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One Step Toward Rethinking Taxes

February 19, 2013

Tax reform, at least in American politics these days, is generally discussed at only the most abstract level. There is general agreement that it would be nice to lower tax rates while broadening the base by getting rid of loopholes. The latter, of course, are seldom specified in any detail, and are very much in the eye of the beholder.

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 wide — 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.

Under the proposal, anyone who owned such a security would have to mark it to market value at the end of each year and pay taxes on the gain, assuming there was one, at ordinary income tax rates.

Then there is the strategy of “covered call writing,” followed by some cautious investors. An investor who owns, say, 100 shares of I.B.M., sells a call option allowing the purchaser to buy the stock at a fixed price for a certain amount of time. The current law treats the profit or loss on the option as a capital gain or loss, but does not levy any tax on the stock until it is actually sold.

Under the Camp proposal, that would change. When the individual sold the covered call option, that would be treated as being equivalent to the sale of the stock, and capital gains tax would be owed on the difference between the market value at the time and the price the investor paid. While the call option was still open, any gain or loss in the stock would be treated as ordinary income or loss, as would any change in the value of the option.

If that provision became law, covered call writing would probably fade away as a tactic used by individuals, at least when the investor had a gain in the stock before writing the option.

The taxation of bonds bought at a discount on the market would also change. Bonds trade at a discount because their interest rate is below the current market level or because the issuer’s creditworthiness has fallen since the bond was issued.

Right now, “there is a tax benefit to investing in discount bonds as opposed to current-pay bonds with the same yield,” said David C. Garlock, the director of financial services for Ernst & Young’s national tax practice. That is because you do not pay tax on the rise in the bond’s value as it nears maturity, until the bond is sold.

That would change. The unpaid interest would accrue and be taxed each year, just as it is now on zero-coupon bonds. There is a partial exemption for owners of distressed bonds bought at deep discounts, but they would still owe some taxes each year, even if they did not sell the bond.

A change that would affect many investors is a rule that would set the tax basis of securities at the investor’s average cost for that security. Now, investors can, if they choose, use a different basis. So an investor who bought 300 shares of a company over time, at prices of $20, $25 and $30 for each 100-share block, would assert that the first 100 sold was the block bought at the highest price. If the selling price was $35, that would produce a reported capital gain of $5 per share.

Under the average age cost method, the gain would be twice that ($35 less the $25 average cost).

The proposal is notably silent on the question of whether capital gains should continue to get a preferential tax rate. And it does not address the issue of carried interest, which allows private equity firms to treat much or all of what they pay their executives as capital gains. President Obama wants to change that, but Republicans have resisted the idea.

Representative Camp says he plans to try to pass a comprehensive bill to overhaul the tax code during the current session, and there is some evidence that he intends to try to do that on a bipartisan basis. This week he and the top Democrat on the committee, Sander Levin, also of Michigan, jointly appointed task forces of committee members to deal with specific tax issues. They seem to have included every contentious issue there is, from charitable deductions to international taxation.

It is obviously a long way from appointing such groups to actually reaching a deal that can pass both the House and the Senate and be signed by the president. But the Camp proposal may be a start to reaching consensus on some of the details that would be in any successful compromise.