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Tax News & Views
House Ways and Means Committee Chairman Dave Camp, R-Mich., on January 24 released a legislative discussion draft of proposals to reform the tax treatment of financial products. While not an introduced bill, the draft does contain statutory language and indicates the direction Camp is contemplating with respect to changing the treatment of financial products – including significant changes to the taxation of derivatives.
According to Ways and Means staff comments at a press briefing announcing the draft, the reforms were not drafted with revenue in mind and are not meant to be revenue neutral or revenue raising. They are, instead, intended to conform disparate tax treatment of economically similar products and discourage behavior that is done solely for tax purposes.
This is the second draft proposal that Camp has released to spur debate on tax reform. In the fall of 2011, he introduced a discussion draft that proposed reducing the top U.S. corporate tax rate to 25 percent and moving toward a territorial tax system for taxing foreign-source income of U.S. multinationals. (For coverage, see Tax News & Views, Vol. 12. No. 49, Oct. 26, 2011.) Like that prior draft, this discussion draft will not be scored by the Joint Committee on Taxation staff.
In a press release accompanying the discussion draft, Camp notes that the United States has cutting-edge financial markets operating with an antiquated tax code. According to Camp, “updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer, and more transparent for taxpayers; and it will also help to minimize the potential for abuse that has occurred in the past.”
To deal with these perceived problems, the draft proposes changes in several areas.
Mark-to-market for derivatives
In one of the biggest changes, the draft generally requires all taxpayers to mark derivative contracts to market and treat the resulting gain or loss as ordinary, unless the derivative qualifies as a tax hedge. Section 1256 (and its corresponding 60 percent short-term/40 percent long-term capital treatment) is repealed and all derivatives not treated as qualified hedging would be marked to market under a single provision whether or not traded on a regulated exchange. Conforming amendments to remove capital treatment from certain section 988 transactions are included. The draft would require most derivative positions to be marked to market at the end of each tax year – that is, treated as if the derivative had been sold on the last day of the year. Any resulting gain or loss would then be taxed as ordinary income or loss. In addition, the mark-to-market and ordinary character rules would also apply when the derivative is terminated or transferred during the year, even if the gain or loss is not recognized under another provision of the Internal Revenue Code. Fair market value would be used to value the derivative, and if not readily available, the draft would authorize regulations to require the value used by the taxpayer for financial reporting purposes or obtaining credit.
The draft defines the term “derivatives” broadly. Derivatives would include notional principal contracts and any derivative instrument with respect to a stock, a partnership, or trust interest (even if not widely held or publicly traded), evidence of indebtedness (note, bond, debenture), certain real property, an actively traded commodity, or currency. For this purpose, a derivative instrument would be any option, forward contract, futures contract, short position, swap, or similar instrument. Further, the definition includes the embedded derivative component of a debt instrument.
The draft would also apply this treatment to all positions in a straddle – including stock, debt, and financial products that would not be otherwise subject to mark-to-market – if it included at least one derivative position and subject them to ordinary treatment. However, mark-to-market generally would not apply to business hedging to mitigate the risk of price, currency, and interest rate fluctuations and to certain derivatives with respect to real estate such as options to acquire real property.
To qualify for hedge transaction tax treatment under current law, a taxpayer must identify a transaction as a hedge under section 1221 on the day the transaction is entered. The draft would treat a transaction as meeting the section 1221 identification requirement if the transaction is identified as a hedging transaction for tax purposes or is treated as a hedge under generally accepted accounting principles for purposes of the taxpayer’s financial statement. The draft does not extend book/tax conformity to foreign entities whose accounting is maintained under IFRS although IRS administrative guidance has already provided elective deference.
The draft would also modify cancellation of indebtedness (COD) income rules for certain debt restructurings to prevent “phantom” taxable income. According to a summary of the proposal, current law creates COD income for some borrowers, even though the borrower owes the same principal amount that was owed before modification. For qualified restructurings, the draft would provide that the issue price of a modified debt instrument could not be less than the lesser of the adjusted issue price of the debt instrument prior to modification or the issue price of the new debt instrument as determined under section 1274 (generally stated principal).
Current inclusion of market discount income
Under current law, the holder of a taxable bond that is acquired in the secondary market at a discount has market discount. Accrued market discount is recognized as ordinary interest income upon payment on or sale of the bond unless the taxpayer elects to include it into income as it accrues.
For bonds acquired at a discount in the secondary market, the draft would require the holder to currently include in income as interest the sum of the daily portions of market discount for each day the taxpayer holds the bond, and the inclusion would be calculated on the basis of a constant interest rate. These accruals would be limited by the greater of the bond’s original yield plus 5 percentage points or the applicable federal rate plus 10 percentage points. According to the summary of the draft proposal, this change would align the tax treatment of secondary market discount with the treatment of discount that arises when the loan is originally made. The market discount rules currently in effect would be repealed.
For bonds acquired at a premium, the draft would change the deduction from “below-the-line” to “above-the-line,” allowing a reduction in adjusted gross income.
Basis in securities
The draft’s summary notes that current law allows taxpayers to manipulate the amount of taxable gain or loss on the sale of securities by “specific identification” of securities that were acquired at different times or for different prices. In other words, the taxpayer can choose which shares have been sold based on their basis. To address this issue, the draft would require taxpayers to use one of two average-cost-basis rules (together, treated as one method) that are currently used to determine the basis of regulated investment company shares. The draft also would require that brokers use the same method to satisfy their requirements under the recently enacted basis reporting rules of section 6045(g).
Current law applies “wash sale” rules to prevent taxpayers from creating tax losses by selling securities at a loss and then repurchasing substantially identical securities within 30 days before or after the date of the sale. According to the draft’s summary, taxpayers can avoid these rules by directing a closely related party to acquire the replacement securities. The draft would extend the wash sale rules to apply to closely related parties, such as the taxpayer’s spouse or dependents; a corporation, partnership, or trust the taxpayer controls; or certain retirement or education accounts where the taxpayer is the owner or the beneficiary.
The draft reserves a section for other reforms. In the explanatory materials accompanying the draft, the Ways and Means Committee notes that it “recognizes that the discussion draft does not address several technical and policy issues that may need to be resolved in final legislation.” Accordingly, the committee asks for comments on:
As with the earlier international draft, we expect the full Ways and Means Committee or the Select Revenue Measures Subcommittee to hold one or more hearings on the draft. However, none have yet been scheduled.
In his press release, Camp encouraged the business community and other stakeholders to provide comments on the draft.
“If we are to enact tax reform that preserves needed flexibility in the financial markets while ensuring that no one is gaming the system and putting hard-working taxpayers at risk, then we will need the expertise of those who are most familiar with these products. They can identify areas that merit additional attention and their insight is critical,” Camp said.
This draft, also like the earlier international draft, is not expected to become the basis for a stand-alone bill; rather, this is intended to be another piece of a bigger puzzle: the fundamental overhaul of the tax code. We expect additional pieces of this puzzle will fall into place as momentum for fundamental tax reform builds in 2013.
— Jon Almeras
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