Sen. Ron Wyden, D-Ore., the ranking Democrat on the Senate Finance Committee, released a legislative discussion draft Wednesday to lay the groundwork for tax reform in the area of financial derivatives.

The Modernization of Derivatives Tax Act would require mark-to-market treatment for all financial derivatives, treating derivatives contracts as if they had been sold and repurchased at the end of each year. The draft would then require ordinary tax treatment on the resulting gains and losses.

The draft legislation would replace the current hodgepodge of derivative tax rules and instead apply a single tax regime to all derivative contracts, with one rule for transaction timing (mark to market), one rule for character (ordinary), and one rule for source (the taxpayer’s country of residence). The draft would repeal nine sections of the Tax Code and streamline many others, including associated regulations.

The draft would also unify valuation rules for tax and book purposes. To identify and tax substantial hedges on capital assets, the draft would institute a capital hedging rule requiring mark to market and ordinary income tax treatment for combinations of derivatives and their underlying investments, which are identified to have a substantial hedging relationship.

The draft legislation would target sophisticated taxpayers who use derivatives to avoid paying taxes on their investments, according to Wyden’s office, but is not directed at the banks, businesses, and individuals that hedge business risks, or employees who receive stock options, or derivative transaction in pension funds, endowments , insurance contracts, or annuities, or in certain transactions aimed at keeping mortgage rates low.

“The privileged few use expensive accountants and lawyers to shield their wealth so they can pay what they want, when they want,” Wyden said in a statement Wednesday. “Meanwhile hardworking Americans have taxes pulled from their salaries every month—no questions asked. This proposal will help end the ‘Tale of Two Tax Codes’ and create one fair system with simple and straightforward rules that apply to everyone.”

The proposal builds on recommendations made in a report that Wyden called for last year identifying major tax avoidance strategies. The report, entitled "How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions," provides examples of how derivatives can be used for tax evasion, and can be found here.

The discussion draft is a detailed, but not final, document that outlines principles and concepts, according to Wyden’s office. It is being circulated to stakeholders, members of Congress, federal officials and others for review and comment. The responses will be reviewed and, if appropriate, incorporated into legislation. Comments on the proposal can be emailed to

A one-page summary of the legislative proposal can be found here. A longer summary can be found here. The discussion draft text can be found here.

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