The top Republican tax writer in Congress proposed revising rules governing derivatives, replacing a complex system with a simpler one that quickly drew objections from the financial industry.
Taxpayers holding derivatives would be required to mark their holdings to market, under the discussion draft released yesterday by Representative Dave Camp, chairman of the House Ways and Means Committee. They would recognize gains and losses each year and pay taxes at ordinary income rates, regardless of whether they dispose of the asset or close out the position.
Camp’s plan would reduce taxpayers’ opportunities to take advantage of the disparate treatment in today’s tax code of economically similar derivatives, said Steve Rosenthal, a visiting fellow at the nonpartisan Tax Policy Center in Washington.
“Most politicians have shied away from tackling financial products because of their wariness of the complexity” of the issue, said Rosenthal, a former corporate tax lawyer who specializes in taxation of financial transactions. “It’s a pretty bold step and I think this idea is sensible. We’ll just have to see how it plays out.”
The fate of Camp’s proposal is tied to the rest of his efforts to overhaul the tax code. He wants his committee to pass a revenue-neutral rewrite of the individual and corporate tax systems this year, and he’ll face the challenge of confronting interest groups who want to keep their advantages and Democrats who want code changes to raise more revenue.
Camp’s draft is the most “radical” proposal in financial products taxation since the income tax was created, said Viva Hammer of Brandeis University in Waltham, Massachusetts, who was responsible for financial products tax policy at the Treasury Department from 2000 to 2006.
“It’s a revolutionary change,” she said in an interview. “It really uproots the entire labyrinth of financial-products rules and puts a single rule in its place.”
In a statement, Camp described his proposal as an attempt to limit abuses and update the tax code to reflect the modern financial system.
“The lack of consistent and comprehensive tax policy has also contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community,” said Camp, 59, of Michigan.
The mark-to-market rule wouldn’t apply to derivatives used in business transactions to hedge against risks related to price, currency and interest rates. It also wouldn’t apply to stocks or bonds.
Camp’s proposal also would repeal the current “60/40 rule” that allows some investors to treat 60 percent of their earnings as long-term capital gains, which get a preferential rate. Under the proposal, profits and losses on derivatives would be taxed as ordinary income.
As part of overhauling the tax code, Camp seeks to lower rates on ordinary income and corporations. The impact of repealing the 60/40 rule can’t be fully estimated until he sets the tax rates. Under current law, the top rate on ordinary income is 39.6 percent and the top rate on capital gains and dividends is 23.8 percent.
Mark-to-market taxation has some potential drawbacks, those involved with the financial industry said, including questions about how to define the value of the derivatives and liquidity concerns that people will be taxed on money they don’t have.
“It doesn’t make any sense,” said Allan Zavarro, the former global head of futures trading for ABN Amro Bank NV.
A trader could have a profit of $100,000 on interest-rate futures in December that would get caught by the tax, he said. When that position expires in June the next year, the position ultimately may have lost money, though the trader paid the tax as though he earned a return.
“You can be obligated for a tax on positions that aren’t profitable,” he said.
The change would further complicate estimating the value of derivatives that are less liquid or traded off of exchanges that have standard prices, Andrea S. Kramer, a Chicago-based partner and head of the financial products, trading and derivatives group at law firm McDermott Will & Emery LLP, said in a telephone interview.
“It’s very hard to determine fair-market value for derivatives products,” said Kramer, who testified at a joint hearing of the Ways and Means and Senate Finance committees on the subject in 2011. “From an enforcement side, it would be a very big deal to properly enforce. Reasonable people could differ on the marks, not that people are trying to game the system.”
The change in tax treatment could push investors to use exchange-traded funds rather than a futures contract, said Darrell Duffie, a finance professor at Stanford University, near Palo Alto, California.
“Wherever there is no ETF that emulates a popular derivative, one could be created,” Duffie said.
Representative Sander Levin of Michigan, the Ways and Means committee’s top Democrat, said he welcomed Camp’s proposal as a possible way to increase revenue while ending inequities.
“This underlines the need for us to act on a bipartisan basis to raise revenues and close loopholes as we seek further deficit reduction through a balanced package of spending cuts and additional revenues,” Levin said in a statement.
Sage Eastman, a spokesman for Camp, said the committee doesn’t have a revenue estimate for the proposal, and it could either raise money for the government or cost money, depending on other tax-law revisions.
The notional size of the over-the-counter derivatives market was $639 trillion as of June 2012, according to the Bank for International Settlements, a Basel, Switzerland-based organization that tracks derivatives.
Brookly McLaughlin of Intercontinental Exchange Inc. declined to comment. Laurie Bischel, a spokeswoman for CME Group, said she hadn’t read the proposal and had no immediate comment. CME Group, based in Chicago, is the world’s largest futures exchange. Atlanta-based Intercontinental owns the second-largest U.S. futures market.
The draft also proposes that holders of bonds bought on the secondary market at a discount must recognize income in the same way as taxpayers who purchase directly from issuers.
It would also modify the so-called wash-sale rules to prevent taxpayers from selling financial products at a loss and then repurchasing them. Taxpayers would no longer be able to have close relatives or related companies make the second purchase.
For all securities, including stocks and bonds, the draft would require the use of average cost basis to calculate gains as opposed to allowing taxpayers to choose specific shares to sell or use a first-in, first-out method. Average cost basis means using the average price paid for a security, even if the security is purchased in multiple batches.
“Taking away investor choices will simplify things in the long run,” Rosenthal said.
The draft is the second such discussion proposal from Camp, who offered changes to the international tax system in 2011.
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