The proposal outlines changes to tax rules designed to provide greater simplicity and uniformity. Simultaneously, the proposal also seeks to modernize tax rules to minimize Wall Street’s ability to hide and disguise potentially significant risks through the abuse of derivatives and other novel financial products, a contributing factor to the 2008 financial crisis.
The discussion draft includes several reforms for updating and the tax treatment of financial products. One of the main proposals aims to provide uniform tax treatment of financial derivatives. The draft would require taxpayers engaged in speculative financial activity—but not business hedging against common risks—to mark certain financial derivative products to fair market value at the end of each tax year, thus triggering the recognition of gain or loss for tax purposes.
The Tax Code already requires or permits mark-to-market accounting for specific financial products, such as certain contracts and options that are traded on exchanges, and for specific taxpayers, such as securities and commodities dealers and traders, Camp’s committee noted.
“Broadly extending mark-to-market accounting treatment to derivatives would provide a more accurate and consistent method of taxing these financial products and make them less susceptible to abuse, without affecting most small investors who normally do not invest in these products,” according to an overview of the discussion draft. “Derivatives that are used by businesses in the ordinary course of their businesses to hedge against price, currency, interest rate and other risks would not be affected.
Another proposal would simplify the business hedging tax rules. For taxpayers who are engaged in hedging business risks, the draft would allow transactions that are properly treated as hedges for financial accounting purposes to be treated as hedges for tax purposes. The taxpayer-favorable proposal aims to minimize inadvertent failures to identify a transaction as a hedge for tax purposes, even though the transaction satisfies all of the substantive requirements for hedging transaction tax treatment.
Another proposal would eliminate the “phantom” tax resulting from debt restructurings. The draft would reform the tax rules that apply to debt restructurings that do not involve a forgiveness of principal. This change would reduce the prevalence of “phantom” cancellation-of-indebtedness income when debt is restructured—a common practice during economic downturns—thereby creating a more taxpayer-favorable rule.
The discussion draft also proposes to harmonize the tax treatment of bonds traded at a discount or premium on the secondary market. For bonds that are acquired on a secondary market at a discount, the draft would require the holder of the bond to recognize taxable income on the discount over the remaining life of the bond—conforming the tax treatment of such transactions to bonds acquired at a discount directly from the borrower. At the same time, the amount of discount to be recognized for tax purposes would be limited to the discount that typically reflects an increase in interest rates that has occurred since the date the bond was originally issued—as opposed to steeper discounts that often reflect deterioration in the creditworthiness of the borrower. The draft also would allow taxpayers to claim “above-the-line” deductions for bonds acquired at a premium on a secondary market.
Another proposal would increase the accuracy of determining gains and losses on sales of securities. To simplify tax compliance and administration, and to determine more accurately the amount of gain or loss when a security is sold, the draft would require the cost basis of the security to be based on the average cost basis of all other shares or units of the identical security held by the taxpayer.
Yet another proposal would prevent the harvesting of tax losses on securities. The so-called “wash sale” anti-abuse rule has been a feature of the Tax Code for decades, the discussion draft overview noted. The rule is intended to prevent taxpayers from harvesting tax losses by selling securities at a loss and then immediately reacquiring the same securities. However, the wash sale rule under current law only applies if the same taxpayer sells and reacquires the security, and it can be circumvented using related parties such as spouses, children, or entities controlled by the taxpayer. The draft would reform the wash sale rule so that it applies to transactions involving closely related parties.
Camp’s committee said it recognizes that the discussion draft does not address several technical and policy issues that may need to be resolved in final legislation. The committee is inviting comments on how to address such issues, in particular:
