NYSBA Tax Lawyers Comment on Proposals to Reform Taxation of Financial Instruments

The Tax Section of the New York State Bar Association (the "Tax Section") submitted a report (the "NYSBA Report") providing comments and recommendations on proposals to reform the taxation of financial instruments. The proposals were contained in the "discussion draft" that was circulated by the House Ways and Means Committee on February 21, 2014, and included in the Obama Administration's FY2016 budget proposal. The NYSBA Report focused on the proposals that address the taxation of debt instruments, the mark-to-market treatment of derivatives, the calculation of securities bases and wash sale rules.

The NYSBA Report supports a rule that would set a floor on the issue price of certain debt instruments, which would limit the cancellation of debt income in the case of debt-for-debt exchanges and significant modifications of existing debt by financially distressed debt issuers, subject to certain limits for related-party debt. Related proposals that would allow holders to receive nonrecognition treatment on a debt-for-debt exchange with the issuer, and to accrue a market discount currently, were also endorsed by the Tax Section.

Although it acknowledged that a mark-to-market regime for derivatives would be complex administratively and create "many new technical issues," the Tax Section also concluded that such a regime "could be a substantial improvement over current law." The NYSBA Report recommended that only actively traded derivatives (or derivatives on underlying property or positions that are actively traded) should be marked to market, and recommended that additional guidance be provided for derivatives that are used to hedge a non-derivative (also known as a "mixed straddle" transaction). The NYSBA Report recommended separately that the rule allowing dealers and traders to mark their positions to market be extended to all investors who elect to do so. The Tax Section did not reach an agreement on the appropriate tax treatment of derivatives embedded in contracts (such as debt instruments or structured notes).

With respect to proposals on ways to calculate the basis of securities, the NYSBA Report commented on the mandatory FIFO method proposed in the "discussion draft" and the average basis method proposed by the Administration, but questioned whether either proposal warranted changing current law. Lastly, the NYSBA Report recommended expanding the wash sale rules to related-party transactions.

See: NYSBA Report.