The Republican chairman of the tax-writing House Ways and Means Committee, Dave Camp, R-Mich., released a draft document Thursday proposing a series of tax reforms for various types of financial derivatives and other financial products, building on work done by his committee over the past two years.

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 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:

• Valuing derivatives that would become subject to mark-to-market tax treatment.
• Identifying financial products tax provisions under current law that may become obsolete or may require modification in light of the discussion draft.
• Information reporting rules that may be necessary to implement the discussion draft, including the reporting rules that are contained in the draft.
• Other areas of financial products taxation that are not addressed in the discussion draft.

The Ways and Means Committee held 20 separate hearings on comprehensive tax reform in the 112th Congress and released an international tax reform discussion draft in October 2011. Camp released the new discussion draft on financial products tax reform, in part, as a response to the input and feedback the committee received during a joint hearing of the Ways and Means Committee and Senate Finance Committee examining the complex relationship between the tax code and financial products. 

“The U.S. is a leader in the financial world, but our broken and antiquated tax code has failed to keep up with the rapid pace of financial innovation on Wall Street,” Camp said in a statement. “The lack of consistent and comprehensive tax policy has also contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community.  Updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer and more transparent for taxpayers; and it will also help to minimize the potential for abuse that has occurred in the past.” 

The committee is encouraging stakeholders to review and comment on specific legislation prior to formal legislative action.

“If we are to enact tax reform that preserves needed flexibility in the financial markets while ensuring that no one is gaming the system and putting hardworking taxpayers at risk, then we will need the expertise of those who are most familiar with these products,” said Camp. “They can identify areas that merit additional attention, and their insight is critical.”

Republicans may see agreement from their Democratic colleagues on the committee. House Ways and Means ranking member Sander Levin, D-Mich., expressed cautious support. “These are interesting ideas that might cure some inequities and raise revenues, and I welcome such an approach," Levin said in a statement. "This underlines the need for us to act on a bipartisan basis to raise revenues and close loopholes as we seek further deficit reduction through a balanced package of spending cuts and additional revenues.”

Ernst & Young quickly weighed in with a comment on Camp's proposals Thursday. "The proposals released today appear to be motivated by a desire to make the Tax Code work better," said David C. Garlock, E&Y's director of financial services, transaction tax, in a statement. "The proposals with the broadest effect would appear to be those calling for marking to market of derivatives, with certain important exceptions, and the requirement to use average cost basis when taxpayers are selling stock out of holdings that were acquired at two or more different times. The latter provision may raise some revenue as it takes away a popular tax planning opportunity. With regard to marking to market of derivatives, the proposal carves out an exception for hedging transactions, which should blunt the effect of the proposal significantly for many if not most derivatives used by businesses. Derivatives that are part of straddles are not exempt but rather cause the other positions in the straddle also to be marked to market. The effect of this could be quite broad. Other provisions in the proposals generally would correct various problems with the taxation of financial products that have been identified by practitioners and bar association committees.  These would be welcome changes to the tax code if enacted. However, one proposed rule would require current taxation of market discount on debt instruments, subject to a ceiling on the yield to maturity. If interest rates rise, so that debt with lower stated interest rates begin to trade at a discount, this proposal would take away a tax deferral opportunity that investors could obtain by investing in older bonds with low stated rates rather than newer bonds with higher rates. This also might raise revenue, depending on the projections of interest rates during the relevant revenue-estimating period (generally 10 years)."

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