Marking financial derivatives to market is the optimal solution to the complex state of derivative taxation because most taxpayers already mark their portfolios to market, but there is disagreement on how to implement the system, according to panelists at Tax Analysts' Marking Derivatives to Market for Tax Purposes conference in Washington April 25.
"Taxation of derivatives is a big mess," and it continues to get worse, Yoram Keinan of Carter Ledyard & Milburn LLP said. "The reason I believe mark-to-market is a practical solution is because it would consolidate timing and character for derivatives," he added.
"There is no other alternative. We need a coherent and comprehensive set of rules for taxing derivatives," Keinan said.
House Ways and Means Committee Chair Dave Camp, R-Mich., proposed in his tax reform discussion draft a regime that would mark derivatives to market at the end of every tax year. The proposal treats the derivatives as though the taxpayer sold them each year by requiring the taxpayer to recognize gain or loss. President Obama included a similar proposal in his fiscal 2015 budget plan.
The current derivative rules vary significantly based on different factors, including the type of instrument (for example, notional principal contracts), the nature of the holder (for example, dealer/trader), or the purpose of the transaction (for example, hedging), said Keinan. The derivative timing rules are based on the character of the underlying security or contract, the type of holder, and the purpose of the transaction, as in section 475, said Keinan. Also, there are antiabuse rules regarding timing, he said, adding, "This is just timing, and when you add character to this, you have a big mess as well."
To put marking to market in perspective, Joint Committee on Taxation Legislation Counsel Viva Hammer pointed to the income tax "gong" at the end of every year for wages, which make up 70 percent of tax receipts. She asked the audience to imagine a system in which the same gong strikes every year for derivatives, which generate cash at odd moments. "This system is mark-to-market," said Hammer.
Taxpayers hesitant to mark derivatives to market often suggest that valuation and liquidity problems could arise under a mark-to-market regime. They argue that many of these instruments are difficult to value and say it would unnecessarily burden taxpayers to implement mark-to-market because it would require them to value the derivative before they dispose of it.
Panelist Lee A. Sheppard, Tax Notes contributing editor, said that valuation concerns are exaggerated because taxpayers who use derivatives are already doing the calculations for financial accounting purposes. "Nearly all sophisticated holders of these contracts have a marked book somewhere even if you aren't a reporting company, because you cannot do this without knowing what your position is on a pretty regular basis," she said.
When it comes to valuation, "it's simply false, specious, and disingenuous to say you don't know what mark to use," Hammer said.
The second significant problem is with a taxpayer's ability to pay a tax on a derivative they have not disposed. Opponents of mark-to-market argue that requiring taxpayers to pay tax without selling the derivative could bankrupt companies. Hammer sees this concern as a potential positive because it would force investors in derivatives to carefully manage their portfolios and determine whether the portfolio gets too large at any given time.
As for the liquidity issue, mark-to-market rules are like the original issue discount rules, which require taxpayers to recognize ordinary income on imputed interest even though they may not have realized the gain, said Hammer. No taxpayer has "lost life or limb over marking its portfolio," she added.
Although marking derivatives to market would be a rather significant paradigm shift, Sheppard views it as something that has been coming for a while.
In 1981 Congress required exchange-traded futures to be marked to market by all holders, explained Christopher E. Bergin, president and publisher of Tax Analysts. In 1993 Congress required dealers in securities to mark their trading books to market, and in 2003 the Financial Accounting Standards Board implemented rules requiring all holders to mark derivatives to market unless they are part of a hedge, Bergin said.
Sheppard also said that section 446(b), which says that the tax administrator has the power to change a taxpayer's accounting method if it doesn't clearly reflect income, gives Treasury the power to require derivative marking. We are "tiptoeing up to" derivative marking, as further evidenced by the 2004 regulations for contingent payment swaps and the 2011 proposed regulations (REG-111283-11) that are bringing more derivatives into the marking regime, she said.
Camp has proposed placing the tax identification and valuation rules in line with generally accepted accounting principles, Sheppard said. The Camp reform draft says that if hedges were identified for GAAP, they were identified for tax purposes. Camp is trying to get the definition changed for hedges, she said. Tax law currently defines hedges in a way that allows the taxpayer to identify almost anything as a hedge, but doesn't allow some hedges, such as Hoover hedges, which are viewed as hedges under financial accounting, Sheppard explained.
However, there is resistance to marking derivatives to market, much of it coming from lawyers, said Sheppard. "Accounting recognizes losses early, and this drives lawyers crazy, but you gotta do it," she said, emphasizing that lawyers need to be comfortable with early losses and that everybody uses financial numbers daily.
Tax is moving in the direction of mark-to-market, said Hammer. Over the last 33 years, more and more transactions and instruments are being marked to market, starting with futures contracts on U.S. exchanges, then over-the-counter foreign exchange contracts, and then securities by dealers, she said.
Potential for Financial Regulation
Marking to market could be another form of regulatory control because it would require derivative holders to more carefully manage their portfolios, said Hammer. If taxpayers are concerned about liquidity issues, they shouldn't have that many derivatives, she said, adding, "If you have enough derivatives that the tax is going to bankrupt you, then recording that will require you to accept that the portfolio is too large to manage."
Hammer challenged taxpayers, and the IRS, to get the marks to market wrong, saying that eventually taxpayers will have to justify how they got a number on a return when the disposition turned out very different. "The marvelous thing about mark-to-market is that it's self-correcting, and fast," she said.
Speaking about the 2008 financial crisis, Hammer said that if banking institutions had been marking to market throughout the period they owned the portfolio, they wouldn't have gotten to a point where they had enormous portfolios they didn't know how to deal with. Similarly, it would have been useful for taxpayers to have backstops reminding them what was in their portfolio, again to avoid reaching the point of "blowup."
The panel vehemently disagreed on the appropriate implementation of a mark-to-market regime, specifically whether the new regime should apply to all taxpayers and derivatives. Keinan said that implementation should be a stepped process that would first apply to publicly traded derivatives or derivatives the underlying securities of which are publicly traded. Then, after several years, if the implementation proves to be successful, the scope could be expanded over time, he said.
Also, taxpayers that are marking their positions to market for financial accounting purposes should be marking them to market for tax purposes, said Keinan. Another necessary first step, according to Keinan, is to eliminate 60/40 treatment under section 1256.
But Hammer said there is strong evidence that implementing a new regime in steps creates incongruity. "It's better to do nothing than do it in steps," Hammer said.
Keinan, concerned that many taxpayers that do not normally mark derivatives to market for accounting purposes will find it burdensome to comply with a new regime, proposed delaying an expansion of the mark-to-market regime to nonpublicly traded derivatives (or derivatives the underlying securities of which are not publicly traded) until lawmakers can address these issues. Sheppard said that a valuation solution for smaller users is to adopt something akin to the broker reporting rules to require the derivative dealer to report the derivative's value to the holder of the instrument.
Keinan said he is concerned that the interests of the brokers and users are so varied that a system requiring the brokers to report values on behalf of the users will simply not work.
Clarification, April 28, 2014: Lee A. Sheppard said valuation concerns are exaggerated because taxpayers who use derivatives, not those who trade in them, are already doing the calculations for financial accounting purposes.
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