High & Low Finance: Congressman’s Proposal Is a First Step Toward a Tax Overhaul

If real tax change is ever to be adopted, we are going to have to be specific on small things as well as large.

Representative Dave Camp, the Michigan Republican who heads the House Ways and Means Committee, has taken an impressive step in that direction with a proposal to make substantial changes in the taxation of financial instruments.

Mr. Camp’s proposal got relatively little attention in the media, although it has set off alarm bells in some Wall Street precincts, where it threatens to dismantle some cherished ways that Wall Street has invented to allow banks to profit by taking a cut of tax benefits they offer to customers.

“Congressman Camp’s proposal reflects his efforts to respond to the changing realities of modern financial markets,” said Mark Price, who leads the financial institutions and products group at KPMG’s Washington national tax practice.

Studying Mr. Camp’s proposal is not always easy sledding. This is an area of law that has grown exceedingly complicated, in large part because each change in the law is greeted by new tax avoidance tactics and strategies, which eventually lead to new provisions that combat those but may open the way to still more maneuvers. And on and on. Many innovations in finance accomplish nothing for the overall economy, but instead are aimed solely at gaming either tax or regulatory rules.

Lobbyists for one part of the financial services industry or another have gotten provisions passed to benefit their products over those of competitors, leading to demands by competitors for equal treatment.

It would be nice to report that the chairman has found a magic way to end these games, but he has not. Some on Wall Street are already talking about ways that some of his proposals, if enacted, could be abused.

Mr. Camp understands that and has called his proposal a “discussion draft,” one that is aimed at getting comments from those who would be affected.

He will get plenty of them.

One principle that the Camp proposal would establish is to provide what the congressman calls “uniform tax treatment of financial derivatives.” The definition of derivative is very wise — it includes short sales of stock as well as options, swaps and futures.

Under the Camp proposal, a derivative could create only ordinary gains or losses no matter how long it was held. And changes in value would be subject to tax every year, as the market price changed, whether or not the investor sold. There could never be a long-term capital gain involving a derivative, and therefore the investor could never qualify for the preferential tax rate on long-term capital gains.

There are many tax-oriented strategies to create differing tax treatments for what are actually offsetting investments. The idea is to have a loss treated as ordinary income, and recognized as soon as possible, while the offsetting gain is delayed and then treated as a long-term capital gain if that is possible.

The Camp proposal would establish a general rule that both arms of an offsetting strategy will be taxed as ordinary income or loss on a mark-to-market basis at the end of each year. So if one position made money while the other lost, they would wash each other out. There would be little reason to enter into many such transactions. And derivatives — except those that businesses use in ways that qualify for hedge accounting — will automatically be marked to market.

One type of product that appears to be targeted is so-called exchange-traded notes. They are devised to be alternatives to other investments, but with better tax treatment. Consider a mutual fund that invests in the stocks in the Standard Poor’s 500. If you buy shares in that fund, dividends will be distributed to you each year, and you pay taxes on them even if you reinvest them in the fund. But if a bank issues a “note” tied to the total return on the same index, you will not owe taxes until you sell the note. The effect is to defer taxes on the dividend income.

To get that tax break, you pay a fee to the bank that issued the note, and you take the credit risk. If the bank fails, you will suffer no matter how well the index does.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/02/15/business/congressmans-plan-is-first-step-to-a-tax-overhaul.html?partner=rss&emc=rss