Taxation of Financial Products is Plagued by Inconsistency | Big Fat ...

Earlier this month, a joint hearing of the Senate Committee on Finance and the House Committee on Ways and Means focused on the tax treatment of financial products. The goals: to consider how Congress should respond to the potentially inconsistent tax treatment of economically similar financial products, and to determine how well the tax code has responded to the evolving financial products market, according to the Hearing Advisory.

Among those testifying was Thomas Barthold, chief of staff of the Joint Committee on Taxation. Barthold provided some context to the discussion, describing the astronomical growth in some derivative products. For instance, over the past twelve years, the notional amount outstanding of swaps (not including credit derivatives) jumped tenfold, from $14.3 trillion in 1998 to $149 trillion in 2010. Barthold also discussed several issues that arise when determining how to tax financial products. One issue: some instruments have characteristics of both debt and equity, which generally are taxed differently.

Alex Raskolnikov, a professor of law at Columbia, discussed the implications a reduction in the overall corporate tax rate could have on derivatives taxation. ?It is likely that the flaws in the taxation of derivatives will become even more costly if a substantial rate differential between individual and corporate tax rates is introduced.? That?s because taxpayers would have a greater incentive to shift deductions to individuals, assuming they would pay at a higher rate, while also moving income to lower-tax corporations. ?There is every reason to expect that derivatives will be used to accomplish this goal,? he said. On the other hand, if capital gains and ordinary income were taxed the same, taxpayers would have no incentive to use derivatives to convert one type of income to another.

Andrea Kramer, a partner with the law firm of McDermott Will & Emery LLP, and head of its Financial Products, Trading & Derivatives Group, also spoke. She stated that the issue isn?t one of serious loopholes in the taxation of derivatives, at least when it involves taxpayers who use derivatives to manage their risks. Instead, the current definitions of hedging are too limited, Kramer said.

She provided several examples: A company uses derivative transactions to convert the price of its inventory from fixed to floating. Although this is a risk management transaction, it doesn?t currently qualify as a tax hedging transaction. Similarly, an electric utility earning a significant chunk of its annual revenue in the summer months enters into a ?cooling degree day? weather derivative to protect against the risk that summer temperatures will be lower than expected. Again, this currently isn?t treated as a tax hedge. ?The substance of the hedging exemption needs to be expanded,? Kramer said.

Also among those speaking was David Miller, a partner with Cadwalader, Wickersham & Taft LLP. Miller described the current federal tax system as having no basis in the reality of economics. That?s because it is based on the ?archaic system of realization ? the concept that income is not earned, and therefore not taxed, until a taxpayer actually sells property for cash or exchanges it for materially different property.? As a result, the tax system is ?numbingly complex,? and taxpayers can choose a tax treatment that minimizes their taxes, he said.

A mark-to-market system would alleviate these concerns, Miller said. Under this system, the taxpayer compares the value of a financial instrument at the end of year against its tax basis and pays a tax on the difference, regardless of whether the instrument is sold. ?It would help level the playing field between middle-class wage earners who pay tax on all of their economic income and the billionaires who pay no tax on their appreciated stock, and it would eliminate the need for the tax ellipses, permitting tremendous simplification.? If incremental change was preferred, a mark-to-market system could be applied selectively to derivatives, Miller said.

Source: http://bigfatfinanceblog.com/2011/12/26/taxation-of-financial-products-is-plagued-by-inconsistency/

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