The Modernization of Derivatives Tax Act of 2016 – Reversing Reagan-Era Trickle-Down Economics

It’s been a long-time since the the Economic Recovery Tax Act of 1981 (“ERTA”) brought us special treatment for regulated futures contracts and a myriad of other complex rules known collectively as the “straddle rules.” ERTA, a key part of the Regan-era trickle-down economic policy, offered a number of tax incentives for certain derivatives. Over the years, the complexities of the rules expanded with the invention of each new derivatives product. Challenged by the uncertainties and the potential for tax abuse, Congress passed laws and the Treasury Department issued regulations designed to address the uncertainties that each new product created. However, the legislators and the Treasury Department could not keep pace, and today taxpayers are confronted with a complex set of confusing rules that only make matters worse. One noteworthy example is the series of proposed, but never adopted, regulations affecting notional principal contracts dating back to 2004.

The Modernization of Derivatives Tax Act of 2016 (“MODA”), introduced by Senator Ron Wyden, would drastically change the landscape for the taxation of derivatives. MODA would repeal nine sections of the Internal Revenue Code (IRC) and simplify the tax treatment of derivatives with a single timing, character and sourcing rule. This is intended to level the playing field by nullifying the sophisticated tax strategies that are currently possible under the complex, existing derivatives rules. It is estimated that the simplified tax rules for derivatives will raise $16.5 billion over the next 10 years.

What is a Derivative?

A derivative is a financial instrument with a price that is derived from or correlated with one or more underlying assets. The value of the derivative is based on the price fluctuations of the underlying asset, which could be a stock, a stock index such as the S&P 500, commodities, currency, or others. The financial instrument is a contract between two (or more) parties based on the value of the underlying asset(s); it may be in the form of an options contract, SWAP contract, futures contract, or other instrument. The most common examples of derivatives include future/forward contracts, swaps (generally referred to in the tax world as “notional principal contracts”), and options. Under current laws, taxpayers can, with very careful planning, benefit from mismatches to determine the character and timing of taxation of gains and losses. Senator Wyden uses the following example: “Taxpayers can use derivatives like forward contracts to lock in a lower tax rate if they expect gains, or a higher tax deduction if they expect losses. On another hand, they may use derivatives like option ’collars’ to secure investments and remove risk of loss even while benefitting from lower tax rates intended only for taxpayers who bear actual risk. By contrast, middle class working families are stuck paying ordinary tax rates on every paycheck; if they own stocks or other investments, they must ride the ups and downs of the market.”

The Impact of MODA on Investors

The proposed law would have a significant impact on individuals who report income from these assets on their personal income tax returns. Currently, many derivative contracts receive favorable treatment under Section 1256, with 60% of the gains being treated as long-term capital gains subject to the more beneficial long-term capital gain tax rate of 20%, and the remaining 40% of the gains being treated as short-term capital gains taxable at ordinary tax rates as high as 39.6%. Under Senator Wyden’s proposal, the more beneficial long-term capital gains tax rate would be eliminated except for certain types of derivatives, certain hedging transactions and other specific financial instruments. Many investment funds take advantage of this special tax treatment to provide investors with a higher after- tax yield on their investment. By losing the 60%/40% split and being taxed at the higher ordinary rates on all gains recognized, the after-tax yield on the investment is significantly reduced. For example, a $1,000 gain that currently receives the 60%/40% income tax treatment under §1256 would yield approximately $720 after payment of federal income taxes of $280, while the same gain taxed under MODA would yield approximately $600 after the payment of federal income taxes of $400. For illustration purposes only, no effect was given to the federal net investment income tax or state income taxes, which would likely have substantially the same effect under current law and MODA.

There is an old expression: “No good deed goes unpunished!” In time, the investment industry will create new derivative products that fall within the derivatives exempted under MODA or simply develop new tax efficient strategies to work outside the reaches of MODA. Some creative souls will even figure out how to accelerate losses under MODA. Remember ERTA? Back then, most people had never even heard of a swap contract.

Derivatives Used for Hedging

MODA includes new rules for derivative instruments that are used to hedge other derivative instruments or securities. The hedged positions are referred to in the proposed law as Investment Hedging Units (“IHUs”). Holding an IHU would trigger a mark-to-market adjustment. IHUs occur when: (1) the positions meet the delta test (described later) and are identified by the taxpayer, (2) the taxpayer elects to be subject to the IHU rules, or (3) the IRS determines that the positions meet the delta test. The IHU election would have to be made on the books of the taxpayer. The IRS could issue an adjustment where positions should be considered an IHU. (The IRS could also revoke a taxpayer’s election if the IRS believes that IHU treatment should not apply). IHUs with net gains and losses are treated like other end-of-year adjustments (e.g., straddles or constructive sales). The adjustment would be considered ordinary income or loss and subject to ordinary tax rates. Once the IHU is terminated, in other words, one side of the hedge is disposed of; the final treatment of the realization event would be based on the type of instrument disposed of (stock options and capital stock receiving capital gain treatment, etc.). Built-in gains are recognized at the time an IHU is established. The current rules applicable to straddle positions and constructive sale positions are very similar to the MODA proposal for IHUs. Like straddle positions and constructive sale positions, IHUs comprised of derivatives and underlying assets must be offsetting positions. The proposal indicates that the delta of the positions must also be analyzed to determine if the positions are offsetting. If the delta of the derivative and the underlying asset is in the range of -.7 to -1.0, the position would fall under the IHU rules and be included in the mark-to-market adjustment at the end of the year.

Final Observations

MODA introduces ordinary income mark-to-market treatment for derivatives that is very similar to the mark-to-market approach that traders in securities and traders in commodities may avail themselves of, to avoid book-to-tax timing differences – a fact of life that often drives hedge fund managers crazy. It is okay to tell investors that their taxable income is less than their book income, but when the timing differences reverse themselves the following year, investors seem to have a short memory. Under MODA, the mark-to-market method of accounting would apply to all derivatives, and as a result, each such financial instrument would be treated as sold and repurchased on the last day of the tax year. Thus, open transactions would be taxed as the end of each taxable year, thereby preventing the acceleration of taxable losses and the postponement of related taxable gains. In some cases (e.g., unrealized losses from derivative contracts that exceed unrealized gains), a taxpayer might benefit from the recognition of taxable losses in an earlier taxable year under the mark-to-market method of accounting. Under MODA, tax revenues are anticipated to increase significantly over the next 10 years. MODA is sure to have its critics, but so did ERTA. Raising revenue today may seem more important than providing tax cuts like those that trickled down under the Reagan era. You be the judge!