Wyden Offers Mark-to-Market Tax System for Derivatives

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By Aaron E. Lorenzo

May 18 — Pitched as a plan to limit tax avoidance, derivatives would be marked to market for tax purposes under draft legislation from Senate Finance Committee ranking member Ron Wyden (D-Ore.).

Wyden proposed single timing, character and sourcing rules. His draft would treat derivatives as if they had been sold and repurchased at the end of each year, require ordinary tax treatment on resulting gains and losses, and establish a source based on a taxpayer’s country of residence.

“Derivatives are so flexible that they can accomplish all sorts of different games,” said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. “A mark-to-market regime takes away the tax flexibility from derivatives, and that's a good thing.”

In generally aligning tax rules with financial reporting rules, the Wyden proposal, dubbed the Modernization of Derivatives Tax Act, follows a path for taxing financial products similar to a 2013 plan from former House Ways and Means Committee Chairman Dave Camp (R-Mich).

Wyden's definition of a derivative would include any contract—an option, forward contract, futures contract, short position, swap or similar contract—valued in reference to corporate stock, partnership interest, indebtedness, certain real property, an actively traded commodity, currency, and any rate, price, amount, index, formula or algorithm.

Lessons Learned

But Wyden's draft differs from Camp's plan, due in part to lessons learned.

For example, Wyden's draft would establish a new termination or transfer concept, re-examine investment hedging in combination with offsetting positions and reset valuations based on a conclusive presumption equal to values used for applicable financial statements.

But all these new elements create a lot of questions, said Rosenthal. He has in the past advocated different mark-to-market valuation processes like using financial reports from clearing exchanges mandated by the Dodd-Frank Act and questioned whether an accounting-based value could be exploited.

“Policy guys have always been worried that someone would make up a number for financial reporting in order to cheat the IRS,” Rosenthal said.

Opposition to the proposal has already developed, particularly related to existing tax code Section 1256 rules that allow preferred, long-term capital gains tax rates on 60 percent of securities dealers' derivatives income and ordinary income tax rates on the remaining 40 percent.

One tax lobbyist said the business community wouldn't find much to like in the plan, especially if it is used for the purpose of raising revenue.

Opposition to 60/40 Rule

Wyden's proposed legislation, like Camp's plan, would repeal the 60/40 rule (17 DTR G-5, 1/25/13).

“The proposed legislation is a tax on risk management that will hurt consumers most,” said Anita Liskey, managing director of corporate marketing and communications for CME Group Inc., the options and futures exchange company. “Traders cannot use futures to avoid paying taxes.”

The 60/40 rule was put in place to eliminate tax avoidance, Liskey said, and it ensures that taxes are paid by futures traders in the current year rather than rolling that tax obligation forward. In addition, the 60/40 rule prevents double taxation on futures and options traders who would otherwise have to report both their gains and losses as gains at the end of each year, she said.

“Without this rule, users of these important risk management tools will be unfairly taxed on gains regardless of whether gains are actually realized,” Liskey said.

She warned that the Wyden draft would hurt liquidity and negate other federal rules meant to reduce systemic risk.

Exemptions Included

Wyden's proposal would include exceptions related to business hedging; employee stock options; derivative transactions in pension funds; endowments; insurance contracts or annuities; and other transactions connected to maintaining low mortgage rates.

House Ways and Means Committee Republicans declined to comment on Wyden's plan until they had time to process it. His staff requested feedback to the draft.

For his part, Wyden believes the proposal offers a simpler alternative to current complexities involved in taxing derivatives. He recently introduced a proposal to simplify depreciation schedules, and more proposals are expected from him as he lays the building blocks to more broadly address revising the tax code next year (91 DTR G-3, 5/11/16).

Wyden’s proposal would raise $16.5 billion over 10 years, according to an estimate from the Joint Committee on Taxation.

To contact the reporter on this story: Aaron E. Lorenzo in Washington at aaron@bna.com

To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com

For More Information

Texts of the Modernization of Derivatives Tax Act discussion draft, the JCT revenue estimate and JCT technical explanation are in Tax Core.

A section-by-section summary of the bill is at http://src.bna.com/e5J.