Legislative Update: Proposal to modify taxation of financial derivatives

Proposal to modify taxation of financial derivatives

Senate Finance Committee ranking member Ron Wyden (D-OR) today released a discussion draft of proposed legislation to modify the taxation of financial derivatives.

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The “Modernization of Derivatives Tax Act” (MODA) attempts to unify and simplify the treatment of derivatives by creating one timing rule, one character rule, and one sourcing rule for all derivatives. 

The proposed draft is estimated by the Joint Committee on Taxation to increase tax revenues by $16.5 billion over 10 years.  Documents relating to the discussion draft—including legislative text and a technical explanation prepared by the staff of the Joint Committee on Taxation—are available on the Finance Committee’s website.

Summary of proposals

Among other modifications, the proposals in the discussion draft would:

  • Require taxpayers to use a mark-to-market method of accounting for derivatives (except derivatives that are hedging transactions) and recognize the resulting gain or loss
  • Require taxpayers to use a mark-to-market method of accounting for a non-derivative position (“an underlying investment”)—e.g., stock in a corporation, partnership interest, certain real property, actively traded commodities, currency—that is part of newly defined “investment hedging units”
  • Characterize gain or loss derived from a derivative—and, in the case of an “investment hedging unit,” all or a portion of the underlying investment—as ordinary income or loss
  • Source any item of income (except to the extent that section 871(m) applies to a payment), deduction, gain or loss to the country of residence of the taxpayer
  • Repeal certain existing Code sections that apply to derivatives, including section 1256
  • Create a new exception from the definition of capital asset for debt instruments held by certain insurance companies taxed under section 801(a) or 831(a)

Definition of “derivative”

The discussion draft defines a derivative as any contract (including any option, forward contract, futures contract, short position, swap, or similar contract) the value of which is determined directly or indirectly by reference to one or more of the following:

  • Stock in a corporation
  • Partnership or beneficial interest in a partnership or trust• Evidence of indebtedness
  • Certain real property
  • Any actively traded commodity
  • Any currency
  • Any rate, price, amount, index, formula, or algorithm, or
  • Any other item prescribed by the Secretary of the Treasury

Among the items excluded from the definition of a derivative by the discussion draft are: American depositary receipts (ADRs); contracts that require the physical delivery of real property; hedging transactions (as defined under section 1221(b)); certain positions in securities lending and sale-repurchase transactions; options received for the performance of services; insurance, annuity, and endowment contracts if issued by an insurance company; contracts relating to stock issued by members of the same affiliated group; and contracts generally requiring physical delivery of a commodity that is used in the normal course of a taxpayer’s trade or business.

Mark-to-market rule

The discussion draft generally provides that taxpayers must recognize gain or loss on a derivative contract and an underlying investment held at the close of the taxpayer’s tax year as if it had been transferred or terminated at that time. The discussion draft also has special rules regarding taxable events for investment hedging units.

Investment hedging units (IHUs)

The discussion draft provides a comprehensive regime for the taxation of “investment hedging units” or “IHUs.”  In general, an IHU would comprise one or more derivatives and one or more underlying investments or portions thereof. The derivative and underlying investment would be subject to the mark-to-market method of accounting and gain or loss on those items would be ordinary.

The existence of an IHU would be determined when a taxpayer holds (directly or indirectly including through certain related-party attribution rules) both a derivative and an underlying investment or portions thereof during the applicable hedging period, provided the derivative and the underlying investment have a certain financial relationship (“delta”). To be considered an IHU, all derivatives relating to an underlying investment would have to have, singularly or in combination, a delta between -0.7 and -1.0.  

Further, a taxpayer could elect to apply the IHU rules to all derivatives with respect to an underlying investment and all of such underlying investments without regard to the delta test, but such an election would be irrevocable. A taxpayer that fails to satisfy the IHU derivative testing and identification requirements would be treated as having made the election to apply the IHU rules to all derivatives with respect to an underlying investment.

IHU taxable events would include the establishment of the IHU, and any modifications to the IHU made thereafter—such as the acquisition, termination, transfer, sale or exchange of any included derivative or underlying investment.  Built-in losses would not be recognized during the establishment of an IHU or when position are added to the IHU, while built-in gains would be recognized at such times. In general, the IHU derivative testing and identification requirements would apply at the following times during which a taxpayer simultaneously holds one or more derivatives with respect to an underlying investment and one or more portions of the underlying investment: (1) the beginning of that period; (2) immediately after the taxpayer enters into another derivative with respect to the underlying investment or acquires an additional amount of such underlying investment; (3) after the taxpayer terminates or transfers one or more derivatives with respect to the underlying investment or sells or exchanges any portion of the underlying investment (except if the underlying investment is not part of an IHU); or (4) such other times as prescribed in regulations.

After the IHU is terminated, the underlying investment again would receive capital treatment and the holding period is reset.

Technical and conforming amendments for derivatives

Finally, the discussion draft would repeal nine Code sections—sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259—and amend numerous other Code sections that apply to derivatives.

KPMG observation

This discussion draft proposal, if enacted, would sweep away the various timing and character rules that apply to different derivative contracts. Applying a single timing and character rule to all types of derivative contracts would simplify certain aspects of any tax analysis. No longer would it be necessary to categorize a contract and identify the rules that would apply—although it would still be necessary to determine whether the contract is a “derivative” as defined under the discussion draft. A single rule for all derivatives would eliminate the electivity that comes with different rules for different types of contracts. It would also clarify the tax treatment of new financial products. 

Furthermore, this proposal appears to be based, in significant part, on the earlier discussion draft presented in 2014 by then-chairman of the House Ways and Means Committee, Dave Camp.  The Camp proposal addressed the tax treatment of financial derivatives, although today’s proposal addresses a number of uncertainties presented by the Camp proposal, including scope and valuation. 

For example, the discussion draft clarifies that a derivative would not include direct ownership of an underlying investment, and expressly carves out of the definition of derivative certain things such as insurance contracts, annuities, options received in connection with the performance of services, and lenders of a security under a securities loan. The proposal also does not apply to certain contracts on real property and commodities used in the normal course of a trade or business if those contracts require physical settlement or permit cash settlement only in unusual or exceptional circumstances. Furthermore, the discussion draft expressly applies to any derivative with respect to any rate, price, amount, index, formula or algorithm, something that was uncertain in Chairman Camp’s proposal.

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