The Internal Revenue Service is facing challenges keeping ahead of financial services companies that create sophisticated financial derivatives and offer them as a way to evade tax liabilities.
A report released last week by the Government Accountability Office examined financial derivatives such as variable prepaid forward contracts and cross-border total return equity swaps, illustrating how they were able to achieve improper or disallowed tax results. The report noted that taxpayers have used financial derivatives such as these to lower their tax liability in ways that the courts have found improper or that Congress has disallowed.
“Taxpayers do this by using the ease with which derivatives can be redesigned to take advantage of the current patchwork of relevant tax rules,” said the report. “As new products are developed, [the] IRS and taxpayers attempt to fit them into existing ‘cubbyholes’ of relevant tax rules. This sometimes leads to inconsistent tax treatment for economically similar positions, which violates a basic tax policy criterion.”
While the tax rules for each “cubbyhole” represent Congress’s and the Treasury’s explicit policy decisions, some of these decisions were made long before today’s complex financial derivative products were created, the report noted.
Some experts have suggested alternative ways to tax financial derivatives aside from the current approach. The IRS and the Treasury Department need to provide guidance to taxpayers when application of the tax law is complex or uncertain, as is often the case for financial derivatives, the report noted. Guidance to taxpayers is an important tool for the IRS to address tax effects and potential abuse. However, between 1996 and 2010, the Treasury and the IRS did not complete 14 out of 53 guidance projects related to financial derivatives that they designated as a priority for guidance on their annual Priority Guidance Plans.
While completing guidance is important in providing certainty to taxpayers and the IRS, and reducing the potential for abuse, challenges such as the risk of adverse economic impacts from the guidance changes and the transactional complexity of financial derivatives could delay the completion of guidance, the GAO noted. Since challenges may prevent the IRS from finalizing its guidance within a 12-month period, taxpayers need to be aware of the status of the ongoing guidance projects, some of which may take a number of years.
The IRS sometimes identifies new financial derivative products or new uses of them long after they have been introduced and gained considerable use, slowing down its ability to address potential abuses. The IRS’s 2009-2013 Strategic Plan lists strengthening partnerships across government agencies in order to gather and share information as key ways to identify and address new products and emerging tax schemes more quickly.
Through their oversight roles in the financial derivative markets, the Securities and Exchange Commission and the Commodity Futures Trading Commission may have information on financial derivatives that is relevant to the IRS. Similarly, bank regulators may gain relevant knowledge of derivatives’ use. IRS officials said such routine communications in the early 1990s did provide them with relevant information.
While the IRS communicates with the SEC and the CFTC on derivatives, it does not do so systematically or regularly, according to the report. Strengthening partnerships with the SEC and the CFTC would increase the opportunities for the IRS to gain information on new financial derivative products and uses.
The GAO recommended that the Treasury determine whether alternatives to the current approach to taxing financial derivatives would promote consistent treatment of economically similar positions and be beneficial. It also said the Treasury and the IRS should provide more public information on the status of Priority Guidance projects, including those related to financial derivatives. The IRS should also strengthen its information-sharing partnerships with relevant agencies, according to the report.
The IRS agreed with the third recommendation and disagreed with the second, while the Treasury disagreed with the first two recommendations. The GAO said it continues to believe its recommendations would be beneficial.
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