United States: The Financial Product Tax Reform Proposals

Last Updated: January 8 2014
Article by Peter J. Connors

This report reviews the ambitious proposal from House Ways and Means Committee Chair Dave Camp, R-Mich., to reform the taxation of financial products. Among the topics included in the proposal are: (1) a comprehensive set of changes that would place all derivatives on mark-to-market taxation, with gains and losses being taxed as ordinary income; (2) a provision allowing financial accounting hedges to serve as identifications of tax hedges; (3) a provision expanding the wash sale rules to apply to transactions involving related parties; (4) a provision requiring taxpayers to use average cost basis in determining gain or loss on "specified securities" transactions (and for brokers to report on that basis); (5) a change to the debt modification rules that would eliminate most cancellation of indebtedness income; (6) a change to the market discount rules that would generally be favorable to distressed debt holders but would require the accrual of market discount; and (7) changes to bond premium amortization rules.

* * * * * * * * * *

While comprehensive tax reform is unlikely over the next year, the likelihood of tax reform in specific areas continues to have reasonable prospects. In this regard, House Ways and Means Committee Chair Dave Camp, RMich., released a discussion draft of proposed legislation in January 2013 that would make radical changes to the treatment of financial instruments.1 Joint hearings on tax reform and taxation of financial products were previously held on December 6, 2011. The Obama administration has also weighed in with its own proposals.2 Camp should be commended for his efforts to simplify the taxation of a very complex area.

The proposals, which were partly based on a report of the American Bar Association Section of Taxation Financial Transactions Committee, contain myriad changes to current law, with different objectives.3 However, in many ways the proposals go beyond the suggestions of the ABA members. Some of the proposals seek to conform the treatment of similar transactions that involve financial product derivatives and place all of them on mark-to-market accounting. Another group of proposals is taxpayer favorable and would eliminate traps in the treatment of distressed debt and debt exchanges. Yet another group involves tax reporting, which can be viewed as an attempt to enhance tax compliance.

There is no detailed revenue scoring information. However, according to those familiar with the legislation, the total package is scored at tens of billions of dollars. Thus, the revenue aspect of the proposed legislation will make enactment attractive to legislators.

I first review the non-debt-related provisions and then review the debt-related provisions.


A. Background

Several current law provisions inform the tax treatment of derivative financial instruments. In some cases, the type of product governs taxation. In others, the class of taxpayer holding the security governs its tax treatment. The principal issues are the timing of recognition of income and, because of the distinction made in the tax law between capital gains and losses and ordinary gains and losses, the character of those gains and losses. Source is also an issue in the international context.

1. Notional principal contracts. Regulations under section 446 govern the taxation of notional principal contracts (NPCs). Broadly speaking, these are swap contracts, such as interest rate swaps and total return swaps. Foreign currency swaps are governed by another provision of the code. An NPC typically has two payment flows, the periodic flows and the non-periodic flows. Periodic payments generally receive ordinary income treatment. Non-periodic payments made at maturity are often swap termination payments. Those payments often produce gain or loss to the taxpayer. Non-periodic flows with front-end or back-end payments must be analyzed to determine if they are significant. If they are significant, they are treated as deemed loans. The parties to the contract must account for the loan independently of the swap. The time value component associated with the loan is not included in the net income or net deduction from the swap, but it is recognized as interest for all purposes of the code.4

2. Options and forward contracts. Options, with an exception for non-equity options and dealer equity options that are taxed under section 1256, are taxed on a wait-and-see basis. Under section 1234, the character of the seller's gain is based on the underlying property subject to the option. Thus, if the underlying property would produce capital gain or loss, the gain or loss on the option will be capital gain or loss. Forward contracts are also subject to open transaction treatment. The analysis is more complicated when the forward contract is prepaid.5

3. Section 1256 contracts. Section 1256 provides that a group of five financial products (section 1256 contracts) are subject to mark-to-market treatment at year-end. Gain or loss is treated as 60 percent long-term capital gain and 40 percent short-term capital gain. When adopted in 1981, section 1256 included only regulated futures contracts. Greatly expanded, it now includes some contracts held by dealers such as dealer equity options and dealer securities futures contracts.6 Taxpayers may elect to have section 1256 not apply to a section 1256 contract that is part of a mixed straddle or a hedging transaction.7

4. Dealers. Section 475 governs the tax treatment of dealers in securities, as well as traders in securities and dealers and traders in commodities who elect into this provision. Taxpayers who are subject to this provision receive ordinary gain or loss treatment and must mark the securities held to market at the end of the year. Many securities are governed by this provision. They include both physical securities and derivative securities.8 Taxpayers are allowed to identify securities that they desire to not have subject to mark-to-market rules. They fall into three categories: (1) securities held for investment; (2) securities (or obligations to acquire a security) that are acquired (including originated) by the taxpayer in the ordinary course of a trade or business and are not held for sale; and (3) securities that are a hedge of a security to which section 475 does not apply or are a hedge of a position, right to income, or liability that is not a security in the hands of the taxpayer.9

Taxpayers who are not dealers are either investors or traders in securities. Gain or loss on property held by such a taxpayer is ordinarily capital gain or loss under section 1221(a), with some narrow exceptions. Traders are allowed deductions for expenses, whereas investor expenses are subject to limitations. Several code sections are devoted to ensuring that gain or loss is properly categorized as capital or ordinary.

For example, enacted before section 475, section 1236 provides that gain on the sale of a security is not gain from the sale or exchange of a capital asset unless the security was identified as held for investment and the security was not held by that dealer primarily for sale to customers in the ordinary course of his trade or business. There is some obvious overlap between this provision and section 475, which also applies to dealers. Other characterization rules that may apply include section 1233 (dealing with short sales), section 1234 (dealing with option transactions), section 1234A (dealing with terminations), section 1234B (dealing with securities futures transactions), section 1258 (dealing with conversion transactions), section 1259 (dealing with constructive sales), and section 1260 (dealing with constructive ownership transactions).

5. The wash sale and straddle rules. Overlaying each provision are sections 1091 and 1092. Section 1091 denies taxpayers deductions for losses on the sale of securities when a wash sale has occurred. A wash sale occurs when substantially identical stock or securities have been acquired within 30 days of a sale (either before or after). Quite surprisingly, the wash sale rules do not apply when a related party makes the acquisition or sale, but a common law wash sale rule has developed that has occasionally filled the void.10 There are exceptions from the wash sale rules for dealers.11

Section 1092 denies the deduction for losses when there is unrealized gain on an offsetting position. These offsetting positions are referred to as straddles. When applicable, the provision can result in permanent deferral.

6. Mixed straddles. Complex problems arise in mixed straddles, when one of the positions in the straddle is a section 1256 contract entitled to mark-to-market and 60/40 treatment,12 and the other position is not. Section 1092 (b)(2) directs Treasury to issue regulations regarding mixed straddles in general, and it specifies that those regulations should provide that a taxpayer may offset gains and losses from positions that are part of mixed straddles, either by a straddle-by-straddle identification or by the establishment of a mixed straddle account. Reg. section 1.1092(b)-3T and -4T address gains and losses from positions that are part of mixed straddles. The existing mixed straddle rules are relevant because the proposal introduces a new set of rules for mixed straddles.

The temporary Treasury regulations were recently amended to segregate pre-identification gain and loss on a mixed straddle position from post-identification gain and loss, preventing taxpayers from using identified mixed straddles as an alternative to selling assets to accelerate gain or loss.13 Before the issuance of the amended temporary Treasury regulations, reg. section 1.1092(b)-3T(b)(6) provided that if any positions of a section 1092(b) (2) identified mixed straddle were held by the taxpayer on the day before the day the section 1092(b)(2) identified mixed straddle was established, the position or positions would be deemed sold for their fair market value as of the close of the last business day preceding the day the section 1092(b)(2) identified mixed straddle is established.

The approach of the prior regulations is supported by the legislative history of section 1092 and arguably permits taxpayers to selectively recognize gains and losses; however, Treasury and the IRS believe that the prior recognition treatment is merely suggested by the legislative history and not required.

To prevent these types of transactions, the regulations add new reg. section 1.1092(b)-6T, which provides that after August 1, 2013, any unrealized gain or loss on a position or positions on the day before the day a section 1092(b) (2) identified mixed straddle is established is taken into account at the time, and has the character, provided by the code provisions that would apply to that unrealized gain or loss if the section 1092(b)(2) identified mixed straddle were not established.14 In a reaction to criticism over the regulations, the effective date has been deferred until final regulations are issued. In light of the proposals, however, the regulations may become moot.

B. The Proposal

1. The Camp proposal. At the heart of the Camp proposal is the addition of new section 485, which would subject all derivatives to mark-to-market treatment, with the gain or loss being ordinary income. Existing section 475 would be rewritten, with all the derivative provisions being culled out. New section 486, defining the term "derivative," would also be added. Thus, section 485 would apply to (1) "any evidence of an interest in" (or any derivative financial instrument with respect to) any share of stock in a corporation; any partnership or beneficial ownership interest in a partnership or trust; any note, bond, debenture, or other evidence of indebtedness; any real property (with some exceptions); any commodity actively traded (within the meaning of section 1092(d)(1)); or any currency; (2) any NPC; and (3) "any derivative financial instrument with respect to" any interest or instrument described in subsections 1 and 2.15

Under new section 486, the term "derivative financial instrument" would include any option, forward contract, futures contract, short position, swap, or similar financial instrument.16 The term "notional principal contract" means any financial instrument that requires two or more payments at specified intervals calculated by reference to a specified index up one or more notional principal amounts.17 An amount will not fail to be treated as a payment merely because that amount is fixed on one date and paid or otherwise taken into account on a different date. The term "specified index" means any one or combination of (a) a rate, price, or amount (whether fixed or variable); (b) any index based on any information (including the occurrence or nonoccurrence of any event) that is not within the control of any of the parties to the instrument and is not unique to any of the parties' circumstances; and (c) any other index as the Treasury secretary may prescribe.18 Interestingly, weighing in on an important issue, the technical explanation states that it is intended that a credit default swap be treated as a derivative either because it represents an option on a debt instrument or because it qualifies as an NPC.19

The definition of derivative contains limitations on the rules' applicability to real property. An interest or instrument is not a derivative if it is either (1) on a track of real property as defined in section 1237(c) or (2) only on real property that would be inventory or if held directly by the taxpayer.20

With those modifications, as revised, section 475 would apply only to shares of stock in a corporation; partnership or beneficial ownership interests in a widely held or publicly traded partnership or trust; and notes, bonds, debentures, or other evidence of indebtedness.21

One noteworthy aspect of section 485 is that it would apply to derivatives on stock even if such stock is not actively traded, whereas it would apply to commodities only if they are actively traded.22 For section 475 dealers, that aspect is not troubling because of the nature of dealer business. For other taxpayers, however, subjecting derivatives on non-marketable stock to mark-to-market treatment is problematic. Moreover, the provision applies not only to derivatives but also to an "interest in" stock, so it literally applies to contractual rights regarding stocks.23

Section 486 would apply to derivatives embedded in debt instruments (embedded derivative components).24 A debt instrument is not considered to have an embedded derivative merely because the debt is denominated in a nonfunctional currency, the payments on that debt instrument are determined by reference to the value of a nonfunctional currency, or the debt instrument is a contingent payment debt instrument, variable rate debt instrument, or a debt instrument with alternative payments schedules.25 This aspect of the proposal is a fundamental change from existing law, which has generally treated debt instruments as a single position.26 It is also inconsistent with the current treatment of contingent payment debt obligations, which are subject to the non-contingent bond method under reg. section 1.1275-4. Thus, the effect of the proposal is to greatly diminish the importance of those regulations. The technical explanation notes that one example of a debt instrument with an embedded derivative component is debt that is convertible into the stock of the issuer.27 The technical explanation states that the provision treats this convertible debt as two instruments, nonconvertible debt (not subject to the mark-to-market rule) and an option to acquire stock of the issuer (subject to the mark-to-market rule).

A noteworthy point is that the mark-to-market rules will apply to the nonderivative that is part of a mixed straddle -- a term that will be introduced in new section 485. A straddle is defined as in section 1092(c), without the exception for identified straddles.28 Under a coordination rule, the current-law exception from the straddle rules for qualified covered calls would be eliminated.29 Mixed straddles are straddles consisting of nonderivatives. However, the rules do not apply evenly. Built-in gain is recognized when the mixed straddle is created, but loss is deferred.30 This feature may be the most controversial part of the proposal. Because of the broad scope of the provision, it would apply to simple transactions like the sale of a covered call or the purchase of a put.

Section 485 would not apply to financial derivatives that are part of a hedging transaction (as defined in new section 1221(c)) or part of section 988 hedging transactions.31

Many financial product provisions would be deleted under the proposal. This would include section 1234B (concerning securities futures contracts), section 1236 (prohibiting dealers from obtaining capital gain treatment), and section 1256 (providing 60/40 treatment for section 1256 contracts).32 These changes achieve the muchneeded goal of simplification.

The proposal contains some limited guidance on valuation. When there is no readily ascertainable fair market value, FMV is to be determined under the method used for purposes of a report or statement to shareholders, partners, or other proprietors, beneficiaries, other persons as the secretary may specify, or for credit purposes.33 For terminations, valuation will take place upon the termination.34 No blockage can be considered in the determination of value.35 For convertible debt instruments with an embedded derivative, the valuation of the embedded derivative component is determined based on the debt instrument with and without the component.36

2. The administration proposals. Two Obama administration proposals address financial product reform. The administration's 2014 budget proposals would also include a mark-to-market provision, although it would be much more limited than the Camp proposal.37 A derivative contract would be broadly defined to include (1) any contract whose value is determined, directly or indirectly, in whole or in part, by the value of actively traded property; and (2) any contract regarding a contract described in category (1).38 A derivative contract embedded in another financial instrument or contract would be subject to mark-to-market if the derivative by itself would be marked to market.39 Further, a financial instrument that is not otherwise marked to market that is part of (or becomes part of) a straddle transaction with a derivative contract would be marked to market, with preexisting gain recognized at that time and loss recognized when the financial instrument would have been recognized in the absence of the straddle.40

The administration's 2013 budget proposal would have been narrower. It would have required dealers in commodities, commodities derivatives, securities, and options to treat the income from their day-to-day dealer activities in section 1256 contracts as ordinary in character, not capital.41 The proposal would have applied to partnerships as well as individuals.

To read this article in full, please click here.

The author gratefully acknowledges the thoughtful comments of his colleague, Stephen C. Lessard, a managing associate in Orrick's New York office. An earlier version of this report was presented at the Tax Review meeting on November 18.

Originally published by Tax Analysts, December 23, 2013.


1 House Ways and Means Committee discussion draft, "Tax Reform Act of 2013" (Jan. 23, 2013) . The release includes draft legislative language (discussion draft) and a technical explanation of the provisions. See Ways and Means Committee, "Technical Explanation of the Ways and Means Committee Discussion Draft Provisions to Reform the Taxation of Financial Instruments" (Jan. 24, 2013) (technical explanation).

2 See, e.g., Treasury Department, "General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals," at 62 (Apr. 2013) .

3 See ABA tax section, "Options for Tax Reform in the Financial Transactions Tax Provisions of the Internal Revenue Code" (Dec. 2, 2011) . Charles H. Egerton, former chair of the ABA tax section, should be commended for efforts in developing this and several tax reform white papers.

4 Reg. section 1.446-3(g)(4).

5 See, e.g., Notice 2008-2, 2008-2 C.B. 252 .

6 Under section 1256(b)(1), a section 1256 contract is any (1) regulated futures contract, (2) foreign currency contract, (3) non-equity option, (4) dealer equity option, and (5) dealer securities futures contract. The term does not include (1) any securities futures contract or option on such a contract unless the contract or option is a dealer securities futures contract; or (2) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. Section 1256(b) (2).

7 Section 1256(d) (mixed straddles) and (e) (hedging transactions).

8 A security is defined in section 475(c)(2) as any (A) share of stock in a corporation; (B) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (C) note, bond, debenture, or other evidence of indebtedness; (D) interest rate, currency, or equity NPC; (E) evidence of an interest in, or a derivative financial instrument in, any security described in subparagraph (A), (B), (C), or (D); or any currency, including any option, forward contract, short position, and any similar financial instrument in that security or currency; and (F) position that (i) is not a security described above, (ii) is a hedge for that security, and (iii) is clearly identified in the dealer's records as being described in this subparagraph before the close of the day on which it was acquired or entered into (or such other time as the secretary may by regulations prescribe). Contracts marked to market under section 1256(a) are not included in subparagraph (E) and thus are not subject to section 475 treatment.

9 Section 475(b)(1).

10 See, e.g., Shoenberg v. Commissioner, 77 F.2d 446 (8th Cir. 1935), aff'g 30 B.T.A. 659 (1934) (transactions involving sale and purchase of stock by the taxpayer and a controlled corporation showed intention by the taxpayer to hold title and retain dominion over the stocks, and did not amount to a bona fide sale by the taxpayer); Horne v. Commissioner, 5 T.C. 250 (1945) (loss deduction claimed on the sale of a certificate was disallowed when eight days earlier the holder had purchased another certificate in contemplation of the sale of his old certificate for the purpose of establishing a tax loss deduction). See also Cottage Savings Association v. Commissioner, 90 T.C. 372, 392-394 (1988) (court refused to apply "nonstatutory wash sale" doctrine).

11 See section 1091(a).

12 Section 1256(a)(3).

13 T.D. 9627 .

14 Reg. section 1.1092(b)-6T(a).

15 Proposed section 486(a).

16 Proposed section 486(b).

17 Proposed section 486(c)(1).

18 Proposed section 486(c)(2). While not using the same language, the technical explanation makes changes to the definition of specified index that are intended to be broad, which is consistent with regulatory proposals from 2011. See REG-111283-11 , 76 F.R. 57684 (Sept. 16, 2011), which proposed to amend the definition of specified index to include both financial and nonfinancial indexes. See prop. reg. section 1.446-3(c)(2).

19 Technical explanation, supra note 1, at 9.

20 Proposed section 486(e). The technical explanation notes that this provision is intended to allow a narrow exclusion from the mark-to-market rule for contracts for single pieces of real estate and for contracts for real estate held for sale by real estate developers. Technical explanation, supra note 1, at 9, n.44.

21 Commentators have pointed out that the derivatives definition includes (or may include) mergers and acquisitions stock purchase agreements; employee stock options; variable annuities; joint venture buyout rights; fund capital calls; subscription rights; rights of first refusal; umbrella partnership real estate investment trusts; investments in commodity funds and other funds organized in passthrough form; warrants; swaps; options; forward contracts; futures contracts; short sales; other typical derivatives, both exchange-traded and over the counter; convertible bonds and other convertible instruments; structured notes; repos and securities loans; securities held in brokerage margin accounts; American depositary receipts; mortgage passthrough securities; trust preferred securities; tender options bonds; and loan participations.

22 Proposed section 486(a).

23 Section 1259, which causes a taxpayer to have entered into a constructive sale when it enters into an offsetting position such as a short sale, specifically carves out contracts for sale of stock, a debt instrument, or a partnership interest that is not a marketable security if the contract settles within one year after the date that contract is entered into. Section 1259(c)(2). These are commonly thought of as the M&A exclusions.

24 Proposed section 486(d).

25 Proposed section 486(d)(2)(B).

26 See Chock Full O'Nuts v. United States, 453 F.2d 300 (2d Cir. 1971) (a convertible debenture issued as a convertible debenture is an indivisible unit and not taxed like a bond/warrant investment unit that represents two separate and independent obligations).

27 Technical explanation, supra note 1, at 10.

28 Proposed section 485(c)(5).

29 Discussion draft section 401(c)(2)(C) and (D).

30 Proposed section 485(c)(2)-(3).

31 Proposed section 486(f). New section 1221(c) would define a hedging transaction as (1) a transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily (a) to manage risk of price changes or currency fluctuations for ordinary property that is held or to be held by the taxpayer; (b) to manage risk of interest rate or price changes or currency fluctuations for borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer; or (c) to manage other risks as the secretary may prescribe in regulations; and (2) a transaction (x) that is clearly identified as a hedging transaction before the close of the day on which it was acquired, originated, or entered into (or such other time as the secretary may by regulations prescribe), or (y) is treated as a hedging transaction (within the meaning of generally accepted accounting principles) for purposes of an audited financial statement of the taxpayer that is certified as being prepared in accordance with GAAP and is used for the purposes of a statement or report to shareholders, partners, or other proprietors, or to beneficiaries, or for credit purposes.

32 Discussion draft section 401(d)(1). Interestingly, no change would be made to section 1234A. For a case expanding the application of section 1234A to the abandonment of stock, see Pilgrim's Pride Corp. v. Commissioner, 141 T.C. No. 17 (2013) .

33 Proposed section 485(e)(1).

34 Proposed section 485(e)(2).

35 Proposed section 485(e)(4).

36 Proposed section 485(e)(3).

37 See Treasury, supra note 2.

38 Id. at 63.

39 Id.

40 Id. According to the Joint Committee on Taxation, these provisions would raise approximately $16.4 billion. See JCT, "Estimated Budget Effects of the Revenue Provisions Contained in the President's Fiscal Year 2014 Budget Proposal," JCX-11-13 (May 10, 2013) .

41 JCT, "Description of Revenue Provisions Contained in the President's Fiscal Year 2013 Budget Proposal," JCS- 2-12, at 456 (June 2012) .

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.