Capital Markets/Financial Services Industry - Recent Tax Developments, Panel I
November 14, 2013, 1:45-3:15p
The Camp Legislative Proposal
to Reform the Taxation of Financial Products:
The “Discussion Draft” of January 2013
- Keith Anzel, Managing Director &Chief Tax Officer, Citigroup Global Markets Inc.
- Jack Burns, Executive Director, Ernst & Young LLP
- David H. Shapiro, Principal, PricewaterhouseCoopers LLP
Background – current reform movements
regarding taxation of financial products
• House Ways and Means Chairman Camp introduces
“discussion draft” of bill to reform the tax treatment of
financial products – January 2013 (Proposal not yet
“scored” by JCT (at least not publicly available))
• Various industry groups & practitioners have provided
• HWM held private meetings and public hearing with
taxpayers seeking comments
• Obama Administration introduced similar version of
proposal – April 2013 (This proposal was “scored” by
Treasury economists as raising $18.9 billion over 10 years)
• Senate Finance is working on their version of proposal
• Likely to be introduced (in some form) as part of broader
tax reform package
Overview of the Camp Proposals / Agenda
• Mark-to-Market of Derivatives (including new “mixed
• Book-Tax Conformity for Hedging Identification
• Modification to Treatment of Debt Instruments
• Issue price determination for modifications of “distressed debt”
• Current inclusion of market discount
• Deductions for amortizable bond premium
• Mandatory Use of Weighted Average Method of Cost
Accounting of Securities
• Changes to Wash Sale Rules
Proposal to Mark-to-Market Derivatives
Current Law: For investors/traders, the tax accounting for different types of derivative
transactions is not uniform and is determined based on the type of transaction executed.
• The Core MTM Proposal. Investors/traders would be required to mark-to-market all
"derivatives" (broadly defined) in their portfolio on an annual basis. Resulting income
or loss would be ordinary. (Does not impact accounting methods for hedging
transactions or dealers.) (Effectively repeals current 60/40 treatment for section 1256
• The “Mixed Straddle” Proposal. If a derivative substantially diminishes risk with respect
to a publicly-traded nonderivative position that is held by the taxpayer (i.e., if a
derivative "straddles" an actively-traded nonderivative), built-in gain on the
nonderivative would be recognized immediately. This gain on the nonderivative would
be capital gain. (Built-in loss, however, would not be recognized by reason of the markto-market regime, but would be suspended until the position is disposed of, retaining
its capital loss character.) Thereafter, for so long as the derivative and nonderivative
are held together as a so-called "Mixed Straddle," both positions (including the
nonderivative) would be marked-to-market on an annual basis (each generating
ordinary income/loss). As under current law, the holding period of the nonderivative
would be suspended while it is part of a Mixed Straddle.
Initial Observations on the Core MTM Proposal
• First, the obvious – it is a departure from realization-based taxation.
• Fairness of taxation without cash? What of fairness of variety of scenarios – e.g., marked
gains in in early years followed by marked losses in later years which cannot be carried
back more than 2 years?
• Will it create externalities in market? e.g., seasonal based selling to generate cash to pay
tax; reduction in the amount of securities made available for loans; etc. (more later)
• Valuation issues.
• Administrative issues in dealing with derivatives in non-publicly traded securities.
• Valuation of publicly traded securities not so easy either – e.g., swap on 10 shares versus
swap on 1,000,000 shares.
• Lessons of Los Alamos Project and Liquidity Crisis?
• Proposal authorizes regulations to allow taxpayers to rely on financial statements – lessons
of Bank One and 475 regulations? Will Treasury lighten up here?
• Reporting burden on securities dealers? What if taxpayer takes an inconsistent position? If
taxpayer actually uses the instrument as hedge, would reporting be misleading to IRS?
• Sweeping definition of “derivative” to include every conceivable
ownership interest in any financial contract.
• Includes derivatives on illiquid securities.
• Derivatives embedded in debt instruments will be viewed as an instrument separate from
the debt. Specifically, embedded call option in convertible debt is bifurcated. How does
this proposal impact issuers of these sorts of debt instruments?
