U.S. Sees 'Great Difficulties' in Taxing Financial Products

December 07, 2011, 7:41 AM EST By Richard Rubin

(Updates with Camp, Baucus comments starting in seventh paragraph.)

Dec. 6 (Bloomberg) -- U.S. lawmakers seeking to overhaul the Internal Revenue Code are examining how derivatives and other financial products should be treated and how investors can structure transactions for more favorable tax results.

Financial instruments, including exchange-traded notes and options, are susceptible to manipulation, according to a report by the nonpartisan Joint Committee on Taxation. Taxpayers can structure transactions to defer income, accelerate deductible losses and take advantage of lower capital gains rates.

The “ability to combine basic instruments and to create new instruments represents financial innovation that might lower the cost of capital,” the report said. “The flexibility of financial instruments also creates great difficulties in the taxation of financial instruments.”

The report was prepared for a hearing today of the House Ways and Means Committee and Senate Finance Committee. The session is the two panels’ second joint hearing since 1940. The first, on treatment of debt and equity, was held in July.

The hearing is part of a series of discussions on a tax- code overhaul. Ways and Means Chairman Dave Camp, a Michigan Republican, wants to restructure the code to reduce the corporate and individual rates to 25 percent without lowering tax collections.

Changing the Rules

Achieving that goal will require eliminating tax breaks or changing underlying tax rules, such as the way derivatives are taxed. The chairmen of the tax-writing committee didn’t commit to a particular proposal in their opening statements.

Camp said at the hearing today that he hoped to resolve some of the murkiness surrounding financial instruments.

“Today’s marketplace features a wide array 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,” he said.

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said new financial instruments have the potential for mischief.

“They aren’t fair to taxpayers who can’t afford those high-priced lawyers and accountants,” he said.

‘Heading Someplace’

The hearing “means that they are heading someplace,” Bruce Thompson, vice president at Van Scoyoc Associates Inc., a Washington lobbying firm. “Now where they are, I’m not sure.”

Thompson, former senior director of global government relations at Merrill Lynch & Co., said financial institutions that benefit from the current tax system should be wary.

“Ten years ago, they were invulnerable in Washington. They’re not that way now,” he said. “There’s obviously continued anger at the industry. That certainly hasn’t gone away, and it’s from both the left and the right.”

Several features of the U.S. revenue system make it difficult to tax financial products. Those include the ability to defer taxation using some financial instruments and the preferential 15 percent rate for long-term capital gains, said Viva Hammer, a former Treasury Department official who was responsible for tax policy related to financial institutions and products.

“The ability to toggle in and out of capital treatment allows tremendous flexibility in planning your taxes,” she said.

Mark to Market

Hammer said Congress should require mark-to-market taxation of derivatives at ordinary income tax rates.

“Everyone knows what the right answer is, but no one has the courage to impose it,” she said.

Mark-to-market accounting is intended to require companies to assign fair value to financial instruments and to limit the benefits of deferring realization of gains.

David Miller, one of the witnesses set to speak at today’s hearing, in 2008 proposed that large companies and wealthy individuals face a mark-to-market tax regime on publicly traded securities and derivatives. Miller is a partner at Cadwalader, Wickersham & Taft LLP in New York.

Alex Raskolnikov, a professor at Columbia Law School in New York who is scheduled to testify today, supports mark-to-market treatment of derivatives at ordinary income tax rates.

‘Mind-Numbing’ Rules

“The mind-numbing complexity of the current rules, the considerable compliance costs they impose, and the need for Congress to continually monitor and respond to financial innovation will all disappear,” he told a Ways and Means subcommittee in 2008.

The global over-the-counter swaps market is $708 trillion, according to the Basel-based Bank for International Settlements. Derivatives, including swaps, are financial contracts tied to interest rates, currencies or events, such as a company default.

Ken Bentsen, the executive vice president for public policy and advocacy at the Securities Industry and Financial Markets Association, a trade group in Washington, said he welcomed the committee’s discussion.

“These are very good information-gathering opportunities for the members of the committee that will help them as they hopefully ultimately move toward broad-based tax reform,” he said.

Bentsen said he would caution lawmakers about the potential unintended consequences of any changes in the tax treatment of financial products.

“They’re underpinnings of the economy that we have today,” he said.

--With assistance from Silla Brush in Washington. Editors: Jodi Schneider, Robin Meszoly

To contact the reporter on this story: Richard Rubin in Washington at rrubin12@bloomberg.net

To contact the editor responsible for this story: Mark Silva at msilva34@bloomberg.net

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