The Proposed Modernization of Derivatives Tax Act

John Kaufmann Greenberg Traurig Counsel 212.801.2147 | kaufmannj@gtlaw.com

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Outline •  Introduction •  Taxation of Derivatives under MODA •  Issues with the MTM Proposal •  Insurance Company Hedges

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Introduction

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What Does The Act Do? •  Requires that “derivatives” and “investment hedging

units” (“IHUs”) be marked to market for tax purposes; and,

•  Allows insurance companies to treat bonds as ordinary assets.

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Who does the Act Affect? •  Insurance Companies •  Funds •  Individual Traders •  HNWIs •  Borrowers •  Lenders •  Business Hedgers •  Anyone who enters into derivatives

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History and Prognosis •  There is long-term, bi-partisan and bi-cameral support for the reform of the taxation of derivatives:

–  A proposal to mark derivatives to market was made in 2013 by David Camp (R-MI), head of Ways and Means Committee;

–  The Senate Finance Committee ranking minority member Senator Ron Wyden (D-OR.) released a discussion draft, the Modernization of Derivatives Tax Act (“MODA”) in early 2016, containing many provisions similar to the Camp proposal; and,

–  There is talk that a similar proposal may be included in the new administration’s tax reform proposal

•  All such proposals would require that derivatives and certain hedged positions be marked to market.

•  All such proposals would repeal most current provisions applicable to derivatives and items hedged thereby.

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Policy Goals Explicit, Implicit, and Generally Desirable

•  Combat Abuse

–  The current straddle rules (or something like them) are needed to prevent abuse

–  However, the current straddle rules are over-inclusive, punish non-abuse behavior, and often do not clearly reflect income

–  MODA may address the same abusive behavior that the straddle rules were designed to curb

•  Clearly Reflect Income

–  A realization-based system of accounting does not reflect Haig-Simons income

–  MTM-based accounting gives the fairest representation of accessions to and reductions in wealth

–  The unequal treatment of economically equivalent transactions is evidence of lack of clear reflection of income in the treatment of one, the other, or both of the transactions

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•  Simplify

–  Current law treatment of derivatives is an historical accident, with no over-arching, cohesive structure

–  Treatment of derivative cash flows depends on –

•  Instrument •  Taxpayer •  Transaction •  Business purpose

–  Sophisticated taxpayers can take advantage of current law complexity

Taxation of Derivatives –Current Law and MODA

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Tax Accounting – General Concepts •  Timing

•  Character

•  Source

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Uses of Derivatives •  Speculation

•  Hedging

•  Arbitrage

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Taxation of “Naked” Derivatives – Current Law

•  Timing: It depends

•  Character: It depends

•  Source: Generally, consistent with taxpayer residence (with carve-out for 871(m))

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Current Law Tax Treatment of Naked Derivatives

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Instrument Character Timing Source Options Capital OT ROT/871(m)

Forwards Capital OT ROT/871(m)

1256 Contracts (Futures, e.g.)

Capital – 60/40 MTM ROT/871(m)

Swaps - PPs Ordinary RAC ROT/871(m)

Swaps - TPs Capital OT ROT

Swaps - NPPs Ordinary/ROP Amortize ROT

Contingent Swaps

Ordinary MTM ROT/871(m)

•  ROT Source of item is consistent with the residence of the taxpayer

•  871(m) Re-sourcing rule for dividend equivalent payments on certain equity derivatives

•  OT Open transaction (“wait-and-see” accounting) •  MTM Mark-to-market

•  PP Periodic payment •  RAC ratable accrual •  TP Termination payment •  NPP Nonperiodic payment •  ROP Return of principal

Capital Underlier

Taxation of Offsetting Positions – Current Law

•  Tax Hedging Rules

•  Straddle Rules

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Current Law - Hedging •  Definition A tax hedging transaction is a transaction entered into to manage the risk

of price changes or currency fluctuations wrt ordinary property, or to manage interest rate or FX risk wrt borrowings or ordinary obligations. Treas. Reg. §1.1221-2(b).

•  Character Gain or loss from tax hedging transactions is ordinary. Code section 1221(a)(7).

