This article originially appeared in the December 7, 2011 edition of Tax Notes Today.
The diversity and complexity of financial products are expanding faster than Congress can regulate, and lawmakers may need to overhaul their tax treatment, panelists testified at a rare joint hearing of the House Ways and Means and Senate Finance committees on December 6.
Derivatives have been used more widely in recent years, but they can pose serious risks, said Finance Committee Chair Max Baucus, D-Mont. "Let us clarify and simply the tax treatment of these products," he said.
The hearing focused on whether incremental changes would address the lack of transparency and consistency with financial products or whether fundamental reform is needed. The tax law applicable to notional principal contracts (NPCs) sets forth specific ways of allocating rights of ownership, risk, and potential returns, said Thomas Barthold, chief of staff of the Joint Committee on Taxation. There can be an infinite number of ways to allocate those attributes, he said.
"The bottom-line result is that while the underlying economics of two different financial situations may be identical, the tax treatment under present law may not be equal," Barthold said.
Moving to a Mark-to-Market Regime?
Lawmakers gave considerable attention to marking financial instruments to market, several options for which were included in a report submitted by the American Bar Association Section of Taxation on December 5. (For related coverage, see Doc 2011-25528 .)
David S. Miller, a partner with Cadwalader, Wickersham & Taft LLP, proposed requiring some companies and individuals to mark to market all of their publicly traded property and derivatives of publicly traded property, aside from business hedges. "It is simple to apply and all but foolproof," he said, calling the current system "archaic." (For prior analysis, see Doc 2008-20805 or 2008 TNT 200-48 .)
Publicly traded companies are already required to mark to market their marketable equity securities, some debt securities, and some types of derivatives under generally accepted accounting principles.
Alex Raskolnikov, a professor at Columbia Law School, agreed with Miller, calling the mark-to-market method a plausible approach. For most derivatives, "one of the counterparties is either an exchange, so that they are already publicly traded and subject to mark-to-market [accounting] . . . or a financial institution that probably marks to market that very derivative for tax purposes," he said.
Marking to market will become easier now that the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) has passed, Raskolnikov said. Hedging transactions, however, should be subject to a different regime, he argued.
"Our tax system does not measure economic income, which I think should be the center of our tax universe," Miller said. Yet there are problems Congress must consider when weighing whether to adopt a mark-to-market system, he said. The natural consequence of imposing such a system on some products and not others is that it encourages a behavioral shift to those other products, he said. Congress also has to consider the taxpayer's ability to pay those taxes, because there has not been a realization event when the tax is collected, he said.
Andrea S. Kramer, a partner with McDermott Will & Emery in Chicago, took a different approach, telling lawmakers that a mark-to-market regime would be inappropriate. She expressed concern about what would and would not be included in that system and said there would be questions of valuation for the assets.
"From an administrative and policy standpoint, I personally believe it would be very, very difficult to impose a mark-to-market system," Kramer said. It is easy to find a value for publicly traded securities under a mark-to-market system, but applying that treatment to privately traded securities or other products would lead to broad differences in value, she said.
Kramer urged lawmakers to take what she called a realistic view of Congress's ability -- or inability -- to make dramatic, successful changes to the taxation of financial products. Avoiding abuse and encouraging economic development can be accomplished better by "putting more transactions into the hedging and risk management bucket," she said.
For taxpayers who use derivatives to manage risk, the basic rules governing derivatives are too restrictive and inhibit commercial activity, Kramer said. She also rejected the notion of an "angel list" outlining specific types of hedges that are acceptable under the law. Instead, Congress can best reduce abusive transactions by expanding the definition of hedging transactions, she said.
Ways and Means member Charles B. Rangel, D-N.Y., and Finance member Benjamin L. Cardin, D-Md., both argued that whatever changes are made could be unraveled quickly by a Congress influenced by lobbyists. "Lobbyists don't care what's fair or not -- they're paid to make changes," Rangel said.
Regarding financial products, "the broader the reform, the fewer possibilities there are to create loopholes," Raskolnikov said, adding, "If the incremental line-drawing continues, that's just an invitation to continue as it's been going so far."
The Dodd-Frank Act added section 1256(b)(2)(B), which was intended to carve out financial instruments that are not required or eligible to be marked to market. Finance member Bill Nelson, D-Fla., pointed out that neither the House nor Senate versions of the bill contained a provision to exempt traders from that section, but such a provision was added in the conference committee, thus allowing traders to defer taxes on realized but not recognized gain on derivatives.
