Yesterday, top Senate Finance Committee Democrat Ron Wyden proposed major changes in the taxation of financial derivatives, contracts such as swaps, options, and forwards that derive their value from an underlying asset or index. The key to his proposal is a requirement that dealers annually mark-to-market derivatives and that investors pay tax on any gains (or recognize losses), even if they don’t actually sell the security. This idea has long been the “holy grail” of tax policy for financial products, as I testified to a House Ways and Means Subcommittee three years ago.
The current taxation of derivatives is complicated and inconsistent, and investors often reduce their tax liability by exploiting gaps in the law and manipulating the character, timing, or source of their income. Two years ago, the U.S. Senate Permanent Subcommittee on Investigations highlighted abuses of so-called basket options by hedge funds.
In the Modernization of Derivatives Tax Act, Wyden builds on the mark-to-market proposals of President Obama and former House Ways & Means Committee Chairman Dave Camp. But Wyden’s plan is more comprehensive than Obama’s and would apply to all derivatives, not just those that are publicly-traded or that reference publicly-traded assets or indices. Unlike Camp’s proposal, Wyden’s would extend to investment hedging units, which combine derivatives with the investment positions they offset.
Wyden also tackles the key issue for any mark-to-market design: how to value a derivative that an investor does not actually sell, as generally there is no actual price to report (except for those derivatives that are traded on exchanges, like futures). Wyden’s solution: Permit taxpayers to rely on the value they report for financial accounting purposes, and not allow the IRS to challenge that valuation.
But barring an IRS challenge makes it possible for each side of the same derivative to value their position differently according to their separate financial accounting--and whipsaw the agency. Moreover, many retail customers don’t have such financial reports---and may be hard-pressed to calculate their values.
A better solution would require dealers to regularly value derivatives for their customers, and report those valuations to the IRS. The customer’s use of these valuations would be presumed correct, unless the IRS could establish otherwise. Brokers might object to sharing their valuations with customers, but the Dodd-Frank law already requires swap dealers to disclose their mark to their customers or notify their customers of the right to receive the mark, upon request. Thus, swap dealers already share much of this information with their customers.
Seventeen years ago, accountants adopted mark-to-market for derivatives. At that time, I wrote an article entitled Tax and Accounting for Derivatives: Time for Reconciliation, urging tax administration to follow the accountants’ practice. The time is long overdue to catch up.
