Tax Analysts Blog

Financial Product Reform Might Not Be Imminent

Posted on Jan 13, 2014
Comprehensive tax reform might be far in the future, but that doesn’t mean that no changes to the tax system will be made over the next few years. The medical device excise tax is unpopular and might be repealed soon. Extenders are bound to be dealt with eventually, and it’s likely a few won’t be renewed, signaling their “permanent” death. President Obama has pushed for economic stimulus for his so-called promise zones. It’s possible that Congress will move on any or all of these items this year. But what about the taxation of financial products? Would lawmakers consider moving pieces of House Ways and Means Chair Dave Camp’s draft in the absence of a larger reform bill?

No, according to Joint Committee on Taxation economist Karl Russo. At a Practising Law Institute seminar last week, Russo said, “I think it is unlikely to have the financial products discussion draft passed with no other changes to the tax code.” He also threw cold water on practitioner hopes that some of the technical fixes in the Camp draft would become law, although he didn’t quite rule it out.

Russo’s opinion isn’t definitive, of course. It is still possible that Congress will move some financial tax reform. Lee Sheppard has written that the Camp mark-to-market and subchapter K proposals scare a lot of people because ideas that raise revenue don’t ever entirely die; they just go on the shelf and wait for another day. And it would be a shame if financial product reform had to wait until Congress and the White House agreed on broad revenue and individual taxation policies.

There is bipartisan consensus on some unpopular aspects of potential financial products reform. Both Camp and Obama have proposed marking products to market. Camp’s draft would effectively eliminate stuffing allocations, a controversial and aggressive tax position that is commonly used by the hedge fund industry and seems favored by Treasury and the administration. Camp and Obama have also both pushed for passthrough entity reform, something that would dramatically affect the financial sector. Sheppard has argued that one of the major problems with the taxation of hedge funds is that they are allowed to operate as partnerships and twist subchapter K law.

The mark-to-market proposals have caused the most practitioner stir, which usually indicates that change is desperately needed. Camp’s draft contains proposed section 485, which would require all derivatives to be marked to market at the end of the year. Marked gains and losses are considered ordinary. Naturally, this wouldn’t go over all that well with hedge fund investors or fund managers, whose profits interests receive capital gains treatment. Obama’s 2014 budget proposal contained a very similar mark-to-market proposal, but like all the rest of the president’s budget ideas, it went nowhere.

The financial sector is largely responsible for the recession that is still slowing down the world economy. The Dodd-Frank act didn’t fix nearly enough of the problems with financial products or banks’ overreliance on sketchy investments for high profits. The tax rules governing this area are part of the problem. There is no reason why fixes to derivatives, hedge fund taxation, and passthrough rules should have to wait for Republicans and Democrats to agree on how to tax the rich or on overall revenue levels for the federal government. Financial product tax reform is needed and ideas are on the table, and it shouldn’t be tied to broader questions that might not be answered until one party controls all of Washington.

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