Barthold said that under section 1256, regulated futures contracts are marked to market annually and are given special character, in that they are treated as 60 percent long-term capital gains and 40 percent short-term capital gains.
At the start of the conference committee meetings, the scope of regulated futures contracts subject to section 1256 was somewhat unclear, Barthold said. The IRS takes a narrow view of section 1256 contracts, he said. Without the change in the conference, "you could have had an expansion of section 1256 [and] since a lot of contracts are reconciled within a 12-month period, in the normal course, a number of contracts would be short-term gain to individuals," he said.
As a result, the changes under section 1256 were beneficial, and the conference committee's action "was intended to clarify the scope of section 1256 to say that it did not include swap contracts," Barthold said. That change increased the JCT's estimates of the bill's projected revenue, because it clarified which contracts would be subject to the preferential 60 percent long-term capital gains treatment.
Section 1256(b)(2)(B) excludes contracts that do not qualify as NPCs, which are defined in reg. section 1.446-3(c). Proposed regulations issued in September provide that credit default swaps are NPCs. (For REG-11283-11, see Doc 2011-19606 or 2011 TNT 180-13 . For prior coverage, see Doc 2011-24132 or 2011 TNT 222-1 .)
Raskolnikov warned that a substantial reduction in the corporate tax rate and a move to a territorial tax system would increase the urgency of changing the taxation of financial products, which is "in dire need of reform." Ways and Means Chair Dave Camp, R-Mich., recently circulated a discussion draft of a plan to lower the top corporate tax rate to 25 percent and adopt a territorial system. (For prior coverage, see Doc 2011-22525 or 2011 TNT 208-1 .)
If corporate rates are lowered but individual rates remain unchanged, the tax base could erode, Raskolnikov said. There would be a greater payoff in devising financial instruments to shift income to low-tax corporations while shifting related deductions to high-tax individuals, he said. While that is not a reason to oppose lowering the corporate rate, it is a reason to reform financial products taxation to cope with the new financial products that would result, he said.
Different From 1986
Lawmakers also expressed the sense that current reform efforts may differ significantly from the last major tax overhaul, the Tax Reform Act of 1986.
Twenty-five years ago, when TRA 1986 was passed, "the tax treatment of financial instruments and derivatives was relatively new and not highly developed," said Finance ranking minority member Orrin G. Hatch, R-Utah. Hatch's counterpart on Ways and Means, ranking minority member Sander M. Levin, D-Mich., said there has been "an explosion, in terms of financial instruments."
The JCT's report on financial instruments taxation (JCX-56-11) showed that the volume of financial instruments traded in the United States exceeded $65 trillion. The notional amount outstanding of swaps, not including credit derivatives, held by banks required to report to the Office of the Comptroller of the Currency grew tenfold between 1998 and the end of 2010, expanding from $14.3 trillion to $149.2 trillion, according to the report.
There has been a "huge increase in the use of these instruments and the failure to understand them," Levin said.
The following documents are available from Tax Analysts:
- Opening statement from Senate Finance Committee Chair Max Baucus, D-Mont. Doc 2011-25458
- Opening statement from House Ways and Means Committee Chair Dave Camp, R-Mich. Doc 2011-25459
- Opening statement from Finance ranking minority member Orrin G. Hatch, R-Utah. Doc 2011-25460
- Opening statement from Ways and Means ranking minority member Sander M. Levin, D-Mich. Doc 2011-25461
- Release from Baucus. Doc 2011-25544
- Joint Committee on Taxation report (JCX-56-11). Doc 2011-25294 , 2011 TNT 233-33
- Testimony of Andrea S. Kramer, McDermott Will & Emery. Doc 2011-25462
- Testimony of Sen. Carl Levin, D-Mich. Doc 2011-25463
- Testimony of David S. Miller, Cadwalader, Wickersham & Taft LLP. Doc 2011-25464
- Testimony of Alex Raskolnikov, Columbia Law School. Doc 2011-25465
- Letter and report from the American Bar Association Section of Taxation. Doc 2011-25349, 2011 TNT 234-25
- REG-11283-11. Doc 2011-19606, 2011 TNT 180-13.
- Tax-related excerpts of P.L. 111-203, the Dodd-Frank Wall Street Reform and Consumer Protection Act. Doc 2010-14454 , 2010 TNT 125-28
- Discussion draft from Camp. Doc 2011-22576 , 2011 TNT 208-27