Paul L. Caron

Friday, February 8, 2013

Fleischer: A Sensible Change in Taxing Derivatives

NY Times DealBookNew York Times DealBook:  A Sensible Change in Taxing Derivatives, by Victor Fleischer (Colorado):

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. ...

From a public policy standpoint, the proposal deserves the praise it 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. ...

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.

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Looks like if a taxpayer enters a straddle using a derivative, both the derivative hedge and the underlying security are subject to MTM treatment and the character is ordinary. I have a suspicion that that means we'll see a lot of straddles created on 12/30 of each year on stocks with unrealized losses that will be unwound on 1/2.

Posted by: jpe | Feb 8, 2013 6:52:12 AM