• Potential impact on compensatory stock options?
Initial Observations on the Mixed Straddle Proposal
• First, the obvious – it has a one-way revenue impact
favoring the government. Built-in gains (but not losses)
• Assume Taxpayer holds low basis, high value stock, with long-term holding
period (e.g., 30 years). Taxpayer buys a 1 week, at the money put option, to
protect from volatility resulting from the week’s earnings announcement.
Taxpayer forced to recognize 30 years of gains.
• Administrative issues associated with relying on straddle
• What does it mean to “substantially diminish risk of loss”?
Comments on the Discussion Draft
• Investment products that would be discouraged by the Core MTM and
Mixed Straddle proposals: stock loans and rehypothecation from brokerage
accounts, structured notes, convertible debt, options, access products,
• Valuation and implementation issues
• Impact of proposal on market liquidity
• Implementation issues related to mixed straddle, market discount and
average cost basis proposals.
• Gain/loss from marks should be capital, not ordinary. [unique concern of
RICs, which are unable to carryforward NOLs]
• Uncertainty around straddle definition – suggests a “clear
reflection”/matching principle, as in business hedge area.
• Strong recommendation to drop the average cost basis requirement (from
persepctive of RIC itself, and the RIC shareholders)
• Options Exchange Coalition
Book-Tax Conformity of Hedge Identification
Current law: Gain/loss from a qualifying hedging transaction is ordinary. Result
depends on the contemporaneous identification of the transaction as a “tax hedge”
pursuant to Treas. Reg. 1.1221-2(f). Ordinary treatment is permitted without an
identification by virtue of the “inadvertent error exception,” but application of this
exception is not entirely clear in the context of section 1256 contracts.
Proposal: In an effort to simplify the tax hedge identification requirement, the proposal
would effectively deem a tax hedge identification to have been made in situations
where the transaction is properly treated as a hedging transaction in a taxpayer's
audited GAAP financial statements.
A welcome step towards simplification (and an apparent reaction to the IRS's begrudging
application of the inadvertent error exception).
Practically speaking, it is less important if the Core MTM Proposal goes forward (because in that
scenario, derivatives would generate ordinary gain/loss in any event).
Although it is a step in the right direction, it is important to note that it does not fully adopt a
book/tax conformity regime. There are “tax hedges” that are not “book hedges” (and vice
versa). So, taxpayers will still need to be vigilent regarding their identifications (perhaps
moreso). (In other words, the proposal could give a false sense of security.)
Modifications to the Treatment of Debt Instruments
• Issue price determination for modifications of
• Current inclusion of market discount
• Deductions for amortizable bond premium
Issue price determination for modifications of
Current Law: In the case of a significant modification of a debt
instrument that is publicly traded, the issue price of a modified
debt (which equals its fair market value) may be substantially
lower than the adjusted issue price of the unmodified debt,
resulting in cancellation of indebtedness (“COD”) income to the
issuer, even if the principal balance of the debt instrument is not
Example. Corp X previously issued $1,000 bond, now trading at $400
(due to its financial distress). If debt is significantly modified (e.g.,
extension of maturity, change in interest rate, covenant changes, etc),
then a debt-for-debt exchange occurs. Issue price of “new debt” is
$400 (because it is publicly traded).
Result under current law: issuer deemed to retire $1,000 debt for
$400 (COD of $600). But recent purchaser at $400 has no gain/loss.
Issue price determination for modifications of
distressed debt – con’t
Proposal: In the case of any specified debt modification, the issue
price of the modified debt instrument is the lesser of (i) the
adjusted issue price of the existing debt instrument; or (ii) the issue
price of the modified debt instrument which would be determined
under OID principles for non-publicly traded debt.
