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Thursday, January 20, 2005

Hasen on A Realization-Based Approach to Taxation of Financial Instruments

DhasenDavid M. Hasen (Michigan) has published A Realization-Based Approach to the Taxation of Financial Instruments, 57 Tax L. Rev. 397 (2004). Here is part of the Conclusion:

Financial contract innovation undermines the federal income tax system in two basic ways, both of which are related to the inconsistent and incomplete application of realization principles in the income tax. First, it disaggregates the kinds of economic returns that a real economic investment generates from ownership of the investment itself. Because historical practice generally supported realization-based taxation for risk-based returns that derived from assumption of an investment risk, but not for other kinds of risk-based returns, the principal tax effect of this disaggregation has been to extend the realization rule to many contexts in which there is neither precedent nor a sound policy basis for doing so. Second, financial contract innovation presents an opportunity for the seemingly limitless combination of different kinds of assets and returns into new assets with new returns. In economic terms these new assets may mimic other familiar assets, or they may have economic characteristics that share those of two (or more) other assets without being reducible to either. In the first case the tax law must be able to identify and tax the combination as the familiar asset; in the second case it must be able to tax the asset in a way that both approaches accuracy as compared to similar instruments and avoids arbitrage opportunities. In the absence of rules that address these distinct effects of synthesis and hybridization, the capacity that financial contract innovation affords to carve up and reallocate returns on underlying assets creates opportunities for tax avoidance by exploiting inconsistency and discontinuity.

I have argued for a two-pronged approach to deal with these problems. The first prong would confine application of the realization rule to the investment-risk return of an asset, and the second would apply realization and accrual principles consistently to all financial returns, whether freestanding or combined as part of a complex financial instrument.

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