Washington, D.C. - 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 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.

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.

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