Senate Finance Committee ranking minority member Ron Wyden, D-Ore., released a discussion draft last week that would reform the tax treatment of derivatives.
The proposal builds on a discussion draft released in 2013 by former Ways and Means Committee Chair Dave Camp, R-Mich. Like Camp, Wyden is proposing to require taxpayers to mark-to-market derivatives at the end of the year, but the Wyden draft includes several changes intended to address some issues raised in response to the Camp draft.
At its heart, Wyden’s bill would generally require derivatives, and their underlying investments, to be reported on a mark-to-market basis annually, and all resulting mark-to-market gain or loss would be ordinary. In effect, it would expand the mark-to-market treatment under Sections 475 and 1256 to nearly all derivatives, while denying the 60-40 split of capital gains and losses available for Section 1256 contracts. Taxpayers would be allowed to rely on book valuations of derivatives for tax purposes. Like Camp’s version, the definition of derivatives under the proposal is intended to be broad and would cover any contract, futures contract, short position, swap or similar instrument.
However, Wyden’s draft adds several new carve-outs. He retains Camp’s exceptions for derivatives related to real property and derivatives that are part of a hedging transaction defined in Sect. 1221 (b), but also includes exceptions for employee stock options, insurance contracts, annuities, endowments, derivatives of commodities used in the ordinary course of a trade or business, securities lending transactions and sale-repurchase transactions, contracts on stock issued by a member of the same worldwide affiliated group, and certain embedded derivatives in debt instruments. The proposal would also require taxpayers to bifurcate contracts with derivative and nonderivative components, although if the derivative component could not be separately valued, then the entire contract would be required to be treated as a derivative.
Perhaps the biggest change is Wyden’s attempt to create a new regime to cover the hedging of capital assets. Capital asset hedging would be included in mark-to-market treatment when rising to the level of an “investment hedging unit” (IHU), defined as contracts associated with one or more underlying investments having a “delta” between minus 0.7 and minus 1.0 (indicating a hedge relationship). Any modification of an IHU would be considered a taxable event.
The draft is Wyden’s second major installment in an effort to set the stage for tax reform in 2017. Two weeks earlier, he released a discussion draft to overhaul depreciation. (See our earlier Tax Hot Topics
for more information.) Major tax legislation is unlikely this year, but these ideas may have substantial impact on future tax reform, particularly if the Democrats take back the Senate in November.
This particular proposal on derivatives could also gain traction outside of tax reform. The Joint Committee on Taxation estimated that Wyden’s version would raise $16.5 billion over 10 years, making it an attractive revenue raiser with support in both parties. The original version was proposed by a Republican lawmaker, and the president has supported the idea in the last several budget requests.
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