Comprehensive Tax Reform: Tax Treatment of Financial Products

On January 24th, 2013 draft legislation was released to change the way financial instruments were to be taxed. The intent of the legislation was to garner responses from the financial services industry with hope that such comments would provide valuable feedback to contribute to comprehensive tax reform later this year. A staffer speaking on the condition of anonymity expressed that the legislation was not drafted as a way to generate new federal tax revenues. In fact, the draft is considered to be just part of a larger scale tax reform aimed at shaping the United States into an improved tax system using a revenue-neutral approach.

House Ways and Means Chairman Dave Camp has made clear that he wants feedback from the public. “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 hardworking taxpayers at risk, then we will need the expertise of those who are most familiar with these products,” he said.

Some also believe that with revisions to the code and regulations, the financial recession of 2008 could have been shortened by identifying abuse of derivatives and other financial instruments used by Wall Street. The draft works under the premise that the tax code needs to be updated to include these recent financial strategies, as tax rules have not kept up with financial product innovation.

Summarized in the draft legislation are the following items:

Providing Uniform Tax Treatment of Financial Derivatives

Broadly extending mark-to-market accounting treatment to derivatives would provide a more accurate and consistent method of taxing these financial products and make them less susceptible to abuse, without affecting most small investors who normally do not invest in these products. Derivatives that are used by businesses in the ordinary course of their businesses to hedge against price, currency, interest rate, and other risks would not be affected.

Simplifying Business Hedging Tax Rules

For taxpayers that are engaged in hedging business risks, the draft would allow transactions that are properly treated as hedges for financial accounting purposes to be treated as hedges for tax purposes. This taxpayer-favorable proposal would minimize inadvertent failures to identify a transaction as a hedge for tax purposes, even though the transaction satisfies all of the substantive requirements for hedging transaction tax treatment.

Increase the Accuracy of Determining Gains and Losses on Sales of Securities

To simplify tax compliance and administration, and to determine more accurately the amount of gain or loss when a security is sold, the draft would require the cost basis of the security to be based on the average cost basis of all other shares or units of the identical security held by the taxpayer.

Prevent the Harvesting of Tax Losses on Securities

The so-called “wash sale” anti-abuse rule has been a feature of the tax code for decades. It is intended to prevent taxpayers from harvesting tax losses by selling securities at a loss and then immediately reacquiring the same securities. However, the current law wash sale rule only applies if the same taxpayer sells and reacquires the security, and it can be circumvented using related parties such as spouses, children, or entities controlled by the taxpayer. The draft would reform the wash sale rule so that it applies to transactions involving closely related parties.