The IRS and Treasury are putting the brakes on a few regulatory projects in the financial institutions and products area because tax reform just might make them irrelevant. The bet is that mark-to-market is coming, and soon enough that it doesn't make sense to eliminate regulations to make room for new ones that could quickly become obsolete.
Stalled projects include ones on contingent notional principal contracts, section 1001 issues for non-debt financial instruments, and hedging transactions under section 446. (Prior coverage: Tax Notes, Mar. 13, 2017, p. 1363.)
Congressional interest in mark-to-market has been low since Senate Finance Committee ranking minority member Ron Wyden, D-Ore., introduced the discussion draft of the Modernization of Derivatives Tax Act (MODA) of 2016, but tax reform efforts will likely reinvigorate the debate about it. "I think there is a lot of receptiveness to mark-to-market," said Steven M. Rosenthal of the Urban-Brookings Tax Policy Center. Former House Ways and Means Committee Chair Dave Camp included a version of mark-to-market in his Tax Reform Act of 2014, an indication that there might be both bipartisan and bicameral support for it in principle. Whether agreement can be reached on the details is a separate question, but one that lawmakers might agree is worth attempting given the revenue scores of the Wyden and Camp proposals. The Joint Committee on Taxation's estimate for Wyden's discussion draft was $16.52 billion over 10 years, and the estimate for TRA 2014's mark-to-market provision was $15.7 billion.
Another aspect of mark-to-market that might give it support among Republican lawmakers is its compatibility with the House Republican "Better Way" blueprint, said David S. Miller of Proskauer Rose LLP. "Under the blueprint, financial assets are subject to the income tax, so if an individual buys publicly traded stock, they are taxable on the gains, and if they buy a derivative to offset it, they would be subject to the straddle rules," Miller said. "MODA could apply to that individual if the blueprint is enacted," he said.
In redrafting MODA to fit the blueprint, Congress will need to devise a way to deny interest-equivalent deductions, said Michael Farber of Davis Polk & Wardwell LLP. The denial of interest deductions in the destination-based cash flow tax will be very difficult to enforce in a world where derivatives are marked to market, because one or more derivatives can be structured to act like debt so that marks can function as the equivalent of accreting interest deductions.
"There is going to be some pushback at the edges," particularly regarding the scope of a mark-to-market regime, Rosenthal said. He said he favors extending mark-to-market to publicly and non-publicly traded derivatives, with or without publicly traded underlying investments, but that perspective is not universally shared. Still, there seems to be sufficient common ground to advance a mark-to-market regime. Recent changes in the political and regulatory spheres — particularly the cancellation of the healthcare vote and the executive orders on reducing regulations — may give it an unexpected boost.
There are reasons to think that the Trump administration might be interested in pursuing mark-to-market, although the president and his advisers have not yet publicly commented on it. Mark-to-market could help meet two of the stated goals of the Trump campaign: tax code simplification and deficit-neutral policy. The campaign's tax reform plan noted that reducing or eliminating "loopholes available to the very rich" was one of the ways that Trump would pay for tax reform. Similarly, Wyden cited stopping "the privileged few" from using complex financial tools to avoid paying taxes as motivation for releasing the MODA draft.
Several of the items that the administration appears to be interested in — particularly reducing the corporate tax rate and allowing taxpayers to deduct the cost of child care expenses from their income taxes — would need significant offsets to be revenue neutral. There may be support in Treasury too: Treasury Secretary Steven Mnuchin worked at Goldman Sachs and with hedge funds and will be familiar with financial products, Rosenthal noted.
The simplification argument may be the one that wins over the administration because mark-to-market would result in "one timing rule, one character rule and one sourcing rule for all derivative contracts," as the JCT report on MODA points out. In contrast, the JCT's explanation of current law is a litany of the various and often disparate rules that attempt to address particular transactions and types of products.
Miller, who urged Congress to develop a mark-to-market system for publicly traded derivatives and derivatives with respect to publicly traded property in 2011, said that on balance, if some of the problems with MODA are fixed, it could be a dramatic improvement. He explained to Congress in 2011 that "as Ptolemy's system was geocentric, our federal tax system is based on the equally archaic system of realization — the concept that income is not earned, and therefore not taxed, until a taxpayer actually sells property for cash or exchanges it for materially different property." He pointed to the straddle rules in section 1092 as an example of the sort of Ptolemaic rules that attempt to fit the taxation of financial instruments into the realization model. "I don't think taxpayers can comply with the straddle rules as they exist today, and I don't think the government can enforce them," he told Tax Analysts. A narrowly tailored mark-to-market regime would mostly make the jobs of both taxpayers and the government easier, he said.
