Rep. Dave Camp (R-MI), Chairman of the House Ways and Means Committee, has proposed a major overhaul of the tax treatment of derivatives. According to Camp, per Richard Rubin of Bloomberg News, “the lack of consistent and comprehensive tax policy has contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community.” As Rubin explains, the heart of the Camp proposal is that firms holding derivatives will be required to mark their holdings to market:
[Taxpayers] would recognize gains and losses each year and pay taxes at ordinary income rates, regardless of whether they dispose of the asset or close out the position.
Camp’s plan would reduce taxpayers’ opportunities to take advantage of the disparate treatment in today’s tax code of economically similar derivatives, said Steve Rosenthal, a visiting fellow at the nonpartisan Tax Policy Center in Washington.
“Most politicians have shied away from tackling financial products because of their wariness of the complexity” of the issue, said Rosenthal, a former corporate tax lawyer who specializes in taxation of financial transactions. “It’s a pretty bold step and I think this idea is sensible. We’ll just have to see how it plays out.”
This is a very significant step, as the current tax treatment of derivatives is realization-based. In December of 2011, Rubin reported on the downsides of the current tax treatment of derivatives:
Several features of the U.S. revenue system make it difficult to tax financial products. Those include the ability to defer taxation using some financial instruments and the preferential 15 percent rate for long-term capital gains, said Viva Hammer, a former Treasury Department official who was responsible for tax policy related to financial institutions and products.
“The ability to toggle in and out of capital treatment allows tremendous flexibility in planning your taxes,” she said.
Congress should require mark-to-market taxation of derivatives at ordinary income tax rates, Hammer said.
“Everyone knows what the right answer is, but no one has the courage to impose it,” she said.
Mark-to-market accounting is intended to require companies to assign fair value to financial instruments and to limit the benefits of deferring realization of gains. [Emphasis added]
In the same article, Rubin referenced the testimony of Alex Raskolnikov of Columbia Law School before a joint hearing of the House Ways and Means Committee and the Senate Finance Committee. Raskolnikov explained how mark-to-market taxation would work as an alternative to the current realization-based tax regime:
In a mark-to-market system, all gains and losses are taxed as if each position is terminated (or sold) at the end of each taxable year and re-entered (re-acquired) at the beginning of the next year. Thus, this system would base tax liability on annual fluctuations in value, whether or not any given asset is sold or retained by a taxpayer. Losses from derivatives would be deductible only against gains from derivatives. Excess losses would be either immediately refundable or available to reduce gains from derivatives in other tax years — either in the future or with a limited carryback. Importantly, the rate applying to gains and losses would be flat. If one believes that most derivatives users are either high net worth individuals or large corporations, one would set that rate at the top marginal rate, individual or corporate, as appropriate. A more precise approach would set the rate at the top individual or corporate rate applying to any given taxpayer in any particular tax year. As in many versions of the anticipa- tory and retroactive tax regimes, business hedges would be excluded from mark-to-market rules and subject to a special treatment.
The main objections to mark-to-market taxation are valuation and liquidity concerns. The former highlights informational demands of obtaining valuations of all derivatives as well as administra- tion and enforcement concerns with verifying these valuations. The latter reflects unease with forcing taxpayers to pay tax on ‘‘paper gains’’ before they receive any cash related to these gains.
One of the advantages of a mark-to-market system is that it will discourage the use of derivatives as a tax arbitrage strategy and it will intend to increase transparency, which will tend to benefit the consumers of financial services as opposed to the firms that package and sell financial services.
Rather oddly, Ryan Grim and Zach Carter of Huffington Post have an article on the Camp proposal with an alarming title — “Dave Camp Bank Tax Bill Would Punish Obama-Friendly CEOs” — that obscures the reality of the bill, which they describe pretty faithfully in the text:
House Ways and Means Committee Chairman Dave Camp (R-Mich.) is considering legislation that would significantly increase taxes for the nation’s largest banks while providing tax breaks to struggling homeowners.
The draft legislation, which may get significant revision before it’s presented to a congressional committee, would be vehemently opposed by Wall Street and other major corporations that trade heavily in derivative securities.
Yet the focus of the article is the notion that Camp is punishing the Business Roundtable because some of its members were part of the bipartisan Fix the Debt coalition, which has pressed for tax increases as well as spending cuts as part of a grand bargain on deficit reduction. The problem with this thesis is that (a) there is good reason to believe that non-financial firms would benefit from Camp’s approach and (b) it would impact many business enterprises that had nothing to do with the Fix the Debt coalition.
Regardless, the Camp bill looks like encouraging news.