Tax Reform Watch: Financial Products– March 03, 2017 by Jay Laurila

Since the November 2016 presidential election, much of the tax reform conversation has rightly focused on the similarities and differences between the proposals outlined by President Trump while on the campaign trail and those put forth by Congressional Republicans, including the “A Better Way” blueprint from House Republicans. While we expect this conversation to continue, one Democratic proposal may move from a standalone proposal to part of overall tax reform. 

Modernization of Derivatives Tax Act

Senate Finance Committee Ranking Member Ron Wyden’s proposal, the Modernization of Derivatives Tax Act (MODA), discussion draft released last year would “prevent sophisticated taxpayers from using derivative contracts to avoid paying taxes on their underlying instruments.” In his view, the tax rules related to financial products, specifically derivatives, are unnecessarily complex and inconsistently applied.
The MODA as envisioned by Sen. Wyden would simplify tax reporting by repealing nine current sections of the Internal Revenue Code (IRC), including those that govern the tax treatment of short sales, options and futures contracts. The proposal requires mark-to-market tax treatment for these and all other derivative contracts at the end of each taxable year. Transactions using derivative contracts would be taxable at ordinary income rates. 

Potential Impact

Taxpayers currently relying on favorable tax treatment under IRC Section 1256, which allows 60% of realized gain to be taxed as long-term capital gain regardless of the holding period, or who are using derivatives to defer recognition of gain or accelerate recognition of losses would likely no longer be able to employ these strategies. In addition, derivatives such as certain forward contracts would be recognized as ordinary income in a mark-to-market regime versus capital gain on settlement or sale.
As with any proposed tax legislation, the impact on other IRC sections must be considered. Regulated investment companies (RICs), for example, do not have a provision to carry back or forward net operating losses as some other taxpayers do. Mark-to-market, ordinary treatment on derivatives could cause swings in taxable income and loss from year to year and may affect an RIC’s ability to make a required ordinary income distribution. Should a proposal similar to the MODA become part of tax reform, including a proposal to carryforward net operating losses for RICs would be prudent. 

Bipartisan Support?

Many of the ideas presented in Sen. Wyden’s proposal are similar to those released by former House Ways and Means Committee Chairman Dave Camp in early 2014, so they may have some bipartisan support. These proposals also would increase revenue to the U.S. Treasury, potentially allowing for tax cuts elsewhere to keep the overall tax reform plan revenue neutral — an idea supported by Congressional Republicans.
Whether or not the MODA, or some form of it, becomes law as part of tax reform obviously remains to be seen. Professionals in the investment management industry should consider how the MODA may affect future tax planning in their portfolios.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.