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Joint Committee on Taxation Discusses Current Regime's Approach to Tax Planning Using Derivatives

Thursday, December 8, 2011

Jonathan D. Gupta | Bloomberg Law Joint Committee on Taxation, Present Law and Issues Related to the Taxation of Financial Instruments and Products (Dec. 2, 2011) The Joint Committee on Taxation (JCT) prepared a report on issues related to the taxation of derivatives and other financial instruments, including concerns over inconsistent tax treatment of economically similar instruments. The report was presented at a joint hearing of the U.S. Senate Committee on Finance and the U.S. House of Representatives Committee on Ways and Means.

Regulatory, Accounting, and Tax Considerations

The JCT explained that, in addition to economic considerations such as the timing of cash flows, factors in selecting one financial instrument over another can include financial accounting issues (such as treatment as equity or debt) and regulatory considerations (such as different capital adequacy requirements). In addition, tax considerations may also affect decisions related to holding, issuing, and structuring financial instruments.

Three Fundamental Principles

Three principles are fundamental to determining the taxation of financial instruments, namely timing (when an item of income or expense is required or allowed to be taken into account for tax purposes), character (whether an item is income or expense, an asset or liability, or capital gains or ordinary income in the hands of the taxpayer), and source (foreign or domestic, determined based on considerations such as the residence of the payor and payee, the location of the property producing income, and the location of the activity producing the income). These three principles, the JCT noted, apply differently to equity, debt, and derivatives such as options, forwards, and notional principal contracts (swaps). The JCT noted that derivatives can be used to replicate the cash returns of virtually any underlying asset, yet ownership of these assets and economically equivalent derivatives may be treated differently for tax purposes, allowing taxpayers to elect to some extent the timing, character, and/or source of income in the most advantageous manner for tax purposes.

Tax Straddles

In its report, the JCT discussed situations where issues of timing, character, and source intersect, such as with tax straddles. A straddle, the JCT explained, is broadly defined as consisting of offsetting long and short positions. A typical commodity futures straddle, for example, would involve two futures contracts—one to buy and one to sell a commodity—identical as to all terms except for the delivery months. Accordingly, losses on one contract would generally be offset by gains on the other. Losses could be liquidated by entering into an opposite futures contract, while entering into another contract to maintain the original hedge in place. Losses could then be claimed as a short-term capital loss for tax purposes, while the "gain contract" could be held in place, with gains deferred into at least the next tax year and recognized as long-term capital gains. In short, a straddle could be used to accelerate losses while deferring gains, the JCT explained.

Section 1256 Contracts

Internal Revenue Code (IRC) Section 1256 addresses the timing and character issues presented by futures straddles through special timing and character rules for "Section 1256 contracts," defined as any regulated futures contract, foreign currency contract, non equity option, dealer equity option, or dealer securities futures contract. Such contracts require the recognition of gain or loss on an annual basis, while the character of the gain or loss is determined under a "60/40 rule," whereby the gain or loss is treated as long-term to the extent of 60 percent of the gain or loss, and short-term to the extent of the remainder. Straddles that involve personal property other than futures are addressed in Section 1092, which allows any loss realized on one or more positions in a straddle only to the extent the amount of the loss exceeds the unrecognized gain of any offsetting position(s), and which prevents conversion of short-term capital gains to long-term ones.


The JCT noted that the special timing and character rules for Section 1256 contracts create both incentives and disincentives for taxpayers to trade in such contracts. In addition, the mandatory clearing and exchange trading provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act(Dodd-Frank) could cause swaps to meet the definition of regulated futures for purposes of Section 1256, subjecting them to the timing and character rules of that provision. To provide clarity, Section 1601 of Dodd-Frank excludes swaps and certain similar agreements from the definition of a Section 1256 contract. Nonetheless, the JCT noted, uncertainty regarding the scope of Section 1256 persists, for example for interest rate swaps with economic terms identical to futures contracts. However, the Internal Revenue Service recently issued a notice of proposed rulemaking that would eliminate any overlap between notional principal contracts and Section 1256 contracts.

Reforming Derivatives Taxation

In separate comments, Professor Alex Raskolnikov discussed reforming taxation of financial products. Broadly, he suggested that the JCT's report is an important first step, but further steps are required. As a starting point, he argued that more derivatives related tax data should be made available to public finance economists, because currently, researchers' knowledge of revenue losses from derivatives-based tax reduction strategies is "largely anecdotal, wholly unsystematic, and woefully incomplete." He also suggested that three benchmarks can be used to evaluate alternative tax regimes, namely symmetry (whereby both parties to a transaction are taxed under the same timing rule and rate), consistency (whereby all economically comparable transactions are taxed the same), and balance (whereby gains and losses are taxed at the same time and the same rate).

Three Broad Alternatives

With respect to the options for reform, Raskolnikov suggested that there are three broad alternatives—anticipatory taxation, retroactive taxation, or accrual (mark-to-market) taxation. Anticipatory taxation bases income and deduction on the anticipated return from an investment, and therefore, liability arises before any payments are made or even fixed. Retroactive taxation spreads gains and losses backward over the term of the derivative. Finally, accrual taxation applies to all gains and losses as if each position is terminated or sold at the end of each taxable year and re-acquired at the beginning of the next year. Raskolnikov noted the limitations of each of these alternatives, such as the informational demands in obtaining derivatives valuations for an accrual approach. However, he stressed more generally that a reform following any of these approaches would simplify matters by taxing all derivatives the same, rather than distinguishing among forwards, futures, options, swaps, and so forth.

Too Few Exceptions

In her testimony, Andrea Kramer questioned whether tax reform such as a shift to a mark-to-market system for derivatives is necessary to close "tax loopholes." Rather, she asserted that current rules are far too restrictive and thereby inhibit legitimate commercial and financial activities. She described the IRC's treatment of derivatives products as involving a series of anti-abuse provisions coupled with exceptions to ensure that appropriate transactions can continue, and proposed expanding the substance of the hedging definitions. For additional background, see, e.g., Bloomberg Law Reports®—Derivatives Law, Co-ordination with Derivatives Regulators Could Allow Quicker IRS Identification of New Products, According to GAO (Oct. 26, 2011). For instance, regarding hedging transactions exempt from Section 1256, Kramer noted that, although the "hedging transaction" definition in IRC Section 1221(a)(7) refers to any transaction a taxpayer enters into in the normal course of business "primarily to manage risks," the U.S. Department of the Treasury in its regulations reverted to older language requiring "reduction of risk," notwithstanding Congress' suggestion that this term does not as effectively describe modern business hedging practices. As such, common risk management transactions such as using derivatives to convert inventory prices from fixed to floating would not qualify as a tax hedge. Kramer asserted that the definition of hedging transactions should be expanded to cover derivative transactions that change a taxpayer's exposure to economic risks of any type. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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