The Harder They Come: An Overview Of Financial Instrument And Institution Provisions In The Ways & Means 2014 Tax Reform Proposals

Article by Mark H. Leeds1

Keywords: Internal Revenue Code, Tax Reform Act 2014, taxation, financial products

There are a lot of lost causes in the federal income tax arena. It certainly seems the more ambitious the plan, the less likely it will receive serious consideration. Remember the tax proposals in the Simpson-Bowles Plan?2 That's OK, neither do we.

Rep. Dave Camp (R-MI), Chairman of the House Ways & Means Committee, has combined, and improved upon, his various 2013 Discussion Drafts for tax reform into a proposed revamp of the entire Internal Revenue Code, which is entitled, the "Tax Reform Act of 2014." Will this go in the dustbin of history or be the blueprint for future tax legislation? While initial signs are not entirely positive,3 on occasion, ambitious proposals have served as the basis for later game-changing rules. For example, some readers may remember 1976's Limitation on Artificial Loss ("LAL") proposal. Even if you do not, you now know these rules as the passive activity loss ("PAL") rules, which were enacted in 1986.

The Ways & Means Committee released a summary explanation (the "Bill Summary"),4 and the Joint Committee of Taxation released a detailed explanation (the "JCT Report"),5 of the proposed legislation, which we'll call the "Bill." The financial instrument proposals described below build on the Ways & Means Discussion Draft for tax reform of financial products released on January 23, 2013 (the "Discussion Draft").6 Given the similarities of many of the provisions in the Bill to those in the Discussion Draft, the Technical Explanation of the Discussion Draft provides relevant insight to the Bill. We'll start with definitions and then move into the proposed rules.

The Definition of a Derivative

The Bill would add a definition of a "derivative" to the Internal Revenue Code.7 This approach, in and of itself, is novel. Currently, the Code does not contain a blanket definition of a derivative. Under Proposed Code § 486, a derivative would include "any contract (including any option, forward contract, futures contract, short position, swap, or similar contract)" if it references any of eight specified types of property. Those specified types of properties are (i) any share of stock in a corporation (Depositary Receipts, such as ADRs, are treated as stock of the underlying corporation8), (ii) any partnership or interest in a partnership or trust, (iii) any evidence of indebtedness, (iv) certain interests in real property,9 (v) any actively traded commodity, (vi) any currency, (vii) any rate, price, amount index, formula or algorithm and (viii) any other item specified by the Internal Revenue Service (the "IRS"). It appears that the admonition in the Discussion Draft that "the definition of a derivative is intended to be broad" continues to apply.

Proposed Code § 486(c) would provide that each derivative within a host instrument is separated out from the host instrument, unless one or more components cannot be separately valued. In that case, the instrument is treated as a single derivative. Special rules are provided for debt instruments with embedded derivatives such as convertible debt (which can be thought of as a straight debt instrument coupled with a purchased call option). Under this special rule, a debt instrument is not treated as a derivative "merely because" it is denominated or payable in a non functional currency, it is convertible or the parties are required to use an alternative payment schedule for interest income and expense on the debt instrument under the original issue discount ("OID") rules.10

There is a significant list of exceptions for contracts that fall within the definition, but that the Bill would exempt from the treatment of derivatives (described below). The following contracts are not treated as derivatives:

Regular and foreign currency hedging transactions.11 Securities lending transactions ("Section 1058 securities loans") and sale-repurchase transactions.12 The JCT Report clarifies that the exclusion applies to financing transactions. Employee stock options.13 Insurance contracts and annuities.14 Stock of members of affiliates (domestic and foreign).15 Commodity derivatives, provided that the contract requires physical delivery (and permits cash settlement only in unusual and exceptional circumstances) and the commodity is used in the normal course of the taxpayer's trade or business or is for personal consumption by an individual.16 Mark-to-Market Treatment for Derivatives

If a taxpayer holds a derivative, it will be subject to mark-to-market treatment at year-end.17 This provision would apply to positions established after 2014. If a position is established prior to 2015, mark-to-market treatment would apply beginning in 2020.18 All mark-to-market gain or loss would be ordinary in character and, therefore, not be eligible for the beneficial lower tax rates applicable to long-term capital gains.19 Importantly for individuals, mark-to-market losses will be treated as net operating losses.20 As a result, net losses would not be subject to the 2% limitation on miscellaneous itemized deductions21 or the 3% cap on overall itemized deductions22 or the $3,000 per year limit on net capital losses.23

A mark-to-market adjustment is required immediately prior to a disposition of a derivative.24 This rule prevents non-dealer holders of derivatives from recognizing capital gains on derivatives by disposing of such positions prior to a year-end.

Mark-to-market treatment applies to derivatives for which there is no public market, even if the reference property itself is not publicly traded. Taxpayers would not be permitted to take any blockage discount into account in determining the fair market value of a position.25 The JCT Report states that non-tax financial statements showing mark-to-market values should be used in determining fair market value. Nonetheless, the daunting task of determining fair market value of non-traded positions is likely to be a significant impediment to any implementation of this rule.

Furthermore, even though certain real property interests are...