Daily Tax Update - December 6, 2011: Hearing on Taxation of Financial Products

HEARING ON TAXATION OF FINANCIAL PRODUCTS:  Today, the House Ways and Means and Senate Finance Committees held a joint hearing examining the tax treatment of financial products and potential options for reform.

  • In his opening remarks, House Ways and Means Committee Chairman Dave Camp said, "Over the years, there have been few proposals to reform the taxation of financial products on a comprehensive basis. . . . Gaining a better understanding of these products is imperative if we are to enact tax reform that combines needed flexibility in the financial markets with certainty and predictability in the tax code."
  • Senate Finance Committee Max Baucus said in his opening statement, "Many financial instruments serve essential business purposes.  They allow individuals and companies to hedge against risks and minimize exposure to losses, especially in this turbulent economic time. . . . Over the past decade, the use of one type of financial product, derivatives, has grown considerably.  The notional – or theoretical – value of derivatives held by U.S. commercial banks has grown more than six times in the past decade.  It now totals $230 trillion.  Globally, the notional value of over-the-counter derivatives is estimated to total more than $700 trillion.  That equals more than three times the value of all global financial assets." Baucus added, "This growth can make it harder to determine the value of a business holding these financial instruments.  Some believe this lack of transparency is one of the problems that gave rise to the financial crisis. . . . So let us clarify and simplify the tax treatment of these financial products, let us ensure they are taxed rationally and fairly, let us work to make the tax code reflect the goals of transparency, consistency, and the protection of the American taxpayer, and as Mr. Buffet alluded to, let us limit the potential for mischief."
  • The witnesses were:
    • Dr. Thomas A. Barthold, Chief of Staff, Joint Committee On Taxation;
    • Mr. Alex Raskolnikov; Charles Evans Gerber Professor of Law and Co-chair of the Charles E. Gerber Transactional Studies Program, Columbia Law School;
    • Ms. Andrea S. Kramer, Partner, McDermott Will & Emery LLP;
    • Mr. David S. Miller, Partner, Cadwalader, Wickersham & Taft LLP.
  • Dr. Barthold discussed the Joint Committee on Taxation’s report on the taxation of financial products prepared for the hearing.  The report observed that, "Individuals and businesses have various economic motives for trading in financial instruments. For example, businesses issue financial instruments to raise money to finance projects, and individuals hold financial instruments to achieve returns on savings. Businesses also use financial instruments to hedge against risks such as price fluctuations in raw materials, exchange rate movements, and changes in the cost of capital. These financial instruments include equity and debt, instruments that combine features of equity and debt, and derivative instruments. The decision to hold or issue one instrument rather than another is based on a number of economic considerations including the riskiness of a particular instrument, the timing of cash flows produced by the instrument, and the rights or obligations, such as voting control, of the parties to an instrument." 
  • Mr. Raskolnikov stated, "Our knowledge of revenue losses from derivatives-based tax reduction strategies is largely anecdotal, wholly unsystematic, and woefully incomplete. More research can and should be done and Congress can play a critical role in facilitating it. . . . in the absence of comprehensive reform, it is impossible to tax financial derivatives in a manner that meets any accepted benchmark of an effective and efficient capital income tax. As long as the patchwork of current rules remains in place, symmetry, consistency, and balance will all remain unattainable. . . . the fundamental reform alternatives are limited, reasonably well-understood, and even partly reflected in the current law. They include anticipatory taxation, retroactive taxation, and accrual-based (or mark-to-market) taxation. Each of these approaches involves tradeoffs, and the adoption of each approach for all financial products would amount to a significant change in the current law. Finally, it is important to keep in mind how any significant reform unrelated to financial products (such as corporate integration or a switch to territorial taxation) is likely to affect the stakes in reforming the taxation of derivatives. These effects vary from substantial to insignificant to uncertain."
  • Ms. Kramer testified, "[D]espite the enormous size of the derivatives market and American businesses’ use of it primarily for entirely appropriate and economically beneficial purposes, there continues to be a lot of talk about abusive derivative transactions and the need to close ‘tax loopholes.’ A variety of proposals have been put forward to do this, including proposals to move to a mark-to-market system for all derivatives. I believe that these proposals are the result of a misguided perspective on the derivatives market, and I believe more specifically that a move to a more pervasive system of marking-to-market would be a fundamental mistake. Quite simply, we should not go there.  The problem, as I see it, is not that there are serious loopholes in the taxation of derivatives — at least, not with respect to taxpayers who use derivatives to manage their risks. The real tax problem with respect to derivatives is that the basic rules are far too restrictive and as a result are inhibiting legitimate commercial and financial activities."
  • Mr. Miller advocated for a mark-to-market system of taxation for derivatives, stating that "the taxpayer would simply compare the value of the instrument at the end of year with its tax basis and pay tax on the difference, regardless of whether the instrument is sold. I have proposed a system that would require all public companies, all private  companies with $50 million or more of net assets, and the 1/10th of 1% of the wealthiest and highest-earning individual taxpayers to mark-to-market all of their publicly-traded property, derivatives of publicly-traded property (other than business hedges), and some publicly-traded debt and liabilities. Mark-to-market gains of individuals would be taxable at long-term capital gains rates and losses would be deductible (and the tax refundable) to the extent of prior mark-to-market gains. This system would at once abandon our geocentric tax system and finally match tax and economics. 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. But it is radical because it would apply to stock and securities as well as derivatives."
  • In conjunction with today’s hearing, the Joint Committee on Taxation has issued a report via
  • Testimony can be accessed here.
  • For additional information, contact Philip R. West - pwest@steptoe.com or  Amanda Varma - avarma@steptoe.com


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