19 May 2016 Wyden discussion draft would reform taxation of derivatives Senate Finance Committee Ranking Member Ron Wyden (D-OR) on May 18, 2016, released a discussion draft that aims to provide one set of clear rules for taxing derivatives by requiring the recognition of gains each year (i.e., mark to market) and applying ordinary tax treatment to those gains. Requiring mark-to-market and ordinary tax treatment for derivatives was also proposed by former House Ways and Means Committee Chairman Dave Camp (R-MI) under a draft preceding the Tax Reform Act of 2014, and subsequently picked up in President Obama's budget proposals. The Wyden draft goes beyond these proposals, however, to create a more comprehensive regime for taxpayers that both have obligations or rights with respect to a derivative and own the underlying investment, in which case both the derivative and the underlying investment would, in certain instances, be subject to mark-to-market and ordinary tax treatment. Senator Wyden said the draft Modernization of Derivatives Tax Act (MODA) would prevent taxpayers from using derivative contracts — described as "financial bets" between two parties over whether the value of a stock, commodity or underlying investment will increase or decrease over time — to avoid paying taxes on their underlying investments. The Joint Committee on Taxation has scored the draft as raising $16.5 billion over 10 years, and noted that it would expand the scope of the mark-to-market rule to a broader group of taxpayers and contracts than has been subject to the rule in the past. The draft would also exclude from capital treatment, and thus treat as ordinary in character, any bonds or other indebtedness held by most insurance companies. Regulatory authority is included to prevent the avoidance of Federal income tax through sales or exchanges of these types of insurance company assets. "The privileged few use expensive accountants and lawyers to shield their wealth so they can pay what they want, when they want," Wyden said in a news release. "Meanwhile hard working Americans have taxes pulled from their salaries every month — no questions asked. This proposal will help end the 'Tale of Two Tax Codes' and create one fair system with simple and straightforward rules that apply to everyone." Some of the practices targeted under the draft were raised in a March 2015 Wyden report on tax avoidance strategies involving derivative contracts and other financial products, including "collars" to lock in the value of a security without being treated as having constructively sold it for tax purposes, meaning no capital gains taxes are owed. That report, "How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions," recommended marking derivatives to market, meaning that each derivative held by a taxpayer is treated as if it were sold on the last business day of the year for its fair market value, and any gain or loss is included in income for that tax year. The overall purpose of the draft is to simplify the tax treatment for derivatives — one rule for character, one for timing and one for source of income. It would not apply to taxpayers subject to Sections 475 and 1221 (hedging business risk), and clarifies that a variety of ordinary course transactions relating to derivatives would also not be covered, including securities lending transactions and derivatives on property that envisions physical settlement. The proposal also clarifies that mark-to-market treatment would not apply to employee stock options, insurance contracts, annuities, endowments, etc. The draft would create a special rule, called an Investment Hedging Unit (IHU), in which the taxpayer enters into a derivative while also owning the underlying asset (such as a derivative on corporate stock). If the derivative has a negative delta or correlation between minus 0.7 and minus 1.0 to the asset, it would trigger mark-to-market gain on the underlying asset and then ordinary income at the time the contract is entered. After the IHU is established, subsequent gains would be marked to market annually and taxed as ordinary income. When the derivative that is part of the IHU is disposed of, the underlying investment would once again receive capital treatment and the holding period would be reset. The draft would repeal nine sections of the current code — Sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259 and 1260 — and would create new sections: 491, which would define taxable events with respect to derivatives; 492, which would define IHUs, superseding current anti-abuse straddle rules and constructive sale rules with a new general rule for capital hedging; and 493, which would define derivatives. As was the case with his cost recovery discussion draft released in April, Senator Wyden believes the policies in the discussion draft will provide a basis for broader tax reform, but also that the proposals stand on their own merits. He requested comments on all aspects of the discussion draft as well as other topics on the taxation of financial products within 90 days. The discussion draft sets aside broader questions with respect to tax rates or other base broadening, and comments will be considered solely in the context of proposals contained in the draft, with no inference made with respect to those issues that have been set aside. — Definition of an embedded derivative, i.e., whether and how to improve the definition under the draft — Reporting issues relating to the valuation of derivatives subject to the proposed mark-to-market approach Attached are legislative text, a Wyden one-pager and section-by-section summary, and a Joint Committee on Taxation revenue estimate and technical explanation.
Document ID: 2016-0891 | |||||
