March 1 (IFR) - A new draft tax reform measure on derivatives that is gaining favor in the US House of Representatives holds potentially costly consequences for ordinary workers and investors.
The proposed legislation, released last month by Congressman Dave Camp, chairman of the House Ways and Means Committee, would tax derivatives on a mark-to-market basis.
Mark-to-market accounting values assets at their current value in the market, instead of their nominal or face value, or their value at the time of acquisition.
In this case, the end result could be disproportionate tax liabilities relative to any income the derivatives generate, according to industry lawyers.
They say employees who receive compensatory options, for example, could wind up stuck with large tax liabilities before they can even exercise those options.
"The proposal is surprisingly naive given that the rest of the bill (does) some very good things," said Bruce Kayle, partner at law firm Milbank.
"It was not terribly well thought-out, in terms of its ramifications," Kayle said.
"Its incidences will very surprisingly hit a lot of people, including ordinary investors and rank-and-file employees that, if the Committee had thought about it, would probably not have intended [to affect]."
Mutual funds often use covered call strategies to add leverage to investments. Under current US law, if a written call expires, the amount of premium is taxed as short-term capital gain, meaning there is no tax rate benefit.
Under the new proposal, the writing of the call option is 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 is still outstanding.
If a fund sold a call for US$10,000, for example, the investor could end up having to a tax hit appropriate to a gain of very many multiples of that, Kayle said.
For US workers, stock options received in an employee benefit plan would be counted as income, assuming the value was positive, even before the employee exercised the option or received cash for the underlying appreciation.
Even with these side effects, the Camp draft has been largely praised, since it is viewed as vastly simplifying a complex set of rules that varies across instrument and investor type.
"Camp's proposal would replace a dozen set of rules with a single rule: mark-to-market," said David Miller, partner at law firm Cadwalader Wickersham & Taft.
"For the derivatives to which it applies, the proposal would obviate the wash sale rules, the straddle rules, the short sale rules, the capital loss limitations, the notional principal contract rules, the contingent swap rules, and the constructive ownership and sale rules. The law would be infinitely simpler - and abuse all but impossible."
But in the case of mutual fund and employee stock option issues, the proposed legislation is flawed.
One solution might be to exempt mutual funds from the mark-to-market rule, for example, though the exemption might tilt activity towards the mutual funds themselves, and thus distort investment activity.
"The history of taxation has been that one size does not fit all; that's been as much a source of problems as it has been a solution in the past," said Kayle.
"I think you have to start over and rewrite the whole regime for financial products more generally, not just tackle derivatives separately."
Short-sellers of stock could also see a material change to the tax treatment of their investments.
"In terms of effects, a short-seller might actually benefit from receiving mark-to-market treatment when their investments are in the loss column, though they theoretically might lose out when their investments have gained," said Viva Hammer, professor at Brandeis University and former attorney in the Office of Tax Policy at the US Treasury Department.
"It's unclear whether the policy-makers believe short-selling should be a derivative yet, though." (A version of this article appears in the March 2 issue of IFR Magazine, a Thomson Reuters publication)
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