President Trump's desire to decrease regulations, as expressed in his one-in, two-out order on regulations, may also favor mark-to-market. A mark-to-market system could eliminate the need for projects that the IRS and Treasury have put on hold, but it would also extinguish existing several code sections and their accompanying regulations. New regulations would be necessary for the new laws, but the MODA draft has only three sections, in contrast with the variety of current code sections that deal with derivative contracts.
Non-Actively Traded
MODA applies to derivatives that are not actively traded, and that is likely to remain a contentious issue if the proposal advances. The New York State Bar Association's recent report gave a qualified endorsement of moving to a mark-to-market regime. MODA, or another regime like it, "could be a substantial improvement over current law, so long as (a) the regime is limited to actively traded derivatives and derivatives with respect to actively traded property and (b) the regime provides workable rules for straddles in which a derivative hedges underlying property," NYSBA wrote. With some specific exceptions, NYSBA wants only derivatives that are actively traded or that relate to actively traded property to be marked.
The argument against including non-actively traded positions in mark-to-market is that an expanded regime would be difficult to administer and could lead to taxpayers creating derivatives solely to claim losses. NYSBA pointed out that the IRS probably doesn't have the resources to litigate the valuation disputes that including non-actively traded derivatives and derivatives with respect to non-actively traded property would lead to. Even a symmetry requirement for both sides of a transaction won't solve the potential valuation problems because adding a non-U.S. person into the mix would defeat symmetry. Miller noted that in the current tax system, the only time that we try to value things that are otherwise considered impossible to value is when someone dies. "If every non-traded derivative is required to be valued by each party every single year, you would get estate tax-type disputes every year," he said.
Investment Hedging Units
Investment hedging units (IHUs) are a new development under MODA, and an area where more clarification might benefit both taxpayers and the government if lawmakers take up MODA or a MODA look-alike. An IHU is established if a taxpayer holds derivatives or derivatives that have the same or substantially identical underlying investment, and underlying investments that have a delta relationship with derivatives between -0.7 and -1.0. If a taxpayer has an IHU, built-in loss is not recognized for any position in it, but built-in gain is recognized and realized when the IHU is established and the taxpayer has a taxable event at the end of the tax year, and upon some types of changes to the investments in the IHU. Taxpayers can elect to establish an IHU without doing a delta test if they own an underlying investment and any derivatives of that underlying investment, but the election is irrevocable.
Under MODA, whether a transaction or product is an IHU is something that taxpayers determine or fail to determine at their peril, Farber said. How underlying investments and derivatives are combined or deemed to be combined under MODA is one of the primary uncertainties in making the regime work, because the concept of underlying investments is currently nebulous, he said. "What does it mean to have an IHU with respect to a rate, price, amount, index, formula, or algorithm?" he asked, citing the list of items in MODA section 493(a)(7) that are not assets.
Farber said clarifying the definition of underlying investments is important because if a taxpayer fails to identify a combination of underlying investments and derivatives "with respect to" them, even if the combination of positions is not otherwise an IHU — i.e., does not have a delta of -0.7 or less — it can be deemed an IHU, leading to the draconian result of built-in gain recognition. "If that were not on the table, we could have a coherent discussion about matching derivatives with underlying investments," he said. Further, thought should be given to how to deal with "unbalanced straddles," portfolio positions and other matching issues, he said.
NYSBA advocates for a narrower definition of a mandatory IHU by changing the delta that makes a derivative and underlying investment pair an IHU to -0.8 through -1.0, or the substantial equivalent for complex contracts. Drawing on the lessons learned during the regulation project under section 871(m), the bar association recommends applying the substantial equivalence test for complex contracts here too because it believes the delta test is too hard to apply.
Bifurcation and Other Implementation Issues
Section 492(f) of MODA gives Treasury authority to write regulations regarding IHUs, including rules that require taxpayers to bifurcate derivatives whose value is determined by reference to more than one underlying investment. Farber said even relatively simple instruments may be susceptible to being bifurcated in radically different ways, which means that the IRS and Treasury would have a lot of work to do to figure out the best regulatory approach.
There will certainly need to be refinements to the MODA discussion draft if Congress decides to pass mark-to-market. "My take is that what we're looking at is a long way from complete," Farber said. He suggested that one way to address some of the problems would be to eliminate the penalty of immediately recognizing built-in gain on "deemed" IHUs resulting from failing to make proper identification of combinations of positions and phase in mark-to-market for simple derivatives and obvious offsets first. A gradual transition "is probably a sensible way to start," he said. Congress could make the process smoother by giving the IRS and Treasury a lot of regulatory authority to sort things out.
If information reporting of pricing from financial institutions to taxpayers is part of mark-to-market, a transition period would be necessary. If previous information reporting regimes are a guide for how long financial institutions need to set up and test new systems, the earliest that mark-to-market with reporting could be in place would be about 18 months from the time the legislation is passed and any necessary regulations are released.