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Derivatives Taxation May Be a Promising Candidate for Tax Reform

Posted on August 29, 2017 by Stephanie Cumings

Reforming the taxation of derivatives, an idea that’s long been percolating with lawmakers, could finally gain traction as part of tax reform, but the specifics of major legislative proposals from either side of the aisle could prove to be a stumbling block for this change.

John Gimigliano of KPMG LLP told Tax Analysts that a new approach to taxing derivatives “definitely has a chance” if lawmakers attempt truly comprehensive tax reform. But if tax reform efforts are less extensive and amount to merely tax relief, then major changes to derivatives taxation are less likely. And although there is a bipartisan recognition that changes should be made in this area, it’s likely not a big enough issue to drive a broad, bipartisan tax reform effort, according to Gimigliano, who heads the firm's federal legislative and regulatory services group.

Tax reform details have proven elusive, but the mark-to-market taxation of derivatives is one of the few ideas that has been boiled down to actual legislation. Senate Finance Committee ranking minority member Ron Wyden, D-Ore., recently introduced the Modernization of Derivatives Tax Act (MODA), which would mark to market a broad definition of derivatives while treating all gain or loss as ordinary in character. Wyden’s proposal would raise almost $16.5 billion in revenue by 2026, according to an April 2016 Joint Committee on Taxation score of a draft of the bill.

There have also been rumors that House Ways and Means Committee member Tom Reed, R-N.Y., is working on proposals similar to MODA to include in a broader tax reform package. “We know that Congressman Reed is working on a financial products title, and was working on that perhaps as a standalone bill,” Benjamin Allensworth of the Managed Funds Association said in May. Reed’s bill could be considered as part of a broader tax reform package, but it doesn’t necessarily have to be if that “broader package bogs down,” said Allensworth, who was speaking at an American Bar Association Section of Taxation meeting in Washington.

When asked about the administration’s position on MODA and the tax treatment of derivatives, White House spokeswoman Natalie Strom directed Tax Analysts to the administration’s July 27 joint statement on tax reform principles and said that “further details will be incorporated by the [House Ways and Means and Senate Finance]committees as we continue this process.” The joint statement offered few details about what a tax reform proposal might include, but emphasized that one of the goals was to reduce tax rates “as much as possible.” It also noted that tax reform won’t include the controversial border-adjustable tax, an omission that will leave lawmakers looking for ways to raise revenue that can help offset tax cuts.

“Without the border adjustment revenue, [it] means that we’re scrubbing the business side of the tax code to look for the provisions that aren’t as pro-growth or that, because we’re now lowering the rates significantly, just don’t pack the punch that they did before,” Ways and Means Committee Chair Kevin Brady, R-Texas, said August 23 at an event in Dallas.

Window Dressing?

Wyden’s proposal garnered significant attention when it was released last year as a discussion draft. His mark-to-market system for taxing derivatives is similar to former House Ways and Means Committee Chair Dave Camp's Tax Reform Act of 2014. However, Wyden’s bill also addressed several issues raised by the industry in response to Camp’s plan, such as excluding securities lending transactions, derivatives concerning members of the same worldwide affiliated group, and hedges of assets used in the taxpayer’s trade or business. MODA’s prospects have been promising enough to cause some of the IRS’s financial institutions and products projects to be put on hold.

“This legislation takes aim at a loophole that allows sophisticated investors to artificially lower their tax bills,” Wyden said in a statement on the bill. “Ending these aggressive tax planning tactics is critical to achieving comprehensive tax reform that benefits all Americans, not just those at the very top.” Closing loopholes also appears to be part of the Trump administration’s strategy for tax reform. National Economic Council Director Gary Cohn said in April that President Trump “cares about making the economy work for all people” and that tax reform would undo many of the “loopholes and special interest tax breaks [that] have made their way back into the tax code” since 1986. Cohn did not specify which loopholes would be eliminated.

Steven M. Rosenthal of the Urban-Brookings Tax Policy Center said that both parties and both chambers favor mark-to-market, at least in some form. He agreed with Gimigliano that derivatives reform would likely be a part of any large-scale tax bill, but noted that that bill might not amount to real tax reform. Mark-to-market taxation of derivatives could give a broader tax bill the “window dressing” of reform, he said, adding that that would be politically appealing to congressional leadership that wants to label their efforts as reform.

“The big challenge to get a tax bill moving is to make sure the tax bill is viewed as reform and not giveaways,” Rosenthal said.

Rosenthal also noted that the revenue gains from MODA would likely be dwarfed by tax cuts. He said MODA mostly raises revenue from a timing standpoint, noting that “whenever you change a method of accounting to mark-to-market, it accelerates gains.”

Character Issues

Practitioners have praised the MODA proposals, but they have also raised concerns. The New York State Bar Association Tax Section, in a comment letter from February, identified the character issue concerning the bill. “We support the treatment of mark-to-market gains and losses as ordinary income or loss,” the NYSBA said. “However, we believe that mark-to-market gains and losses should generally be treated as capital or ordinary, depending on the nature of the underlying asset, for other purposes, such as determining the source of mark-to-market gains and losses, determining whether mark-to-market gains and losses are ‘unrelated business taxable income’ or qualifying income for purposes of section 7704, and determining whether mark-to-market gain gives rise to effectively connected income.”

Joseph Riley of Willkie Farr & Gallagher LLP said the concept of simplifying derivatives taxation makes sense. He added, however, that characterizing all gains and losses as ordinary leads to a lot of complexity that isn’t necessary, and that it would be simpler to treat derivatives as having the same character as the underlying asset. Riley also said that MODA’s investment hedging unit rules are “very complicated when attempting to actually apply them.” Taxpayers would be treated as holding investment hedging units, which are a new creation under MODA, if there is one or more derivative contracts associated with one or more underlying investments with a delta between minus 0.7 and minus 1.0.

Industry groups have voiced similar concerns. “Obviously there seems to be support for some sort of derivatives reform on both sides of the aisle,” said Karen Gibian, associate general counsel for tax law at the Investment Company Institute, adding that derivatives taxation is confusing and ripe for reform.

“Whether mark-to-market is the right answer is not so simple,” Gibian said. “I think mark-to-market probably makes sense for some derivatives, but I’m not sure that it’s a one-size-fits-all solution.” Gibian said her organization’s main concern with MODA is the characterization of gains and losses as ordinary.

“Our view is that the character should be the same as whatever the underlying investment is,” Gibian said. “I think that makes more sense from a policy standpoint. If you’re trying to prevent people from playing games and you’re trying to level the playing field between the derivative and whatever the underlying security is, it seems to us the character of both should be the same.”

The Investment Company Institute said in a comment letter on Wyden’s discussion draft that “although a mark-to-market approach for all derivatives may be simpler and more uniform than the current derivatives taxation regime, it would come with its own potential complexities, uncertainties and irregularities.” Rosenthal agreed about the potential for unforeseen complications. If drafted correctly, a proposal like MODA could reduce gamesmanship, but that’s a “big if,” he said, adding that “derivatives are very complicated, and any error in the drafting could create more problems.”

The Securities Industry and Financial Markets Association also weighed in on MODA, saying that while it supported a “more rational regime for the taxation of investment securities,” it was concerned that “any broad proposal to mark derivatives to market will require individual retail investors to pay tax on unrealized annual appreciation in a wide array of assets at ordinary income tax rates, before the receipt of cash, and will reduce the current incentives for savings and investment.” SIFMA said that the bill would affect the routine investments of ordinary investors, many of whom are not at all wealthy or sophisticated, and that “Congress should carefully consider the intended scope of these proposals so that they do not increase the federal tax burden of individual retail investors or disrupt U.S. capital markets.”

MODA could “impose significant new tax compliance burdens on the financial services industry and create difficult new administrative challenges for the IRS,” according to SIFMA. The group also cautioned against unintended consequences.

“Any proposal to change the way gain is recognized with respect to a broad category of financial products is inherently complex and our members are concerned that some of the uncertainties in the application of such proposals could linger without timely resolution if substantial regulatory authority is delegated to the IRS to fill gaps,” SIFMA’s letter said. “We remain concerned that line drawing in this area will be difficult and the end-result will be a more complicated, not a simpler, tax code.”