Financial Services Insights – July 2013 – Camp Proposal to Reform Tax Treatment of Financial Products

Taxation is a subject that is never totally out of the public spotlight, and the present is no exception.  Through the efforts of its chairman Dave Camp (R- MI), the House Ways and Means Committee has focused considerable effort on tax reform generally, and in particular the revamping of the tax treatment of financial products.  With control of Congress currently split between the Republicans (majority in House) and the Democrats (majority in Senate), the likelihood of any meaningful tax reform legislation becoming law in the near term would seem to be rather problematic at best.  Nonetheless, Representative Camp's proposal is substantive and certainly thought provoking and represents, to a greater or lesser degree, the thinking of many influential tax policy professionals.  As will be apparent, the proposal, if adopted, would have significant impact on financial service organizations, as well as buyers and sellers of financial products.

Uniform Tax Treatment of Financial Derivatives 

It is safe to say that the tax rules have not kept pace with the rapid evolution of financial products and transactions.  As a result, it is not uncommon under current law for economically equivalent securities or transactions to be taxed differently as to character of income (capital vs. ordinary), amount of income, timing of income and/or source.  The stated goal of the Camp proposal is to bring uniformity to the tax treatment of "derivatives" (see definition below) and to more accurately measure income and loss.

To that end, under the Camp proposal, for derivatives entered into after December 31, 2013:

  • All derivative positions would be marked to market at the end of each tax year, thereby being treated as if sold on the last day of the year (and immediately reacquired).
  • Gains and losses from such marking to market would generate ordinary income and loss. 
  • For straddles (offsetting financial positions) including at least one derivative position (for example, a "mixed straddle"), all positions would be marked to market with ordinary income or loss treatment, even those not normally marked to market (such as stock and bonds).
  • Special rules would apply to positions not otherwise marked to market that become part of mixed straddles.  If the position has built-in gain at the time of entering into the mixed straddle, the position would be treated as if sold for its fair market value at the time of entering the mixed straddle.  Proper adjustment would then be made to any gain subsequently realized with respect to such position to reflect any gain taken into account by the taxpayer by reason of the deemed sale.  So, for example, if a taxpayer owned appreciated stock and wrote a call option (to generate additional income from the stock) or bought a put option (to reduce the risk of owning the stock), merely writing or buying that option would, under this proposal, cause the stock to be treated as sold for tax purposes (and immediately repurchased).  Taxable gain would result, even though the stock would not have actually been disposed, with no cash generated (other than the call option premium, if applicable) to pay the tax.  Further, any increase (or decrease) in the value of the stock while the option is outstanding would be "converted" into ordinary income or loss.
  • If a position has a built-in loss at the time of entering into the mixed straddle, the position would not be treated as sold at the time of entering the mixed straddle, and the amount of the built-in loss would not be taken into account in determining the amount that is marked to market during the period of the mixed straddle.  Rather, the amount of the built-in loss would be taken into account in determining the amount of gain or loss when the position is disposed of in a transaction in which gain or loss would otherwise be recognized.
  • In determining the amount of mark-to-market gain or loss on a derivative, regulatory authority would be provided so that taxpayers would be able to rely on the fair market value of derivatives that taxpayers report for financial reporting or credit purposes if value is not readily ascertainable.   Also, fair market value would be determined without regard to any premium or discount based on the relative size of the taxpayer's position to the total available trading units of the instrument.
  • The so-called "qualified covered call" exception to the straddle rules under current law would be repealed.
  • Code Section 1256 (which generally taxes regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options and dealer securities futures contracts on a 60% long-term, 40% short-term basis) would also be repealed. 
  • This proposal would not apply to hedges used by companies to mitigate risk of price, currency and interest rate changes in their business operations and to certain real estate transactions (for example, options to acquire real estate).

Under this proposal, the term "derivative" is intended to be very broad; more expansive than under current rules.  As defined, it would include, for example, an option, a forward or a futures contract with respect to any stock, partnership interest or debt regardless of whether the contract or interest (or the underlying contract or interest) is privately held or publicly traded.  It would include most notional principal contracts (swaps), as well as short sales and short securities futures contracts.   Thus, a "naked" short position in stock would be subject to mark-to-market, ordinary treatment.

Further, the term "derivative" would include generally an embedded derivative component of a debt instrument.  In that case, the instrument generally would be treated as two separate instruments – a derivative subject to these rules and a debt instrument that would not.  An example would be convertible debt, which would be treated as non-convertible debt (not subject to mark-to-market) and an option to acquire stock of the issuer (subject to the mark-to-market rules).  A debt instrument would not be treated as having an embedded derivative component merely because it was denominated in or specified payment by reference to a nonfunctional currency, was a contingent payment or variable rate debt instrument or had an alternative payment schedule.

Treatment of Business Hedges 

Under the proposal, in the case of hedging transactions entered into after December 31, 2013, taxpayers would be permitted to rely on, for tax purposes, an identification of a transaction as a hedge made for financial accounting purposes. Taxpayers would effectively be protected from inadvertent errors under the existing hedge identification tax requirements, yet would be prevented from using hindsight to identify a transaction as a hedge.

Deduction for Amortizable Bond Premium 

Amortizable bond premium of an individual would be treated as an "above-the-line" deduction in determining adjusted gross income ("AGI").

Currently, it is not a deduction in determining AGI.  Rather, in the case of taxable bonds, a taxpayer may elect to amortize the bond premium over the remaining life of the bond, with the premium applied against and reducing the interest income on the bond.

Current Inclusion of Market Discount 

The holder of a "market discount" bond (value has declined after its original issuance) acquired after December 31, 2013 would include in gross income currently the sum of the daily portions of market discount for each day during the year that the taxpayer holds the bond, computed on a constant interest rate basis.  The result would be consistent with the existing tax treatment of original issue discount ("OID").  The amount included in gross income would generally be treated as interest.  Currently, market discount is taken into account (absent an election to the contrary) upon the retirement of the bond or a resale of the bond by the purchaser.

However, to address market discount resulting from changes in the creditworthiness of borrowers (as distinguished from moves in interest rates),  the amount of taxable market discount would be limited to the greater of (i) 5 percentage points above the bond's original yield or (ii) 10 percentage points above the applicable Federal rate ("AFR") for the bond.

Brokers would be required to report includible OID and market discount to the IRS and to customers with respect to bonds acquired after December 31, 2013.

Cost Basis 

For securities sold, exchanged, or otherwise disposed after December 31, 2013, taxpayers who sell a portion of their holdings in substantially identical securities would be required to determine taxable gain or loss based on the taxpayer's average cost basis in the securities, in accordance with the method currently permitted for regulated investment company ("RIC") stock.  Basis would be determined on an account-by-account basis; if the taxpayer owned securities in more than one account, basis calculations would be made separately in each account. 

Wash Sales 

For sales and other dispositions after December 31, 2013, the proposal would expand the scope of the wash sale rule to acquisitions by certain related parties -- taxpayer's spouse, dependents of the taxpayer or other taxpayers with respect to whom the taxpayer is a dependent, controlled or controlling entities and certain qualified compensation, retirement, health and education plans or accounts.  In addition, the basis of any substantially identical stock or securities would not be adjusted to include the disallowed loss in the case of any acquisition by a related party other than the taxpayer's spouse.  While certain related party transactions are currently addressed in IRS guidance (such as involving IRAs and Roth IRAs), this proposal would formalize by statute the broader coverage of the wash sale rule.

Michael Laveman is a partner with EisnerAmper LLP.

Financial Services Insights – July 2013

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