•  Timing Gain or loss from tax hedging transactions must be taken into account in a method that clearly reflects income. Treas. Reg. §1.446-4(b). Generally, this will be when offsetting gain or loss from hedged items are taken into account.

•  Identification Requirement To benefit from the character rule of Code Section 1221(a)(7), the hedge and the hedged item must be properly identified in the taxpayer’s books and records in a timely manner. Treas. Reg. §1.1221-2(f).

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Current Law - Straddles •  Definition A straddle is offsetting positions in personal property. Code

section 1092(c). –  “Offsetting” = substantial diminution of risk of loss. –  Ex: Long physical gold, short gold futures contract

•  Loss Deferral Loss with respect to one leg of a straddle may not be taken into account to the extent that there is built-in gain in the other leg. Code section 1092(a).

•  Interest Capitalization Interest expense and carrying charges allocable to property that is part of a straddle must be capitalized, rather than deducted currently.

•  Exemption for Hedging Transactions The straddle rules do not apply to hedging transactions. Code section 1092(e).

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Current Law – Straddles (con’t) Policy Goal : Prevention of Abuse

• Example: In May of Year 1, taxpayer enters into a long March Year 2 silver futures contract, and a short June Year 2 silver futures contract. On December 31, Year 1, the taxpayer terminates the “loss” leg and immediately enters into a replacement position. Loss may be taken in Year 1. In certain cases, loss may be short-term, and gain may be long-term.

–  Note: Under current law, this transaction would be thwarted by the mark-to-market rule of

• Example: In January of Year 1, taxpayer borrows $100 at 5% annual interest. The loan proceeds are used to buy physical gold. At the same time, that taxpayer enters into a contract to sell the same amount of gold for $105 in 366 days. The taxpayer deducts interest payments currently, and recognizes $5 of long-term capital gain when the gold is sold.

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MODA in a Nutshell •  Derivatives are MTMed

–  Ordinary character (termination, as well as MTM) –  Payee-based source (with 871(m) carve-out)

•  Underlying investments part of an investment hedging unit (an “IHU”) are MTMed –  -0.7 delta test –  See below for definition of underlying investment

•  Certain instruments are excluded –  Real property –  83(e)(3) options –  Derivatives on 864(f) worldwide affiliated group members –  Commodities used in the normal course of trade or business –  Insurance contracts –  ADRs

•  Certain transactions are excluded –  1221(b) hedging transactions –  988(d) integrated hedging transactions (no mention of 1.1275-6 integrated hedging transactions) –  Securities loans and repos to the extent provided in regulations

•  Repeal of certain existing derivative-relevant sections –  1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259, 1260 –  IHUs carved out of the straddle rules –  Tax hedging transactions are excluded from the new rules

•  Certain debt of insurance companies treated as ordinary under new 1221(a)(9). –  Eliminates “gap hedge” problem for insurance companies that hedge policy risk with debt portfolio –  Stand-alone provision – not part of derivative reform.

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MODA – Important Definitions •  Derivative

•  IHU

•  Delta

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MODA - Definition of “Derivative” •  Any contract (including any option, forward contract, futures contract, short position, swap,

or similar contract) the value of which, or any payment or other transfer with respect to which, is (directly or indirectly) determined by reference to any one of the following (each an “underlying investment”):

–  A share of stock;

–  A partnership or beneficial ownership interest in a partnership or trust;

–  An evidence of indebtedness;

–  Real property (with important exceptions);

–  An actively traded commodity;

–  A currency;

–  A rate, price, amount, index, formula, or algorithm; or

–  Any other item as the Secretary may prescribe.

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Derivative - Exceptions •  The following are excepted from the definition of derivative:

–  Physically-settled contracts with respect to real property;

–  ADRs and ADSs;

–  Contracts that are part of a business hedging transaction or certain FX hedging transactions;

–  To the extent provided by the Service, the right to the return of the same or substantially identical securities transferred in a securities lending transaction, sale-repurchase transaction, or similar financing transaction;

–  An option described in Section 83(e)(3) received in connection with the performance of services;

–  Insurance contracts, annuities, and endowment contracts;

–  A derivative (determined without regard to MODA) with respect to stock issued by any member of the worldwide affiliated group in which the taxpayer is a member; and

–  A contract, with respect to a commodity used in the normal course of the taxpayer’s trade or business, that requires physical settlement.

