Tax Reform – The Next Installment: Reforming the Taxation of Financial Instruments

After the fiscal cliff deal failed to include a framework for comprehensive tax reform, many in Washington predicted that the momentum for tax reform would wither away. Although Congress has many important issues on its agenda in the new session, including immigration and gun control, the House Ways and Means Committee’s Discussion Draft to Reform the Taxation of Financial Instruments (the “Discussion Draft”) keeps the discussion alive and shows that the reports of tax reform’s death are greatly exaggerated.

The Discussion Draft has several notable characteristics:

- What does it do? The bill attempts to update the tax code to keep pace with rapid innovations on Wall Street by making the rules simpler, fairer and more transparent, while minimizing the potential for abuse. These rules include consistent mark-to-market treatment for derivatives and average basis reporting for the sale of securities.

- What was left out? The proposal does not completely revamp how the federal government taxes financial transactions and instruments. Several significant issues — including active financing, carried interest, debt versus equity financing and the deductibility of interest expense — were left out.

- Tweaks, not wholesale changes. Further, the issues that the proposal does address are reformed in a targeted way. Most of the proposal’s changes are intended to increase transparency and change the timing of how income is taxed.

- Tightening and loosening of tax rules. The draft proposal tightens the tax treatment of financial instruments in some circumstances while loosening rules in others. The approach outlined in the proposal is consistent with the Committee’s efforts to simplify the Internal Revenue Code (the “Code”).

- One piece of the puzzle. The Ways and Means Committee released a draft international tax reform proposal in October 2011 that would move the United States to a territorial system. Like the international proposal, the draft on financial instruments represents just one piece of a larger puzzle to reform the federal tax system. As the 113th Congress moves forward, expect the Ways and Means Committee to release additional pieces of its tax reform positions in other substantive areas.

- Feedback is welcome, but act fast. The Ways and Means Committee is soliciting feedback on the draft proposal from stakeholders. Although there is no official deadline for comments, the time frame for tax reform to begin moving is uncertain, so those interested in the proposal should act quickly to ensure that their voices are heard.

- Momentum continues to build. The draft proposal represents the latest stage in an ongoing effort by the congressional tax writing committees to pursue comprehensive tax reform. The Discussion Draft appears to be a House Republican proposal, rather than a bipartisan or bicameral product. However, Ways and Means Ranking Member Sander Levin (D-MI) appears to support the Discussion Draft as part of a strategy of raising revenues and closing loopholes to reduce the federal deficit.

If enacted into law, the proposals in the Discussion Draft would be effective for transactions entered into after December 31, 2013.

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