U.S. Studies Derivatives That ’Game’ Tax Rules

U.S. lawmakers seeking to overhaul the Internal Revenue Code are examining how derivatives and other financial products can be used to exploit the tax system.

Financial instruments, including exchange-traded notes and options, are susceptible to manipulation, according to a report by the nonpartisan Joint Committee on Taxation. Taxpayers can structure transactions to defer income, accelerate deductible losses and take advantage of lower capital gains rates.

“Because our system of taxation has no basis in the reality of economics, sophisticated taxpayers are free to choose a tax treatment that minimizes their taxes, and choose they do,” said David Miller, a partner at Cadwalader, Wickersham & Taft LLP in New York, at a joint hearing of the House Ways and Means and Senate Finance committees in Washington today.

Another witness at the hearing, Alex Raskolnikov, a professor at Columbia Law School, said the tax treatment of financial products must be overhauled and can’t be changed piecemeal.

“Derivatives have been used to game every aspect of our tax system,” he said.

Today’s session is the second joint hearing of the two tax- writing panels since 1940. The first, on treatment of debt and equity, was held in July. The hearing is part of discussions on a tax-code overhaul. Ways and Means Chairman Dave Camp, a Michigan Republican, wants to restructure the code to reduce the corporate and individual rates to 25 percent without lowering tax collections.

Changing the Rules

Achieving that goal will require eliminating tax breaks or changing underlying tax rules, such as the way derivatives are taxed. The chairmen of the tax-writing committee didn’t commit to a particular proposal in their opening statements.

Camp said at the hearing that he hoped to resolve some of the murkiness surrounding financial instruments.

“Today’s marketplace features a wide array of products that can result in different tax or financial accounting treatment of economically similar products, including debt, equity, mixtures of the two and financial derivatives,” he said.

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said today that new financial instruments may lead to “mischief.”

“They aren’t fair to taxpayers who can’t afford those high-priced lawyers and accountants,” he said.

‘Heading Someplace’

The hearing “means that they are heading someplace,” said Bruce Thompson, vice president at Van Scoyoc Associates Inc., a Washington lobbying firm. “Now where they are, I’m not sure.”

Thompson, former senior director of global government relations at Merrill Lynch & Co., said financial institutions that benefit from the current tax system should be wary.

“Ten years ago, they were invulnerable in Washington,” he said. “They’re not that way now. There’s obviously continued anger at the industry. That certainly hasn’t gone away, and it’s from both the left and the right.”

Several features of the U.S. revenue system make it difficult to tax financial products. Those include the ability to defer taxation using some financial instruments and the preferential 15 percent rate for long-term capital gains, said Viva Hammer, a former Treasury Department official who was responsible for tax policy related to financial institutions and products.

Tax Planning

“The ability to toggle in and out of capital treatment allows tremendous flexibility in planning your taxes,” she said.

Congress should require mark-to-market taxation of derivatives at ordinary income tax rates, Hammer said.

“Everyone knows what the right answer is, but no one has the courage to impose it,” she said.

Mark-to-market accounting is intended to require companies to assign fair value to financial instruments and to limit the benefits of deferring realization of gains.

Miller, one of the witnesses speaking at today’s hearing, has proposed that large companies and wealthy individuals face a mark-to-market tax regime on publicly traded securities and derivatives.

Andrea Kramer, another witness at the hearing, questioned the workability of a mark-to-market system, particularly for assets that aren’t publicly traded or for which the value can’t be easily determined.

“From an administrative and a policy standpoint, I personally believe that it would be very difficult to impose an mark to market system that would actually accomplish the reforms we’re talking about,” said Kramer, a partner at McDermott Will & Emery in Chicago.

Swap Market

Raskolnikov said today that the tax system Camp is contemplating -- with a lower corporate rate and lighter taxes on income earned outside the U.S. -- would establish more incentives to create financial products that take advantage of those differences.

The global over-the-counter swaps market is $708 trillion, according to the Basel-based Bank for International Settlements. Derivatives, including swaps, are financial contracts tied to interest rates, currencies or events, such as a company default.

Ken Bentsen, the executive vice president for public policy and advocacy at the Securities Industry and Financial Markets Association, a trade group in Washington, said he welcomed the committee’s discussion.

“These are very good information-gathering opportunities for the members of the committee that will help them as they hopefully ultimately move toward broad-based tax reform,” he said.

Bentsen said he would caution lawmakers about the potential unintended consequences of changes in the tax treatment of financial products.

“They’re underpinnings of the economy that we have today,” he said.

To contact the reporter on this story: Richard Rubin in Washington at rrubin12@bloomberg.net

To contact the editor responsible for this story: Mark Silva at msilva34@bloomberg.net

Bloomberg reserves the right to edit or remove comments but is under no obligation to do so, or to explain individual moderation decisions.

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