– A specified debt modification is an exchange by an issuer of a new debt instrument for an
existing debt instrument issued by such issuer, or the significant modification of an existing debt
– Example (same as prior slide). Corp X previously issued $1,000 bond, now trading at
$400 (due to its financial distress). If debt is significantly modified (e.g., extension of
maturity, change in interest rate, covenant changes, etc), then a debt-for-debt
exchange occurs. Issue price of “new debt” is $1,000 (so long as no principal is
– Result under proposal: issuer deemed to retire $1,000 debt for $1,000 (No COD). But
recent purchaser at $400 has $600 of gain.
• Effectively operates as a nonrecognition rule for debt issuers that restructure their distressed debt .
Prevents the realization of COD income to the issuer if no portion of the debt has been relieved. Does
not extend nonrecognition treatment of modifications to holders of debt (to prevent the recognition of
phantom gain). Thus, will it really make workouts easier, by eliminating some of the tax friction?
Current Inclusion in Income of Market Discount
Current Law: Market discount accrues on a ratable basis and the holder of a
market discount bond includes such discount in income as principal payments are
made on the bond, upon disposition of the bond or when the bond is retired.
Proposal: Market discount would have to accrue on a yield-to-maturity basis, at
a maximum rate equal to the greater of (i) the AFR at the time of purchase plus
10%, or (ii) the original yield to maturity of the debt instrument plus 5% (the
“Yield Cap”). The holder of a market discount bond would include market
discount in income as it accrues.
• Observations: Refinements needed to the technical language to make it work
properly, and to deal with various scenarios (e.g., floating rate debt, debt that is
past due, asset-backed debt, etc.)
Amortizable Bond Premium
Current Law: Individual taxpayers are only allowed to deduct an amount of
amortizable bond premium as an itemized deduction.
Proposal: The provision allows the deduction for amortizable bond premium of
an individual as an “above-the-line” deduction.
Observation: The proposal is unnecessary as current rules make amortizable
bond premium an offset to interest income rather than a separate deduction
item. As a result, any limitation on the deductibility of amortizable bond
premium by individuals is rendered inapplicable.
Mandatory use of Weighted Average Method
of Cost Accounting for Securities
Current Law: Taxpayers holding securities that are substantially similar, and which were
purchased at different prices (i.e., have different tax bases) are permitted, upon the sale
of a portion of the securities, to identify which shares are treated as sold.
Proposal: Requires taxpayers to determine the basis of stock or bonds that are sold on or
after January 1, 2014, using the average cost method. Thus, the proposal would eliminate
FIFO or specific identification. Proposal requires taxpayers to determine tax basis with
respect to each account in which securities are held.
- Scores revenue for fisc, but how much, when done on account-by-account basis.
- Presumably, a taxpayer will still be allowed to specifically identify which securities it
sells for purposes of determining the holding period of the securities that are sold. If
this is the case, other difficulties could arise, because, in effect, two systems will be
needed to track a taxpayer's tax attributes.
- Compliance burden, not only from a systems perspective, but also, technical items like:
(i) basis shifting issues; (ii) premium or discount bonds; and (iii) a potential taint to the
average pool calculation where accurate basis information is not available
Changes to the Wash Sale Rules
• Current Law: Wash sale tax rules prevent the recognition of
unrealized losses on securities, where such securities are sold
within a 61-day period beginning 30 days before an acquisition
of the same (or substantially identical) security. The rules do
not include provisions governing related parties.
• Proposal: Expand the wash sale rules to apply to acquisitions of
substantially identical stock or securities held by the taxpayer or
a related party.
• Codification of Rev. Rul. 2008-5
What is the tax policy driving the reform proposal? Presumably:
• Uniform treatment of derivatives – combining goals of simplicity
and fairness (i.e., trying to reduce legal uncertainties, while at the
same time, reducing opportunities for taxpayers to game the
system by using different instruments)
• Revenue for the fisc (Note: Administration’s proposal scores $18.8
billion over 10 years)
Does it meet these objectives?
At what cost? Are we simply trading simplicity in the law/rules for complexity
Would we be better off to simply “fix” rules that exist (or write them in the
first place)? Consider – would there be a “reform movement” if Treasury had
addressed 1234A, credit default swaps, prepaid forwards, constructive sales,
contingent swaps, straddles, etc. with timely regulations?