Overview
On May 18, Senate Finance Committee Ranking Member Ron Wyden (D-OR) released a discussion draft of a new regime for the taxation of derivatives. The Modernization of Derivatives Tax Act (MODA) is intended to prevent the use of derivatives by taxpayers to avoid taxes and simplify the Tax Code. The bill would require mark to market and ordinary income tax treatment for all derivative contracts and would source gains and losses to the taxpayer’s country of residence. The bill is estimated to raise $16.5 billion over 10 years.
Currently, the Tax Code has numerous sections with different rules for timing and characterization depending on, for example, the type of taxpayer, the type or use of the derivative, or the type of property underlying the derivative. In addition, there are targeted rules to prevent particular abuses. The existing patchwork of rules is complex and gives taxpayers options for determining the treatment of derivatives. Ranking Member Wyden’s bill would unify and simplify the treatment of derivatives and eliminate most of the optionality by prescribing essentially one timing rule, one character rule, and one sourcing rule for all derivatives. The bill would repeal nine sections of the Tax Code1 and streamline others.
This proposed bill gives new life to some of the derivatives taxation questions that were hotly debated during the Dodd-Frank Wall Street Reform and Protection Act in 2010. At that time, the Congress adopted amendments to section 1256 and explicitly excluded a series of swaps and certain securities futures contracts or options from the definition of “section 1256 contract.” We expect MODA, if considered by the Senate, to revive the debate about different tax treatment for various derivatives products (i.e., over-the-counter swaps versus exchange-traded futures contracts).
The bill proposes the addition of three new sections to the Tax Code. First, it proposes adding section 491, titled “Rules for Treatment of Derivatives.” The bill would define taxable events with respect to derivatives and the tax treatment of gains and losses. Under new section 491, gains and losses on derivatives would be taxable upon termination or transfer at ordinary income rates. If derivatives are not terminated or transferred by the end of the year, they will be treated as if they were terminated or transferred and then repurchased, otherwise known as “marked to market.” The gains and losses on those derivatives marked to market would be ordinary. The source of those gains and losses would be the country of residence of the taxpayer, with some exceptions. For purposes of computing gains and losses on derivatives, taxpayers may rely on valuations used for financial statement purposes or valuations provided by a broker under section 6045(b). In addition, basis is determined using a first-in, first-out method or, if the taxpayer elects, an average cost method.
The provision also requires mark to market and ordinary tax treatment for combinations of derivatives and their underlying investments, which the bill defines as “Investment Hedging Units” or “IHU” in section 492. New section 492 would take the place of the current anti-abuse straddle rules and constructive sales rules found in sections 1092 and 1259. The new rule would apply to taxpayers who use derivatives to hedge capital assets. Under this provision, a derivative and its underlying investment will be treated as an IHU if the ratio of the expected change in the fair market value of the derivative to the change in the fair market value of the associated underlying investment is between negative 0.7 and negative 1.0 (the delta).2 A taxpayer may elect to forgo computing the delta and treat all derivatives with respect to an underlying investment and all of the underlying investment as part of the IHU, and thus subject to the requirement that they be marked to market and taxed as ordinary income.
New section 493 defines a derivative as any contract the value of which, or the payment or other transfer with respect to which, is determined by reference to one or more of several enumerated interests, including stock, partnership or trust interests, debt, currency, actively traded commodities, and price or index. Certain items are expressly excluded from the definition of derivative, including: certain interests in real property; ordinary business hedging transactions; securities lending or sale-repurchase transactions; compensatory options; insurance contracts, annuities, and endowments; derivatives with respect to stock of members of the same worldwide affiliated group; commodities used in the ordinary course of business; and American depository receipts.
This proposed bill follows other proposals from former Chairman of the House Ways and Means Committee Dave Camp (R-MI) and the Obama Administration in its Fiscal Year 2014 Revenue Proposals (“Greenbook”) (and each year thereafter) to require mark-to-market taxation and treat gains and losses from derivative contracts as ordinary. Unlike MODA, however, the Camp proposal and Greenbook would retain the straddle and constructive sale rules, and the Greenbook would limit the definition of derivative to those referencing actively traded personal property.
The Wyden bill would also treat debt instruments held by insurance companies as ordinary instead of capital assets. This would be a significant change for the industry, which typically holds large portfolios of bonds. Currently there is a character mismatch since interest income is ordinary but losses are capital. Insurance companies had previously used the identified mixed straddle rules to trigger capital gains to offset their losses from the bad bonds, but Treasury regulations issued in 2014 would suspend the gain or loss until the straddled property is actually sold and thus shut down this self-help measure. The Wyden proposed bill would resolve the issue.
A summary of Senator Wyden’s legislation is available here and a section-by-section of the bill is available here. Comments on the draft legislation can be emailed to: Financial_Products@finance.senate.gov, or mailed to: Senate Committee on Finance, 219 Dirksen Senate Office Building, Washington, DC 20510.
1 Specifically, the bill would repeal sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259, and 1260.
2 The delta concept is similar to the one adopted in the section 871(m) regulations.
