Yesterday, House Ways and Means Committee Chairman Dave Camp (R-MI) released a Discussion Draft on reforming the tax treatment of financial products. This is the latest in the Committee’s efforts to seek input and feedback on elements of comprehensive tax reform legislation which they have been working on over the last few years. In 2011, they released a Discussion Draft on international tax reform.
This draft exemplifies the kind of serious discussion tax reform will involve. Figuring out how to reform or replace these elements of the tax code is complicated, and Camp’s draft shows his Committee is committed to thinking through these issues and seeking feedback. The process for a comprehensive reform of our tax code will involve tough choices and tradeoffs, and every provision must be reviewed and discussed on its merits. We are pleased to see this process moving forward.
In this draft, Camp outlines six proposals that seek to provide greater simplicity and uniformity in the tax treatment of financial products:
- Uniform tax treatment of financial derivatives: Currently, the tax treatment of derivatives varies depending on type, profile of the taxpayer, and other factors. This proposal would require all derivatives to be marked to market (current/fair value) at the end of each tax year, and any gain or loss would be treated as ordinary income or loss. There are carve outs for real estate transactions and hedges on price, currency, and interest rate changes. It would also repeal the current “60/40 rule” that allows some investors to treat 60 percent of their earnings as long-term capital gains (this provision is also in the President's budget).
- Simplify business hedging tax rules: Currently, taxpayers have to identify a transaction as a hedge for tax purposes on the day they enter that transaction, but often they fail to do so even if they treat it as a hedge for accounting purposes. This proposal would allow transactions that are properly treated as hedges for financial accounting purposes to be treated as hedges for tax purposes.
- Eliminate phantom tax resulting from debt restructuring: This proposal would reform the tax rules that apply to debt restructurings that do not involve a forgiveness of principal. It sets a floor for the modified issue price of the debt instrument by requiring that it can’t be less than the issue price before modification. Since cancelation of indebtedness is a taxable event, this policy would reduce the “phantom” income tax owed when debt is restructured, common during economic downturns. This attempts to address the differing treatment of debt and equity that is part of the current tax code.
- Harmonize tax treatment of bonds traded at a discount or premium on the secondary market: For bonds sold on the secondary market at a discount (less than the amount to be repaid), this would require the holder of the bond to recognize taxable income on the discount over the remaining life of the bond, which currently applies only to bonds acquired at a discount directly from the borrower. It would also limit the taxable secondary market discount to the amount that reflects an increase in interest rates that has occurred since the bond was originally issued (rather than a change in the borrower's creditworthiness) and allow taxpayers to claim above-the-line deductions for bonds acquired at a premium on a secondary market.
- Increase the accuracy of determining gains and losses on sales and securities: Currently, taxpayers can identify which shares have been sold based on their cost basis (original price) even if they are identical, which helps them manipulate taxable gains and losses. This proposal would require the cost basis of the security to be based on the average cost basis of all other shares or units of the identical security held by the taxpayer.
- Prevent harvesting of tax losses on securities: This proposal would apply the “wash sale” rule -- which prevents taxpayers from harvesting tax losses by selling securities at a loss and then immediately reacquiring the same securities -- to transactions involving closely related parties, such as relatives and controlled entities.
At this time, there are no revenue estimates for these proposals. On face, it appears that the net effect of the proposals would be to raise revenue -- though Chairman Camp would presumably use this revenue to lower rates as part of comprehensive revenue-neutral tax reform. Whether and how much revenue would be generated depends on interactions with the broader tax reform as well as with trends in the broader economy (for example interest rate changes).
The Discussion Draft reminds us that tax reform is about far more than just what to do with tax rates and which deductions or credits to reduce. Tax reform takes a careful evaluation of how to better have the tax code define income, promote growth, improve fairness, and prevent potential abuses. These type of reforms are also apparent in reforming the corporate tax code, as you can see in our calculator. We are excited to see the tax reform process move forward.