Bipartisan US support seen building for derivatives tax

Fri Apr 12, 2013 2:23pm EDT

April 12 (IFR) - President Obama's derivatives tax proposal, nearly a carbon copy of congressman Dave Camp's plan, shows bipartisan momentum behind a simplified tax code for derivatives investments.

The proposal aims to tax derivatives on a mark-to-market basis by valuing positions based on their fair value, but has a handful of flaws, according to experts, and has already caused uproar in the fund management industry.

However, others consider these to be minor issues and believe the proposals may well be pushed through.

"It's an idea whose time has come, we're ready for this," said Viva Hammer, a professor at Brandeis University who formerly worked in the tax policy office at the US Treasury.

"The moment is live when everyone can get their arms around it. It's good policy and the people who would normally oppose it have other fish to fry."

The major complaint from the proposal's detractors is that it would unfairly penalise mutual funds that employ covered call strategies and employees who hold compensatory stock options for years on end with taxes on income they have not necessarily generated.

The framework is all but identical to the proposal from Camp, a Republican who chairs the House Committee on Ways and Means.

"It's the same story [as the Camp proposal] only it's more alarming that its gone from a discussion draft at the committee level to an administration budget proposal this quickly," said Bruce Kayle, partner at lawyers Milbank.

"It's a proposal that evidences a rather alarming lack of focus by what should be a staff that's qualified to identify these kinds of problems."

Mutual funds often use covered call strategies, which involve buying stock and selling a call option on those shares in order to leverage up their investments. Currently, if a written call option expires, the amount of premium is taxed as short-term capital gain, meaning there is no tax-rate benefit.

Under the proposal, the writing of the call option would be treated as if the related physical stock holding had been sold with gains and then marked-to-market at the end of the year, if the written call were still outstanding.

Similarly, employees who receive stock options from their employer would be forced to recognise gains at the end of each year on those options, even if they had not been exercised.

A TAXING PROPOSAL

Obama's proposal makes one substantive change to the Hill proposal, according to lawyers, in that the tax would only hit derivatives that are based on actively traded underlyings.

The change was intended to address a key criticism of the Camp proposal: that it would be impossible or difficult to appropriately calculate the mark-to-market value of an asset that is not actively traded, which would in turn raise questions about the value of the ultimate tax.

But the change was seen by many people as nothing more than cosmetic.

"The actively traded aspect is no more than a band aid on a machete wound; you can't have a functioning mark-to-market tax unless you start with the assumption it would be on an actively traded basis," said Kayle.

Nonetheless, the cross-aisle support for the measure means the idea is probably here to stay, and could be fast-tracked in view of government budgetary issues.

"There's been widespread support, unexpectedly, and the details are relatively minor," said Hammer. "I wouldn't be surprised if this were attached to something unrelated to tax reform that's just lying around, considering how badly they need money."

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