The current tax treatment of gains and losses from entering into derivative transactions, such as swaps and futures, is highly dependent upon the type of derivative, the profile of the taxpayer, and other factors, which can result in very different tax consequences for economically similar transactions. In order to bring uniformity to the tax treatment of derivatives and more appropriately measure income and loss, the draft would require all derivative positions to be marked to market at the end of each tax year so that changes in the value of the derivative result in taxable gain or loss.
Any gains or losses from marking a derivative to market would be treated as ordinary income or loss. For straddles, offsetting financial positions, that include at least one derivative position, all positions in the straddle would be marked to market with ordinary income or loss treatment, including stock, debt and other financial
products that otherwise would not be subject to mark-to-market treatment under this proposal.
For purposes of determining the amount of mark-to-market gain or loss on a derivative, the draft would provide regulatory authority to rely upon the fair market value of the derivative that the taxpayer reports for financial or credit purposes.
The legislation would not apply to common transactions involving derivatives, such as hedges used by companies to mitigate the risk of price, currency and interest rate changes in their business operations and real estate transaction, such as options to acquire real estate. The draft would repeal several tax law provisions that would be superseded by general mark-to-market tax treatment of derivatives, such as provisions that attempt to police the inconsistent tax treatment of derivatives under current law.
The draft would also simplify business hedging tax rules. Currently, taxpayers are permitted to match the timing and character of taxable gains and losses on certain hedging transactions with the gains and losses associated with the price, currency or interest rate risk being hedged. However, taxpayers can only accomplish such matching tax treatment if they properly identify the transaction as a hedge on the day they enter into the transaction. Often, taxpayers inadvertently fail to satisfy this identification requirement, even though they have properly identified the transaction as a hedge for financial accounting purposes. The draft would permit taxpayers to rely upon an identification of a transaction as a hedge that they have made for financial accounting purposes.
The draft would eliminate phantom tax resulting from debt restructurings. Currently, when the terms of an outstanding debt instrument are significantly modified, the issue price of the modified debt instrument does not necessarily equal the issue price of the debt instrument prior to modification. In particular, the issue price of the modified debt instrument can be substantially lower than the issue price of the debt instrument prior to
modification if the debt instrument has lost significant value since the loan was originally made.
The reduction in the issue price resulting from the modification of the debt instrument constitutes taxable cancellation of indebtedness income to the borrower, although the borrower still owes the same actual principal amount as was owed prior to the modification. The draft would eliminate the phantom taxable income problem associated with many debt restructurings by generally providing that the issue price of the modified debt instrument cannot be less then the issue price of the debt instrument prior to modification. This floor on the issue price of the modified debt instrument would be reduced by any amount of actual principal that is forgiven.
The draft would prevent the harvesting of tax losses on securities. For decades, the wash sale tax rules have prevented taxpayers from artificially creating tax losses on securities that have declined in value by selling the securities at a loss and, within a short time before or after the sale, acquiring the same securities. When these rules apply, the loss is deferred until the replacement securities are later sold. However, many taxpayers can avoid the wash sale rules by directing a closely related party, such as a spouse or dependent child, to acquire the replacement securities.
The draft would close this loophole by expanding the scope of the wash sale rules to include acquisitions of replacement securities by certain closely related parties, including spouses, dependents, controlled or controlling entities (such as corporations, partnerships, trusts or estates), and certain qualified compensation, retirement, health and education plans or accounts.