The Senate Finance Committee Democratic staff will release a report March 3 outlining several tax avoidance strategies using financial products that it estimates will cost billions of dollars in lost tax revenue over the next decade and proposed solutions to eliminate those strategies.
The report, provided to Tax Analysts in advance of its release, addresses six problem areas: the use of collars, limited wash sale rules, the use of derivatives to manipulate timing and character, constructive ownership rules, basket options, and nonqualified deferred compensation.
The report argues that "many taxpayers use these sophisticated transactions to cut the taxes they could owe in half, often paying effective rates far lower than people who earn a regular paycheck."
The report identifies areas that create inefficiencies in the current tax system through favoring some high-income taxpayers.
"Derivatives can be used to replicate the cash returns of virtually any underlying asset, allowing some taxpayers to structure a portfolio of underlying securities and derivatives to achieve the desired combination of risk and return as well as the desired timing of cash flows," the report says. It adds that the tax code, both inefficient and outdated, does not provide equal treatment for economically equivalent portfolios of underlying assets and derivatives, allowing taxpayers to elect the timing and character of income.
Although the report offers few details regarding the proposed solutions, it warns that the IRS lacks the resources to monitor and audit large partnerships engaging in these strategies. The report also urges Congress to address the issues raised.
Collars to Defer Gains
In 1997 Congress enacted section 1259 to prevent taxpayers from deferring gains on assets with hedged risks. Section 1259(d)(1) defines a forward contract as a contract to deliver a substantially fixed amount of property -- including cash -- for a substantially fixed price.
In Rev. Rul. 2003-7, 2003-1 C.B. 363, the IRS blessed the use of one variable prepaid forward contract involving an investment bank as a counterparty and an investor seeking to monetize an appreciated equity position without generating currently taxable gain. The Service concluded that in an arrangement under which a shareholder (1) receives cash while simultaneously pledging to deliver shares on a future date; (2) retains the rights to substitute cash for the shares, vote the stock, and receive the dividends; and (3) isn't compelled to deliver the shares, there has not been a current sale of stock or a constructive sale under section 1259.
An example of gain deferral in spite of section 1259 is a taxpayer simultaneously purchasing put and call options, allowing it to sell a block of shares while giving the bank a right to buy the same block of shares for a similar price, thus hedging against price fluctuation. "Congress tried to address this practice back in the 1990s by forcing taxpayers to recognize gains on securities that were entirely hedged using such derivative transactions, but Treasury never followed through with writing and enforcing regulations regarding options and collars," the report says.
The report recommends that Treasury issue regulations that clearly define specific collars as triggering gain on appreciated property under the section 1259 rules.
Wash Sales to Time Recognition of Capital Income
Known as the wash sale rule, section 1091 prevents taxpayers who sell securities at a loss from recognizing the loss if they acquire a "substantially identical" security within 30 days of the loss sale. Section 1091(a) provides that a taxpayer who has realized a loss from the sale of stock or securities may not deduct it if she purchases substantially identical stock or securities within a period beginning 30 days before the sale and ending 30 days after the sale.
There are questions, however, about whether securities and some derivatives are substantially identical within the meaning of the rule.
In the report's example, the taxpayer sells losing stocks and then enters into a derivative with a bank, whereby the bank pays the taxpayer the economic-equivalent return of the stocks that have been sold plus the return of additional stocks that the taxpayer was planning to buy. The addition of other stocks keeps the derivative from being substantially identical to the stock sold.
The report recommends that Congress enact legislation updating section 1091 so it applies to forward contracts, swaps, and derivatives involving commodities and currencies. It also recommends additional regulations or legislation clarifying how to identify substantially identical positions.
Manipulating Timing and Character
The report generally opposes taxpayers' use of derivatives to change the character of gains and losses. For example, a taxpayer may cancel a swap before maturity to recognize capital gains rather than the ordinary income that the taxpayer would recognize if the payments were received under the swap.
To combat this gaming by some taxpayers, the report recommends that Congress pass legislation that marks to market all derivative instruments. President Obama proposed marking to market derivatives in his fiscal 2016 budget proposal, as did former House Ways and Means Committee Chair Dave Camp in his tax reform plan, the Tax Reform Act of 2014 (H.R. 1).
Though largely similar, Obama's proposal is narrowly tailored to include only derivatives with actively traded underlying property, rather than Camp's all-inclusive derivative definition.
Derivatives and Partnerships
Congress enacted section 1260 in 1999 to limit the amount of long-term capital gain a taxpayer could recognize from derivative contracts referencing partnership interests as the underlying asset. Section 1260 treats gain accrued during the period of constructive ownership as ordinary and imposes an interest charge on deferral.
Section 1260, however, applies only to a limited number of derivatives -- swaps, forward contracts, and option collars -- and to the extent Treasury provided in future regulations. But Treasury never wrote regulations under section 1260; leaving opportunities for some derivative contracts to avoid the constructive ownership rules.
Taxpayers use the limited application of section 1260 to mimic ownership of an investment partnership, which allows them to convert ordinary income and short-term capital gains to long-term capital gains.
The report suggests that Congress amend the statute to include deep-in-the-money options and that Treasury also issue regulations expanding the reach of the constructive ownership rules.
The report describes basket options, which were the subject of a Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations (PSI) hearing in July 2014, as a strategy used by taxpayers to convert short-term gains into long-term gains.
The PSI investigated the use of basket options by Renaissance Technologies LLC (RenTec), a hedge fund founded by James Simons in 1982, and estimated that through the use of the options, RenTec avoided paying $6.8 billion in taxes.
Basket options are arrangements between banks and hedge funds in which the bank writes an option to cash-settle on a basket of securities. The bank will then establish a proprietary account and the hedge fund will contribute a small amount of capital -- typically around 10 percent -- while the bank contributes the rest of the capital. In RenTec's case, it was managing trading inside the account and making more than 100,000 trades a day.
Because RenTec is a high-frequency trader, most assets were in the account for fewer than 12 months, and would have been subject to short-term capital gains. The option, often greater than a year in length, would convert the gains to long-term capital under section 1234, which says that when an option is exercised, the gain will have the same character as the underlying assets.
The PSI report recognized that the IRS's difficulty in stopping these arrangements stems from its difficulty auditing large partnerships.
The IRS in 2010 issued a legal memorandum (AM 2010-005) describing the basket arrangement as tantamount to direct ownership by the fund of the securities in the basket. The report suggests that the law is clear that basket options are a tax shelter and says that legislation is not necessary to shut down these transactions.
The report suggests that the IRS and Treasury issue a tax shelter notice, notifying taxpayers that these arrangements are a tax shelter and that the IRS will penalize the taxpayers if they continue using them.
Executive Compensation Deferral
It is common for companies to provide executives with the choice to receive compensation currently or to defer compensation to a later date, often 20 years or more into the future. This differs from a normal employee who generally only has the option to defer compensation through contributions to a section 401(k) plan, which has tightly defined statutory limits.
Executives can defer their compensation through a nonqualified deferred compensation plan. Under the plan, an employee does not include the income until it is actually received.
The report recommends that Congress modify section162(m) to keep companies from being able to circumvent the salary deduction limitation. Section 162(m) applies to executives, so if compensation is limited to when the employee retires, the cap no longer applies. Camp's tax reform plan also proposed including all compensation deferred under a nonqualified deferred compensation plan in the year it vests.
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