A Sensible Change in Taxing Derivatives

It’s not every day that I’m happy with Congress.

Readers may recall David Kocieniewski’s article about Ronald S. Lauder, an heir to the Estée Lauder fortune with a net worth of more than of $3 billion.

Among the legal tax loopholes Mr. Lauder used was one that allowed him to defer millions in taxes by entering into a transaction known as a variable prepaid forward contract. This instrument allows shareholders who hold appreciated stock to monetize an investment without immediately paying tax on the capital gains.

Representative Dave Camp, the Michigan Republican and chairman of the House Ways and Means Committee, recently released a discussion draft of proposed legislation that would tax most financial derivatives on a “mark-to-market” basis. This means that at the end of each year, derivative holders would estimate the market value of the derivative, recognizing tax gains and losses each year rather than waiting until they sell the instrument.

The proposed legislation is an important first step toward a more sensible approach to taxing financial instruments, an area of the tax code plagued by complexity, inconsistency and opportunities for gamesmanship.

While Mr. Camp’s proposal has some imperfections, he should be commended for putting forward a smart piece of legislation. It not only closes some loopholes, it finally presents a fundamental ! and sensible response to the development of modern financial instruments.

The building blocks of our current tax system were laid down in 1954, long before derivatives were commonplace. Mr. Camp’s proposal would shift the taxation of financial instruments like options, swaps and futures from our current realization-based system to a mark-to-market system.

Suppose for example that you approach an investment bank to purchase an option to acquire 1,000 shares of Facebook at $30 a share, just above today’s market price. Assume the option is long-dated and expires in five years. By the end of the first year, assume the value of Facebook has increased to $40 a share.

Under current law, the option contract is treated as an open transaction, and the option holder would not pay tax on the appreciation in value until the option is sold or, if exercsed, until the underlying Facebook stock is sold.

But Mr. Camp’s proposal would require the option to be valued at the end of each year based on what the profit would be had the option been sold and repurchased it at the end of each year. If the option declined in value, you would have the benefit of a tax loss.

Wall Street has responded cautiously to the proposal. A change in the law would not necessarily hurt Wall Street directly. Most financial instruments held by investment banks and some other financial institutions are already taxed on a mark-to-market basis because the banks are treated as dealers, not investors, under section 475 of the tax code.

The proposal would instead probably hurt individuals who enter into bespoke financial contracts with banks in order to avoid tax. The change thus might hurt Wall Street indirectly by reducing demand for such contracts.

But cleaning up the taxation of derivatives would also benefit Wall Street by making it easier for companie! s with bu! siness reasons to hedge risks to do so without facing tax uncertainty. (Legitimate business hedging would be carved out of the new mark-to-market system.)

The legislation includes some intelligent exemptions where mark-to-market would create unnecessary grief, such as for real estate transactions.

There are some additional problems with the legislation that need to be addressed. One is the tax treatment of compensatory stock options, which would be taxed on a mark-to-market basis under the proposal, but were probably not intended to be. Another might be the tax treatment of convertible notes, a common form of financing for early stage start-ups.

Yet another is the unintended application to stock purchase agreements where there is a significant period of time between signing and closing. And valuation of many nontraded derivatives will be tricky. These issues are likely to be addressed as the legislation moves forward.

From a public policy standpoint, the proposal deserves the praise t has received. David S. Miller, a prominent tax lawyer at Cadwalader, Wickersham & Taft, calls the proposal “perhaps the most dramatic reform to our federal tax system since it was introduced nearly a hundred years ago.”

The proposal, Mr. Miller explains, “would replace a dozen sets of rules with a single rule - mark-to-market - and would finally match the tax treatment of derivatives with their economics. It would dramatically improve and simplify the tax code and prevent gaming and abuse.”

Edward D. Kleinbard, a law professor at the University of Southern California, notes the “intelligent, courageous, and sorely needed substantive reforms” in the proposal.

Like Mr. Miller, Professor Kleinbard knows his stuff; he spent many years working on the taxat! ion of fi! nancial instruments as a partner at Cleary Gottlieb Steen & Hamilton. He knows the flaws in our current system and how its inconsistencies are exploited.

Professor Kleinbard praised Mr. Camp for the “exemplary” process of putting out work product early, allowing for commentary and critique from those without back-channel access to the legislative process. The final product will surely benefit.

Nits aside, the proposal is a good one and would accomplish what it sets out to do. It would shut down transactions like Mr. Lauder’s by making the appreciated shares he holds subject to mark-to-market taxation.

It simplifies the tax code, increases fairness and better aligns tax law with the underlying economics. It is an exceptional example of open, bipartisan, sensible lawmaking. Mr. Camp and his counterpart on the Senate Finance Committee, Max Baucus, Democrat of Montana, have held a series of joint hearings on tax overhaul, and we are now enjoying the first fruits of the harvest.

For further reading on the taxation of derivatives, see Taxation of Financial Products: Options for Fundamental Reform by Alex Raskolnikov, and Balance in the Taxation of Securities: An Agenda for Reform by David Schizer.

Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer