Derivatives tax proposal could have dire consequences

A draft proposal in Congress to change the taxation of financial products could affect pension funds and other tax-exempt institutional investors.

Rep. David Camp, R-Mich., chairman of the House Committee on Ways and Means, in January released a discussion draft of proposed changes to the taxation of financial products. This is the second of three discussion drafts produced by Mr. Camp as part of the committee's broader efforts on comprehensive tax reform aimed to “broaden the base, lower rates and move the U.S. to a more economically competitive tax system on a revenue-neutral basis.”

Although the provisions of Mr. Camp's draft target only taxpayers, proposed changes discussed below may nonetheless affect tax-exempt entities such as pension funds.

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.

Generally, the basis of securities sold upon a partial disposition of a taxpayer's holdings is determined under the first-in, first-out method, unless another basis determination method is identified. This requires investors to track the adjusted cost of each acquisition individually, even if several acquisitions are of the same security. Regulations issued in 1996 authorize a simplified method for fungible securities — this is referred to as the average cost method. Currently, only shares in a regulated investment company (i.e., mutual fund) or a dividend reinvestment plan may be accounted for under the average cost method. The draft would expand and mandate the use of the average cost method to dispositions of stock and other specified securities that occur on or after Jan. 1, 2014.

While this proposed change would not impact the tax costs of pension funds, the simplified method of accounting for investments may reduce administrative costs.

It is important to remember that these are draft proposals and may well not be finalized in present form. Given the need for revenue, however, it might not be surprising if some of these proposals gain traction. Pension funds should be aware of the indirect impact any reform on financial products taxation may have on the market and, in turn, fund performance.

Daniel Mayo and Jeff Millen are tax principals and Rowan Liu is a tax associate, all of KPMG LLP, based at its New York headquarters.