Financial Products Changes Recommended by Senate Finance Committee Democrats Worth Attention

March 20, 2015

Shapiro, RichardOn March 3, 2015, the Democratic staff of the Senate Finance Committee issued a report addressing “tax avoidance through financial products and deferred compensation” and recommended certain actions to eliminate what it perceived to be abuses.  Normally, a report produced by the Congressional minority – both House and Senate are of course controlled by the Republicans -- might be given passing attention at best.  And, with Congress seemingly paralyzed politically, it is highly unlikely that there would be a “legislative fix” to any of these transactions anytime soon.  Yet another initiative in Congress for comprehensive tax reform has begun, but skepticism is rampant.  However, with the White House, Treasury and IRS in the hands of the Democrats, this report might well provide incentive for at least an administrative response, where appropriate, and so it is for this reason that the Report should be taken more seriously.

The Report identified six transactions of special note.   With one exception, the Report concedes that their use is “perfectly legal” but that the tax rules and Treasury guidance have failed to keep pace with the variety of strategies to shelter income from taxation.

  1. Using collars to avoid paying capital taxes.  In this form of transaction, a taxpayer owns appreciated stock and locks in the gain by entering into a “collar” -- buying an option to sell the stock (a “put”)  and selling an option to buy the stock (a “call”) at set prices to hedge against stock fluctuation.  Absent a “constructive sale,” no capital gain is currently realized.  When the constructive sale rules were enacted in 1997, Treasury was given authority to write rules determining which kind of collars would constitute a constructive sale, but none have been issued. 

    The Report recommends that Treasury be required to write regulations defining the use of collars where taxpayers are “nearly totally hedged” as constructive sales.
  2. Using wash sales to time the recognition of capital income.  The wash sale rule prevents taxpayers who are not dealers from selling stock or securities (including options) at a loss and reacquiring “substantially identical” stock or securities (or options to acquire substantially identical stock or securities) within a 30-day period before or after the loss.  The wash sale rule also prevents such taxpayers from currently recognizing losses on the closing of short sales if, within 30 days before or after the closing, “substantially identical” stock or securities are sold or the taxpayer enters into another short sale of substantially identical stock or securities. The Report observes that taxpayers can defer realizing capital gains but can realize capital losses at will without changing their economic position by terminating a security that has lost money at the end of a taxable year and then immediately repurchasing a “substantially similar” security.  Further, it notes that the wash sale rule was not designed to deal with modern financial instruments such as forward contracts and swaps and does not apply to assets such as commodities and currencies. 

    The Report recommends that the wash sale rules be updated to address such instruments and contracts and that legislation or regulations consider how to identify and limit the extent to which taxpayers can reconstitute expired positions with “substantially similar” positions.
  3. Using derivatives to convert ordinary income to capital gains or convert capital losses to ordinary losses.  As noted in the Report,  often taxpayers can choose whether they want to realize capital gain/loss or ordinary income/loss and timing the income/loss by holding contracts on capital assets to maturity (generally ordinary treatment) or  having the contract terminated before maturity by a sale of the underlying asset (generally capital gain/loss).   Under proposed regulations outstanding since 2004, in the case of forward contracts and so-called “bullet” swaps (swaps in which a single payment is exchanged at settlement), the final payment at maturity would be treated as long-term capital gains if the underlying asset is capital. 

    The Report endorses legislation that would mark-to-market all derivative instruments and tax resulting gains and losses as ordinary income and loss, regardless of whether the contract is held to maturity or disposed early.  This would be in line with the 2014 Ways & Means Committee (Congressman Camp (R-MI)) proposal as well as the 2015 Obama Administration budget proposal.
  4. Using derivatives to avoid constructive ownership rules for partnership interests.  Prior to 1999, to avoid ordinary income or short-term capital gain treatment as direct owners of partnership interests, many taxpayers purchased swaps or other derivative instruments that mimicked the ownership of an investment partnership.  Then in 1999 Congress enacted the “constructive ownership” rules that limited the amount of long-term capital gain a taxpayer could recognize from derivative contracts that referenced partnership interests as the underlying asset.  The constructive ownership transactions enumerated involved swaps, forward contracts, option collars and  to the extent provided in Treasury regulations, other transactions “that have substantially the same effect” as those set forth in the statute.  Those regulations have not been issued. 

    The Report recommends that legislation could specify additional constructive ownership transactions or Treasury could finish drafting and finalize regulations that expand that list.
  5. Using “basket options” to convert short-term gains into long-term gains.  The Report characterizes the use of basket options as “clearly a tax shelter” and notes that in July 2014 the Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Government Affairs completed an investigation on the misuse of basket options by hedge funds to avoid taxes.  As described in the Report, in a basket option transaction -- which generally occurs between a hedge fund and a bank -- a bank establishes an account in its own name (or that of a subsidiary).  The account is used to maintain a portfolio of securities, making the account a “basket of securities.”  The bank then enters into a “basket option contract” with a hedge fund.  As the option holder, the hedge fund may exercise the option and receive a payout equal to the profits generated by the basket of securities.  The hedge fund acts as an investment advisor and manages the assets within the account, though the account and the securities are technically owned by the bank. The hedge fund characterizes the transaction as a derivative; the trading account (the basket) is treated as the underlying asset for the derivative, not the assets within the account.  Thus, the hedge fund takes the position that it is able to defer gains and losses from the trading of the assets in the account and recast what otherwise might be viewed as short-term gains as long-term capital gain. Realization occurs when the hedge fund exercises or sells the option itself.  The IRS Chief Counsel’s office issued a Generic Legal Advice Memorandum (“GLAM”) in 2010 in which it concluded that the basket options were an account of securities owned by the hedge fund and not options.  But a GLAM has no precedential legal authority.

    The Report encourages the IRS and Treasury to issue a tax shelter notice with respect to this transaction, presumably making this a “listed transaction.”
  6. Avoiding income taxes by deferring compensation.  The Report targets the deferral of compensation through nonqualified deferred compensation (“NQDC”) plans.  The Report illustrates its point through an example from a November 14, 2014 memorandum from the Joint Committee on Internal Revenue Taxation:

    “an individual who expects to earn $500,000 in compensation that would otherwise be includible in gross in[come for] the following taxable year can be allowed to elect (before the beginning of the following taxable year) to defer a portion of that compensation (such as $100,000) to be payable at a specified time in the future (such as in 20 years or, if earlier, upon the individual’s death) and include in income for the following year only compensation reduced by the amount elected to be deferred ($400,000 if the amount is $100,000), rather than $500,000.”

    In addition, the Report targets NQDC arrangements used to circumvent the rules on deductibility of compensation paid to certain executives in excess of $1 million.

    While conceding that the rules have been tightened up somewhat (no doubt referring in part to Internal Revenue Code Sections 409A and 457A), the Report bemoans the fact that taxpayers have some ability to control the timing of the income inclusion, together with the benefit of accruing earnings tax-free during the deferral period.  

    The Report recommends that legislation be enacted to reduce NQDC benefits.
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