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MODA - Definition of an IHU •  IHU: One or more derivatives and an underlying investment wrt

thereto, so long as the derivative(s) has/have a delta of -0.7 or less wrt the underlying investment

•  Delta: The ratio of the expected change in the fair market value of a derivative to any change in the fair market value of its underlying instrument

•  Election: Taxpayers may elect to treat all derivatives and underlying investments wrt thereto as an IHU, regardless of delta. This eliminates the need for delta testing. The election applies to all portions of the underlying investment and all derivatives wrt thereto, and is irrevocable.

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Identification of an IHU Taxpayers are required to test for delta, and to identify IHUs.

•  Timing: Taxpayers must test positions for IHU status at the following times:

–  When the taxpayer first holds positions in an underlying investment and a derivative or derivatives wrt thereto; or,

–  When the taxpayer adjusts any of the positions.

•  Manner: Derivatives and underlying positions in an IHU must be identified in a manner that clearly identifies them as such. This appears to be a books-and-records identification

•  Failure to Identify: Taxpayers who fail to test for delta and identify positions as IHU components are deemed to have made the “regardless of delta” election

•  Incorrect Identification: TBD in regulations

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MODA – Naked Derivatives •  Timing: Gain or loss is recognized upon the occurrence of either:

–  Taxable Year End, or

–  Termination or Transfer. This includes any termination or transfer by offsetting, making or taking delivery, exercise, assignment, lapse, sale or other disposition, assumption or otherwise regardless of whether it would cause gain or loss recognition under current law

•  Character: Ordinary

•  Source: Residence-based, with a carve-out for 871(m) DEPs

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MODA - IHUs •  Timing

–  Entering an IHU Gain is recognized (as ordinary) when positions are acquired that constitute an IHU.

•  Built-in loss is (i.e., pre-IHU loss) not recognized when an offsetting IHU leg is entered into. This loss is recognized when the property is disposed of, terminated or transferred.

•  Holding period of underlying investment is reset to 0

–  Existing IHU Gain or loss wrt all legs of an IHU are MTMed at year end.

–  Adjustments and Terminations of an IHU:

•  Gain is recognized wrt every component of an IHU when any leg of the IHU is adjusted, added to or subtracted from

•  Post IHU Loss is recognized wrt every component of an IHU when the IHU is adjusted, added to or subtracted from

•  Pre- IHU Built-in Loss wrt a position is recognized when that particular position is terminated or transferred

•  Character Ordinary

•  Source Residence of the taxpayer, with carve-out for 871(m) DEPs

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Issues with the Proposal

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Issues - Generally •  Big Problems

–  No MTM of naked underlying investments

–  Delta – brother-sister risk?

–  Vestigial straddles

–  Identification

•  Smaller Problems

–  Payments on derivatives

–  Mark upon entry

–  Bifurcation

–  Valuation

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Naked Underlying Investments •  Underlying investments are not MTMed under the

proposal

•  This could lead to dissimilar taxation of economically similar transactions

•  This could also lead to market distortion

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Delta •  Definition In option pricing, delta denotes the correlation

between an option and the option’s legal referent. However, it appears that the term is intended to simply mean “correlation” in this context.

•  •  Textual Support: “Rate, index, formula” are referred to

as potential underlying investments. However, it is impossible to own intangibles of this type. Therefore, the only way that this reference can be meaningful is for a derivative and its underlying investment to both correlate with the same rate, index or formula. See “brother-sister risk”, below

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Delta – Indirect Risk •  The value of a derivative and an asset may correlate with each other because both

reference the same index or asset, even though neither references the other (“Brother-Sister Risk”, or “Grandparent Risk”).

•  Example 1: A taxpayer purchases shares in a corporation engaged in oil exploration or transporting, and shorts a corresponding notional amount of oil futures contracts. The value of the shares correlates with that of the oil futures contracts. This is because the value of the shares is affected by the spot price of oil (query whether shares “reference” assets of their issuer), and the futures reference spot oil by their terms.

