Overview

On May 18, 2016, Senate Finance Committee Ranking Member, Senator Ron Wyden, released a financial product tax reform discussion draft that, if adopted, would significantly alter the current tax rules with respect to financial products (derivatives), as well as the tax treatment of certain non-derivative positions that are offset by derivatives. The discussion draft is referred to as the Modernization of Derivatives Tax Act, or MODA.

Uniform Timing, Character and Source Rules 

MODA’s stated goal is to provide for uniformity in the tax character, timing and source of gains and losses relating to all derivatives. If adopted, these uniform rules would apply to all taxpayers, including individuals, although businesses that enter into qualifying tax hedges would be exempt.

With respect to timing, MODA would require all non-exempt derivatives (as defined) to be taxed, regardless of the taxpayer’s overall method of tax accounting, (1) upon termination or transfer and (2) if held open at the end of a tax year, on a mark to market basis. Mark to market accounting means that changes in the value of open derivatives held at year end would result in currently taxable gain or loss based on a deemed termination or transfer at the then fair market value. To the extent a derivative is marked to market, appropriate adjustments would be made in the amount of any subsequent gain or loss to reflect any gain or loss previously taken into account. (A payment with respect to a derivative that does not constitute a taxable event, as defined, would, regardless of the taxpayer’s overall method of accounting, be taken into account when paid. Proper adjustments would be made for any subsequent gain or loss to reflect such payment.)

With respect to character, MODA would provide that income, deduction, gains and losses from all non-exempt derivatives would be taxed as ordinary income or loss (and losses would be attributable to a trade or business of the taxpayer for purposes of section 172(d)(4)).

Finally, MODA would impose a residency-based sourcing rule for income, deduction, gain or loss relating to non-exempt derivatives (except to the extent that section 871(m) applies to any payments with respect to the derivative).

Derivatives Defined 

MODA would apply to all derivatives, broadly defined as any contract (including any option, forward contract, futures contract, short position, swap or similar contract) the value of which, or any payment or other transfer with respect to which, is directly or indirectly determined by reference to: (1) any share of stock in a corporation; (2) any partnership or beneficial ownership interest in a partnership or trust; (3) any evidence of indebtedness; (4) subject to limited exceptions, any real property; (5) any commodity which is actively traded (as defined); (6) any currency; (7) any rate, price, amount, index, formula, or algorithm; or (8) any other item as the US Treasury Department (Treasury) may prescribe.

Exceptions. Limited exceptions from the definition of a derivative would be provided for the following: qualifying hedging transactions under section 1221(a)(7) and section 988(d); certain real property and related investments; employee stock options; insurance, annuity and endowment contracts issued by insurance companies; certain embedded derivatives underlying debt instruments; and American Depositary Receipts and similar instruments with respect to stock in foreign corporations.

To the extent provided by the Treasury, a derivative will not include the right to the return of the same or substantially identical securities transferred in a securities lending, repo or similar financing transaction. Exceptions also would be provided for (1) derivatives relating to stock issued by any member of the same worldwide affiliated group (as defined in section 864(f)) of which the taxpayer is a member and (2) any contract with respect to any commodity if such contract requires physical delivery (with the option of cash settlement only in unusual and exceptional circumstances), provided that such commodity is used (and is used in quantities with respect to which such derivative relates) in the normal course of the taxpayer’s trade or business (or, in the case of an individual, for personal consumption).

Embedded Derivatives. Contracts with embedded derivatives would be bifurcated into their derivative and non-derivative components, with the derivative component being marked to market and generating ordinary income or loss. A limited exception would be provided for debt instruments denominated in, or determined by reference to, a nonfunctional currency. If an embedded derivative cannot be separately valued, MODA treats the entire contract as a derivative.

Valuation Principles

For mark to market purposes, MODA would allow taxpayers to rely on valuations provided by brokers under section 6045(b). In addition, taxpayers would be allowed to rely on certain non-tax reports and statements, subject to the following priorities: first, financial statements certified as being prepared in accordance with US generally accepted accounting principles (subject to sub-priority rules); second, financial statements prepared in accordance with international financial reporting standards (IFRS) required to be filed with agencies of a foreign government equivalent to the SEC in jurisdictions that have reporting standards at least as stringent as those in the United States; and third, to the extent provided by the Treasury, statements provided to other regulatory or governmental bodies.

Investment Hedging Units 

While MODA would not apply to stand-alone non-derivative positions (such as stock, securities or commodities), it would apply (requiring mark to market taxation and ordinary income or loss characterization) to any non-derivative that is or becomes part of an investment hedging unit (IHU). 

In general, a taxpayer would be treated as having an IHU if the taxpayer holds the following offsetting positions: (1) derivatives that have the same or substantially identical underlying investment and (2) underlying investments, portions of underlying investments, or items substantially identical to those underlying investments, provided that the underlying investments or portions thereof described in (2) have the requisite “delta” with the derivatives described in (1).  

For these purposes, the requisite delta between the underlying investment position and a derivative relating to the same or substantially identical underlying investment would have to be between minus 0.7 and minus 1.0. “Delta” would be defined as the ratio of the expected change in the fair market value of the derivative(s) to any change in the fair market value of the associated underlying investment(s).

Taxpayers would be required to test for delta when an IHU is first established, and any time it is subsequently modified. For purposes of a taxable event, the taxpayer will determine which portions of an underlying investment have been sold or exchanged on a first-in, first-out basis (unless the taxpayer has otherwise elected an average cost basis method). 

A taxpayer would be required to identify the positions in an IHU, as well as identifying those derivatives and underlying investments which could be part of the IHU but do not meet the delta relationship. To minimize compliance burdens, a taxpayer may elect to forgo the delta test and treat all derivatives with respect to such underlying investment, and all units of such underlying investment, as part of an IHU. This election, once made, is irrevocable and will apply to all subsequently established IHUs. Additionally, the Internal Revenue Service will treat taxpayers who fail to properly identify IHUs as making this election.

Note that any built-in gains on non-derivative positions held prior to entering into an IHU would be recognized at the time the IHU is entered into; pre-IHU built-in losses, however, would be deferred until the non-derivative position is disposed of in an otherwise taxable transaction. When the derivative that is part of an IHU is disposed of, the underlying investment once again receives capital treatment for subsequent gains and losses, and its holding period is reset.

Conforming Changes 

Several provisions of the Internal Revenue Code would be repealed by MODA, including in particular section 1256, which currently provides 60/40 tax treatment to section 1256 contracts (including domestic futures contracts and nonequity options). Other provisions that would be repealed include sections 1233, 1234, 1234A, 1234B, 1236, 1258, 1259, and 1260.

Special Character Change for Insurance Companies 

Although not a derivative tax issue, MODA also would extend ordinary tax treatment to debt instruments held as assets by certain insurance companies.

Effective Date 

If adopted, MODA would generally be effective for taxable events occurring after the 90-day period beginning with the date of enactment, in taxable years ending after the last day of such period.  A transition rule applies to derivatives and underlying investments held as of the close of such 90-day period.

Observations 

While MODA is meant to simplify the taxation of derivatives, the proposal likely raises a new round of difficult questions, including but not limited to the classification of various contracts as derivatives, mark to market valuation questions and issues relating to underlying investments subject to the IHU rules. It is obviously difficult to predict the likelihood that MODA will be adopted in its current or in a revised version. Similar proposals were first introduced by former Chairman of the Ways and Means Committee, Dave Camp, in 2013, and have also been included in the Obama Administration’s Revenue Proposals for fiscal years 2014, 2015, 2016 and 2017.