Congress Considers Tax Reform of Financial Products

Wednesday, December 7, 2011 Print Email

The Senate and the House’s tax-writing committees held a rare joint hearing on reforming the tax treatment of financial products such as derivatives. During the joint hearing between the Senate Finance Committee and the House Ways and Means Committee, members looked at how sophisticated financial instruments such as variable prepaid forward contracts and swaptions were being used to help shield assets fr om taxes.

However, they also talked about how increasing taxes on financial products could affect not only wealthy investors, but also increasingly popular investment vehicles such as exchange-traded funds. The Joint Committee on Taxation staff prepared a report on issues related to the taxation of financial instruments and products, and how investors often chose particular financial products based on their tax advantages.

“Tax considerations affect decisions related to holding, issuing, and structuring financial instruments,” said the report, which was presented by JCT chief of staff Thomas Bathold. “The taxation of financial instruments generally depends on a categorization based on the type of instrument rather than on the economic characteristics of the instrument, though those economic characteristics affect the categorization. Because instruments with similar or identical economic characteristics may be categorized differently from one another, a taxpayer with a particular economic goal may choose one instrument rather than another because of tax considerations.”

Panelists and lawmakers noted that by trying to close tax loopholes in one type of financial instruments, investors and their tax advisors would only be driven to resort to another investment strategy or derivative wh ere they save on taxes.

“The JCT report provides two critically needed tools,” said House Ways and Means Chairman Dave Camp, R-Mich., in his opening statement. “First, the report is helpful in demystifying much of the murkiness surrounding financial products. Today’s marketplace is a veritable buffet of products that can result in different tax or financial accounting treatment of economically similar products, including debt, equity, mixtures of the two, and financial derivatives such as options, futures and forward contracts, and swaps. Second, the report also highlights the complexity of tax rules in this area. In part, this reflects the inherent variety of the products. But this complexity has been further exacerbated by the tendency of Congress to enact tax legislation affecting a particular financial product without evaluating whether or not other approaches would provide more uniformity (and simplicity) to the taxation of existing and future financial products.”

Lawmakers had in mind the recent financial crisis, and how the sinking of the derivatives market in areas such as subprime mortgage-backed securities had led to it.

“Clearly there’s been an explosion in terms of financial instruments,” said Ways and Means ranking member Sander Levin, D-Mich. “This explosion has been part of the downturn in the economy. I don’t think we understood fully what was happening. We essentially had an increasing number of instruments that had similar economic features but were taxed in a very different way, and sometimes not taxed at all. And very importantly, there was very little transparency.”

Senate Finance Committee Chairman Max Baucus, D-Mont., and the other lawmakers examined how the Tax Code can cause uncertainty and inefficiency in the financial products market. And, because of that inefficiency, many resources are dedicated to structuring complex financial products in order to receive a particular tax treatment when those same resources could otherwise be spent investing in the economy, creating jobs and helping U.S. businesses grow.

“Too many resources are spent developing new and complex financial instruments simply to avoid taxes,” Baucus said. “Many financial instruments serve essential business purposes, including farmers in my home state of Montana who use futures contracts to reduce the impact of the market’s ups and downs. But financial advisors have created a complex web of new products that mix debt, equity and derivatives, and the only purpose of some of these new products is to avoid paying taxes. Tax reform can simplify and clarify the tax treatment of these financial products.”

Alex Raskolnikov, a professor at Columbia Law School, pointed out that more research needs to be done on revenue losses from derivatives-based tax reduction strategies, and the need for tax reform. “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,” he said in his prepared testimony. “As long as the patchwork of current rules remains in place, symmetry, consistency and balance will all remain unattainable.”

Andrea Kramer, a partner in the law firm McDermott, Will & Emery, and head of its financial products, trading and derivatives group, argued that efforts to close tax loopholes were frequently misguided. “Often in discussing the tax treatment of derivative transactions, the focus is on their inappropriate or illegitimate uses to game the tax system,” she said. “The reality is that derivatives are an economically valuable financial products and are principally used for legitimate risk management and hedging purposes.”

David Miller, a partner in the law firm Cadwalader, Wickersham & Taft, discussed the use of financial products like variable prepaid forward contracts. He pointed to recent reports by The New York Times andBloomberg of how wealthy investors such as Estée Lauder heir Ronald Lauder and Clear Channel Communications co-founder Billy Joe McCombs had used variable prepaid forwards to hedge their downside risk essentially tax-free.

“Although the IRS has challenged one variant of this transaction, it has issued a Revenue Ruling declaring the basic technique completely legal,” he pointed out. “In fact, in June, Ronald Lauder entered into a variable prepaid forward contract on his Estée Lauder shares and received over $72 million in cash tax-free. These are not transactions available to working-class Americans, but our realization-based tax system permits them.”

Login to ReadyRatios

 

Have you forgotten your password?

Are you a new user?

Login As
You can log in if you are registered at one of these services: