Senator Wyden Issues Report on Tax Treatment of Financial Products
Senator Ron Wyden (D-OR), ranking member of the Senate Committee on Finance, issued a report challenging the fairness of tax benefits provided by certain financial products and questioning their continued utility.
The report, "How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions," asserts that disparate tax treatment decreases economic efficiency by providing incentives to sophisticated taxpayers to spend resources on tax arbitrage scenarios, which undermines the vertical equity (also known as "progressivity") of the tax system.
The report identifies various ways that financial products can be used to lower the applicable tax rate on income and defer tax. It also offers recommendations for closing these loopholes.
First, the report notes that taxpayers who own appreciated stocks can use collars to hedge their gains and that, under current law, the paired options that form the collar are not treated as a constructive sale of the underlying asset. Accordingly, the report recommends that the U.S. Treasury Department ("Treasury") write regulations to ensure that collars on appreciated stock will be subject to the constructive sale rules.
Second, the report explained that, since the wash sale rules are not triggered by certain derivatives or assets, taxpayers may selectively recognize a loss with respect to a security, enter into a swap that references the same security, terminate the derivative after 31 days and re-acquire that same security, thereby recognizing the loss and maintaining exposure to the asset. Accordingly, the report urges Congress to update the wash sale rules to apply to a broader set of financial products and assets (including commodities and currencies).
Third, because income derived from a contract on a capital asset, if held to maturity, is treated as ordinary income while termination of such contract before maturity can trigger capital gains or losses, the report endorses legislation that would require all derivatives to be marked-to-market. This would limit the electivity of tax treatment.
Fourth, while acknowledging that tax rules limit a taxpayer's ability to generate long-term capital gain with respect to a limited subset of derivatives that reference partnership interests, the report notes that either Congress or Treasury should extend the rules to other derivatives that can similarly mimic ownership.
Fifth, the report discussed the ability of certain taxpayers to recast gains and losses from high-frequency trading as long-term capital gains using what are known as "basket options." The report highlighted a non-precedential memorandum by the IRS that clearly indicated the agency's view of such arrangements as not generating long-term capital gains, and recommended that the IRS issue stronger, precedential guidance (such as a tax shelter notice) to warn taxpayers away from such transactions and penalize their moving forward.
Finally, the report addressed tax deferral benefits relating to nonqualified deferred compensation and listed various proposals that could eliminate or limit these potentially unfair benefits to employees and employers.
See: "How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions"; Senator Wyden's Statement at Finance Hearing on Fairness in the Tax Code.