–  Under current law definitions, the futures contracts are not treated as derivatives wrt the shares, because the legal terms of the contracts do not reference the shares. 475(c)(2)(E); 1234A(1); Treas. Reg. 1.871-15(g)(1); Prop. Reg. 1.864(b)-1(b)(2)(ii).

–  However, under current law definitions, the shares and the futures contracts may constitute offsetting legs of a straddle, because the short futures position substantially diminishes the taxpayer’s risk of loss wrt the shares, and the shares and the futures contract reference substantially similar or related property. Treas. Regs. 1.1092(d)-2(a), 1.246-5(d), ex. 2.

–  Under MODA, the futures contracts may be treated as derivatives with respect to the shares, because the value of the futures contracts may be treated as determined “indirectly by reference to” the value of the shares.

•  Example 2: A taxpayer purchases a portfolio of bonds issued by ABC corp, a highly rated investment-grade domestic corporation. At the same time, the taxpayer purchases credit protection on an equivalent principal amount of bonds issued by ABC corp under a credit default swap. The terms of the swap do not reference any particular bond issued by ABC corp, but do reference all bonds pari passu with the purchased bonds.

•  Example 3: The facts are the same as in Example 2, but instead of purchasing protection under a single-name credit default swap, the taxpayer purchases protection on a broad index of domestic investment-grade issuers.

•  Example 4: A taxpayer purchases shares in the SPY, and enters into a long position in VIX futures. Although VIX futures reference the volatility of the S&P 500 contract, rather than the price thereof, they are negatively correlated thereto. This could be an IHU

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Indirect Risk (con’t) The best way to read “delta”, “derivative”, “underlying investment”, and “IHU” depends on the desired

policy result

• Broad Interpretation: If delta is intended to mean mere correlation, embrace the concept. Allow the IHU regime to replace the straddle regime:

–  A broadly-defined IHU regime would combat the abuse targeted by the straddle rules

–  The IHU regime is simple, and less over-inclusive than the straddle regime

• Narrow Interpretation If delta is intended to denote the ratio of change between the value of a derivative and the price of its referent, applicable definitions should be changed to specify that a “derivative” is a contract whose value is determined pursuant to its terms by reference to an underlying investment

–  If a narrow interpretation is used, the current straddle rules, or something like them, would need to be retained

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Best Fit to Policy Goals •  Simplify the Law

–  MTM Derivatives –  Remove IHU Rule

•  Clearly Reflect Income, Avoid Distortion –  MTM everything, remove IHU rule1

•  Prevent Straddle Abuse –  Keep, and broaden the IHU regime

•  Admit brother-sister risk •  Allow for -.07 (or greater) historical correlation •  Omit reference to “derivatives” – any two correlated instruments may constitute

an IHU –  Unhedged derivatives and assets may be dealt with separately

1. This would also prevent straddle abuse

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Problem With Vestigial Straddle Rules If MODA and the current straddle regime co-exist, non-IHU straddles will cause taxpayers

to recognize taxable income in a way that does not reflect economic reality

• Non-IHU Mixed Straddles: Taxpayer holds a derivative and a cash position which constitute “offsetting positions in personal property”, but whose delta >-0.7.

–  Timing Mis-Match: The derivative will be MTMed, and the cash position will be accounted for on realization basis

•  Loss on the derivative will be deferred to the extent of BIG in the cash position, but gain on the derivative will be recognized currently

–  Character Mis-Match: Gain or loss on the derivative will be ordinary; gain or loss on cash position will be capital.

• QCC Repeal: Most QCCs have deltas >-0.7. Repealing the QCC exemption to straddle status would exacerbate the non-IHU mixed straddle problem.

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Identification •  Unbalanced Hedge: Taxpayer buys 1,000 shares of ABC, and

buys 7 ABC puts, each of which references 100 shares, with a delta of -0.875 each. There is clearly an IHU – but what is the IHU?

–  700 shares and 7 puts (-0.875 delta)?

–  800 shares and 7 puts (-0.766 delta)?

–  850 shares and 7 puts (-0.7 delta)?

•  Portfolio Hedge: If more than one investment in a taxpayer’s portfolio correlates with a derivative, which underlying investment should be included in the IHU?

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Payments on Derivatives •  Rule: Payments made pursuant to a derivative other

than pursuant to a taxable event are “taken into account” at the time of payment, and “proper adjustment” is made to subsequent gain or loss.

•  Exception: Option Premium.

•  Interpretation: This appears to be a “we know it when we see it” rule. How to make the rule explicit?

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Payments on Derivatives (Con’t) •  Options and Short Sales: Cash received (paid, in the case of a long option) on Day 1 is offset by an equal and

opposite obligation (right, in the case of a long option). As an economic matter, these up-front payments should not be taken into account on Day 1.

•  Proper MTM Accounting: Valuing the difference between cash received (paid) on day 1 and the obligation assumed (right received) on a valuation date reflects economic gain or loss as of the valuation date.

•  MODA Treatment: The foregoing is intuitively correct, but not explicit in MODA.

–  Option Premium: Payments on derivatives “other than [wrt] an option” must be taken into account at time of payment. This seems to indicate that options should be accounted for as described above.

–  Definition of “Option”: Many instruments not labeled “options” have option economics (e.g. swaptions, cash-settled options on indices or rates, caps, floors, FOPs). Unclear whether these are “options” under MODA.

–  Short Sales: Short sale proceeds are not mentioned.

–  Nonperiodic Payments: Up-front payments to enter into off-market swaps or forwards should be accounted for in the same way as option premia – but are not mentioned.

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Mark Upon Entry •  General Rule: Heads The Government Wins, Tails The Taxpayer Loses

–  Gain is recognized as ordinary gain upon entry

–  Built-in Loss (incl. loss on a derivative) is suspended until disposition of the BIL position

•  Character: Why is gain on a capital asset that becomes part of an IHU ordinary? It would be capital, if the position were sold and re-acquired. This is exacerbated by the difficulty of identifying IHU components (see “unbalanced hedge”, above)

•  BIL on Derivatives: Built-in loss in derivatives that become part of an IHU is suspended. This does not seem to make sense – the loss would be MTMed at year end, if the taxpayer continued to hold the derivative naked

•  Holding Period: Holding period in underlying investments is reset to zero upon entry into an IHU. In effect, this converts long-term capital loss to potential short-term capital loss

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Bifurcation •  General Rule: Embedded derivatives are marked. If an embedded derivative can not be

separately valued, both the embedded derivative and the host derivative are marked.

–  Exception: FX denominated bonds need not be bifurcated

•  Problem 1: It is often impossible to bifurcate an embedded derivative, because the quality of being embedded may affect the value of a derivative in a way that prevents it from being valued as a stand-alone instrument. Because of this, bifurcation may not be feasible

•  Problem 2: Everything can be bifurcated. When do you stop?

–  Example 1: Floating rate bond. Fixed rate bond + fixed-for-floating swap?

–  Example 2: Fixed rate bond. Zero coupon bond + floating rate interest option + fixed-for-floating swap?

•  Problem 3: Would the foregoing examples mean that Treas. Regs. 1.1275-4 (CPDIs) and 1.1275-5 (VRDIs) are redundant? Or would these rules’ continued viability mean that bifurcation should not be imputed to CPDIs and VRDIs?

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Valuation •  “Derivative” includes non-traded positions

•  Taxpayers with no financial statements (e.g., individuals) may have access to neither financial statements no broker information.

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Insurance Company Hedges

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Insurance Companies – Gap Hedges •  Business hedging rules under Treas. Reg. §§1.446-4 and 1.1221-2 allow taxpayers to match timing

and character of income, deduction, gain and loss on tax hedging transactions with offsetting items on ordinary business property.

Problem •  Insurance companies hedge duration risk of policies by (i) buying bonds, and (ii) entering into

interest rate derivatives.

•  Because bonds held by insurance companies are not ordinary property, derivatives entered into by insurance companies are not tax hedging transactions to the extent that they hedge bond duration.

•  Under current law, insurance companies take the position that rate derivatives are a hedge of the gap between the duration of their policies and the duration of their bond portfolio.

•  The IRS appears to be sympathetic; although the law is ambiguous, this position’ has not been attacked yet.

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Insurance Companies (Con’t) •  MODA allows insurance companies (as defined in the

last sentence of Code section 816(a)) to treat bonds as ordinary assets.

•  This eliminates the gap hedge issue.

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