Under the draft, all derivative positions, with the exception of certain hedging and real estate transactions, would be marked to market on an annual basis by treating the instrument as if it were sold on the last business day of the year for its fair market value.
The term “derivative” would be defined broadly under the draft to include any interest, including a derivative interest, in: stock; partnership interests; indebtedness; real property; actively traded commodities; and currencies.
Any notional principal contract or other derivative referencing any of the above instruments also would be a derivative for purposes of the draft. For example, American depository receipts could be within its scope. Additionally, the embedded derivative component of a debt instrument, e.g., a convertible debt instrument, would also be marked to market. Finally, it would require mark-to-market treatment for direct ownership in stock and certain debt instruments if the stock or debt instrument is hedged with a derivative instrument.
This mark-to-market requirement now applies only to securities dealers and to certain securities traders, and certain commodity dealers and traders; the draft would extend this requirement to all taxpayers. Significantly, the draft would even apply to non-publicly traded derivatives, making compliance difficult due to the lack of readily ascertainable fair market value for these assets. Such a requirement would accelerate gain recognition and increase compliance cost for many taxpayers, and likely affect market liquidity of derivative financial products as these taxpayers look to more cost efficient investment options.
For example, if the draft applies to stock lending transactions, securities lenders and borrowers would be required to mark to market their positions annually. This would eviscerate the tax-free treatment now provided for in Section 1058 of the Internal Revenue Code, along with a significant incentive for taxpayers to engage in stock lending transactions.
Pension funds are active participants in the stock lending market. If taxpayers refrain from entering into stock lending transactions because of the higher tax cost, pension funds might see reduced performance due to the lack of market activity.
The draft would treat any mark-to-market gain or loss on a derivative as ordinary. Additionally, any loss would be deemed attributable to the taxpayer's trade or business. This provision would override existing tax laws governing the character of gain or loss on derivatives. Although investors would lose the ability to generate long-term capital gain, they would benefit from ordinary losses that are neither subject to the 2% floor applicable to miscellaneous itemized deductions nor the capital loss limitations.
While it appears likely that taxpayers may alter their investment strategies to account for this change, it is unclear how this aspect of the proposal would affect market liquidity for pension funds.