House Ways and Means Committee Chair Dave Camp, R-Mich., on Jan. 24 released a discussion draft for reforming the tax treatment of many securities transactions and financial products. The discussion draft is Camp's second major installment in a push toward comprehensive tax reform. In late 2011, he released a discussion draft for moving international tax rules to a territorial tax system (see Tax Legislative Update 2011-11).
Camp's new proposal would significantly change many of the complex tax rules governing the treatment of financial products for traders and financial institutions, but would also change some basic rules for ordinary investors – including the wash-sale rule and taxpayers' ability to sell their shares with highest basis first. The eight major proposals in the draft bill would generally:
- require taxpayers to mark-to-market derivatives at the end of the year, with gain taxed as ordinary (ending the 60-40 split available for certain gains and losses),
- allow taxpayers to treat hedges identified for financial accounting purposes as hedges for tax purposes,
- provide that reductions in issue price in a debt modification are not cancellation of debt income,
- move the deduction for an amortizable bond premium "above the line,"
- require buyers of discounted bonds on the secondary market to include the discount in income over the remaining life of the bond,
- repeal the requirement that accrual-basis taxpayers include the discount on short-term government obligations in current income,
- require taxpayers to use average basis when selling a portion of securities with different bases, and
- expand the wash-sale rule to include transactions by dependents and businesses and accounts under a taxpayer's control.
Like his earlier discussion draft, this proposal is not a finished product, and Camp is seeking feedback. This draft, however, does not include a revenue score. Camp said he is seeking only to modernize and simplify tax rules while minimizing "Wall Street's ability to hide and disguise potentially significant risk through the abuse of derivative and other novel financial products." The bill appears likely to raise revenue, particularly with proposals to require taxpayers to mark-to-market derivatives and deny traders the ability to treat 40% of their income as capital gains. House Ways and Means Committee ranking minority member Sander Levin, D-Mich., immediately praised the draft for its revenue potential.
It remains unclear how the discussion draft may affect the prospect for comprehensive tax reform in 2013. Camp has established his commitment to moving forward this year and has been willing to tackle difficult issues with concrete proposals. Both of his discussion drafts have been generally well-received. But it is not yet clear whether either party really has the appetite for a real tax reform effort in 2013.
The fiscal cliff tax deal signed on Jan. 2 did not provide any expedited process for tax reform. Lawmakers have discussed the possibility of using reconciliation instructions in the budget process to make tax reform easier, but have had trouble even agreeing on a budget resolution in recent years. Neither House Republican nor Senate Democratic leaders have actually committed to pursuing tax reform in earnest in 2013. The parties are also no closer to bridging major tax policy differences, particularly over the question of revenue.
The following is a more detailed description of the proposals in Camp's discussion draft.
Mark-to-market for derivatives
Under current law, gain or loss is recognized at different times depending on the instrument and investor. Section 1256 provides special timing and character rules for specific types of contracts. Gain or loss is determined on Section 1256 contracts on a mark-to-market basis annually with 40% of the gain or loss characterized as short-term capital gain or loss (so the income is ordinary) and 60% as long-term capital gain or loss. In addition, Section 475 requires mark-to-market accounting for dealers in securities and certain traders and dealers in commodities who elect to use it. The 60-40 split is not generally available under Section 475.
Camp's proposal would generally require derivatives 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. 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. There would be exceptions only for derivatives related to real property, derivatives that are part of a hedging transaction as defined in the proposed Section 1221(c) and certain foreign currency hedging transactions.
Treatment of hedges
Gain and loss on property that is part of a hedging transaction is generally treated as ordinary if taxpayers identify the hedging transaction on the day the transaction is entered into. The Camp proposal would instead allow taxpayers this treatment as long as they identified the transaction as a hedge for financial accounting purposes.
COD income debt restructuring
The modification of a debt instrument generates cancellation of indebtedness (COD) income to the extent the issue price of the modified debt instrument has been reduced – even if the lender has not actually forgiven any principal. The Camp proposal would eliminate this type of COD income by providing that the issue price of a modified debt instrument cannot be less than the issue price before modification except to the extent principal is forgiven.
Deduction for amortizable bond premium
Bond premiums are currently deductible only against interest payments and do not reduce adjusted gross income (AGI). Camp's proposal would make this deduction "above the line" for individuals so that it would reduce AGI.
Income from discount bonds
Camp's proposal would require buyers of discounted bonds on the secondary market to include the discount in income over the remaining life of the bond. Under current law, income on the discount is generally not included in income until the bond is resold or retired. The proposal is meant to provide parity with the original issue discount (OID) income rules that apply when a bond is originated.
Government debt tax treatment changes
Camp's proposal would make the following three minor changes to the rules apply to government debt:
- Repeal the requirement that accrual-basis taxpayers immediately recognize income on the discount for short-term government obligations such as Treasury bonds
- Reposition the rules on U.S. savings bonds to a different code section without amendment
- Repeal the provision allowing tax-free exchange of Series E or EE bonds for Series H or HH savings bonds, which are no longer issued
Average basis on securities sales
Taxpayers who buy identical securities at different times typically have different bases in their holdings. Under current law, taxpayers selling a portion of these securities may specify which securities are being sold for purposes of determining their gain or loss. Camp's proposal would require taxpayers to determine gain or loss using the average basis of all the identical securities.
Wash-sale rule
The wash-sale rule defers any losses from a sale of stock or securities if substantially identical securities are bought within 30 days of the sale. The provision is meant to prevent taxpayers from churning stock without changing their economic position just to recognize losses. Current IRS regulations also apply the wash-sale rule to certain related parties.
Camp's proposal would expand the wash-sale rule statutorily to include:
- dependents and spouses;
- individuals for whom the taxpayer is a dependent;
- corporations, partnerships, trusts or estates under the taxpayer's control;
- medical savings accounts or health savings accounts;
- tax-preferred education savings accounts; and
- individual retirement accounts and qualified retirement plans such as 401(k)s.
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