summary (including comparison to current law), (3) detailed technical explanation, and (4) legislative language of the Financial Products Discussion Draft are attached for reference.
New mark-to-market regime for derivatives
As Chairman Camp’s Summary points out, under current law the tax treatment of gains and losses on derivatives is highly dependent upon the particular type of derivative, the profile of the taxpayer, and other factors. Thus, derivatives with virtually identical economic results can produce very different tax and book consequences in terms of character of the instrument and timing and character of income. Those planning opportunities for disparate tax results would be replaced by a single, uniform tax rule under Chairman Camp’s proposal.
Key features of the proposed mark-to-market rule for derivatives:
- Broad definition – The scope of “derivatives” covered by the new mark-to-market regime is intended to be very broad: any option, forward contract, futures contract, short position, swap (including credit default swaps), notional principal contract, embedded derivative feature of debt (e.g., conversion feature), or similar instrument. The derivative does not have to be publicly traded.
- Hedging and real estate carved out – Derivatives used by businesses in the ordinary course to hedge against price, currency, interest rate, and other risks would be exempt from the new mark-to-market regime. Real estate (e.g., options to acquire real estate) also would be exempt. This proposed carve-out would add to the significant pressure already faced under the Dodd-Frank regulatory rules on the distinction between derivatives and hedging.
- Taxed currently – Each derivative would be treated as if sold at the end of the year for fair market value, with the resulting gain or loss taken into account in computing the holder’s income for the year. No longer is gain/loss deferred until the derivative is sold or closed out. Taxing such “imputed” gains could pose liquidity concerns for investors who would be taxed without a corresponding receipt of cash.
- Ordinary treatment – Such mark-to-market gains or losses would be treated as ordinary gains or losses.
- Adjusted for prior gains/losses – Adjustments would be provided to take account of prior year gains or losses of the holder on such derivatives, to avoid double-counting.
- Transfers or terminations covered – Transfers or terminations of derivatives during the year would trigger mark-to-market gains or losses taxed on an ordinary basis.
- Valuation - If fair market value not readily ascertainable, Treasury regulatory authority is provided to use the value as reported by the holder for financial or credit reporting purposes.
- Information reporting – New tax information reporting procedures would have to be developed, and the Discussion Draft seeks comment on how those might work.
Long-term capital gain treatment goes away for futures contracts with repeal of the “60/40 Rule” under Section 1256
Under current law Code section 1256, regulated futures contracts including those future contracts traded on futures exchanges, foreign currency contracts, non-equity options, dealer equity options, and dealer securities futures options, while already marked-to-market, are subject to a favorable income character rule under which 60 per cent of the gain/loss is treated as long-term capital gain/loss and the remaining 40 per cent is treated as short-term capital gain/loss – regardless of the actual holding period. Such treatment is beneficial for investment funds, hedge funds, mutual funds, and other investors which trade frequently and have relatively brief holding periods.
The Discussion Draft proposes to repeal this “60/40” rule under section 1256 as part of the proposed move to a single, uniform mark-to-market, ordinary income regime for derivatives.
Specific basis identification rule for holdings of a security purchased at different times repealed in favor of averaging
The current law rule that permits a taxpayer who has purchased blocs of a particular security at different times to specifically identify the basis of the specific bloc being sold off would be repealed and replaced by a requirement that basis be determined as an average across the taxpayer’s entire holding of the security.
Other proposed financial products tax changes
- Hedging – The hedge identification rules would be simplified by permitting the taxpayer to rely for tax purposes on identification of a transaction as a hedge made for financial accounting purposes.
- Bonds trading at discount or premium in the secondary market – Parity of treatment would be established between bonds issued at a discount and bonds bought on the secondary market at a discount by providing that the holder accrues the discount as income ratably over the remaining life of the bond. Bonds issued or acquired on the secondary market at a premium would now be eligible for an “above-the-line” deduction for bond premium.
- Eliminate “phantom income” from debt restructurings – Debt restructurings in the recent economic crisis were hindered because the reduction in issue price upon the restructuring of debt that had dropped in value gave rise to cancellation of indebtedness income, even though the borrower continued to owe the same principal amount.
The Discussion Draft would eliminate this “phantom income” and tax the borrower only on any forgiveness of principal.
- Wash sale rules tightened to prevent harvesting of tax losses on securities – By including repurchases by specified closely-related parties to the taxpayer.
- Discount on short-term Treasury obligation realized only upon sale or maturity for accrual basis as well as cash basis taxpayers.
Impact and outlook
A key facet of tax reform is eliminating “tax preferences” in order to pay for reduced tax rates. The proposed mark-to-market, ordinary taxation regime for derivatives, along with the repeal of the “60/40” rule under section 1256, illustrate the scope of the “base-broadening” changes that will be necessary to proceed down the path toward a corporate tax rate that dips below 30 per cent. Investment funds, hedge funds, mutual funds, futures traders, and other investors could face a significant tax increase under such proposals.
The Discussion Draft justifies these far-reaching tax changes for derivatives on grounds that could prove politically challenging to confront:
- Protecting taxpayers from another Wall Street bail-out – Along with providing greater simplicity and uniformity, “(s)imultaneously, the proposal also seeks to modernize tax rules to minimize Wall Street’s ability to hide and disguise potentially significant risks through the abuse of derivatives and other novel financial products – an activity that was a contributing factor to the 2008 financial crisis.”
- Fairness among taxpayers – “(A)rcane and often inconsistent tax rules governing derivatives and other financial products have fostered tax-shelter opportunities for some investors while imposing prohibitive tax burdens on taxpayers trying to maintain or sell distressed assets – a process necessary to economic recovery.”
- Taxing Wall Street to pay for rate relief for main street businesses
- No impact on mom-and-pop investors – “Broadly extending mark-to-market accounting treatment to derivatives would provide a more accurate and consistent method of taxing these financial products and make them less susceptible to abuse, without affecting most small investors who normally do not invest in these products.”
- Modernization and simplicity – “(O)ur broken and antiquated tax code has failed to keep up with the rapid pace of financial innovation on Wall Street. . . .Updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer, and more transparent for taxpayers.”
The Discussion Draft solicits input on these proposed tax changes for financial products: “In the interest of transparency, the Committee is soliciting feedback from a broad range of stakeholders, practitioners, economists, and members of the general public on how to improve this proposed set of reforms.” For those directly affected by the proposed tax changes, the time for that would be now.