62 Tax Notes 819

Tax Notes

FEBRUARY 14, 1994

LENGTH: 1032 words

DEPARTMENT: This Week's Tax News (NEW)

CITE: 62 Tax Notes 819

HEADLINE: 62 Tax Notes 819 - ABA TAX SECTION MIDYEAR MEETING: PROFS DISCUSS BLEAK AND EXPLOSIVE WORLD OF NEW FINANCIAL PRODUCTS. (Miscellaneous)

AUTHOR: Johnson, Calvin

Tax Analysts

CODE: Miscellaneous

TEXT:

At the Tax Structure and Simplification Committee meeting on January 28, three law professors examined the challenges to the tax system presented by the exploding world of new financial instruments. Professor Jeff Strnad of USC Law School and Cal Tech, Professor Mark Gergen of Texas Law School, and Professor Reed Shuldiner of Penn Law School led a discussion of financial innovation. While each professor's theory was different, they joined to support incremental movement toward mark-to-market systems for taxing new financial products.

The Future Is Here

Outstanding across the globe are trillions of dollars of new financial instruments for which the tax treatment is unsettled or unsatisfactory. Overtaxation stifles highly beneficial activities that dampen real risk or increase liquidity. Undertaxation allows arbitraging, leading to billions of dollars of easily created, fully marketable, artificial tax losses. The tax law is ill-equipped to respond to financial innovations already in place, and the pace of innovation is increasing.

Strnad previewed his article on 'Taxing New Financial Products: A Conceptual Framework,'to be published in the March 1994 issue of the Stanford Law Review. He presented a theory of 'spanning sets,'drawn from advanced mathematics, to argue that consistent taxation of financial instruments is possible in theory. It is possible, he argued, to replicate the real results from any financial instrument by using a unique combination of atoms or quarks. Each quark would describe a possible outcome of a transaction. The quarks would be combined to describe all the possible results from any given financial instrument, whether new or imaginary. Consistency would be accomplished by breaking down financial instruments into their unique set of constituent quarks, without regard to the form or legal label applied to the instrument. However, consistency would not require that all quarks be taxed under an overall accretion model or a realization or consumption model, so long as the set of quarks applied to each instrument was unique.

While Strnad's spanning set theory gave him optimism about consistency in an ideal world, his outlook turned bleak when he looked at the real world. The taxation of original issue discount bonds, stock, and puts and calls is established, he argued, and thus the tax system is 'overconstrained,'and no court or regulation writer can reach consistency in taxation. In the absence of consistency, a taxpayer can build identical financial results in a number of different ways and so elect to have differing tax results depending only on which way the transaction is presented. Even more threatening, a taxpayer can put together a financial result and its exact 'antimatter'opposite so that there is always a zero real result, but also a usable tax loss.

Gergen presented parts of his work in progress on 'Living in a World With Non Uniform Rules on the Taxation of Financial Contracts.' He argued that 'the sea of taxing financial instruments' is still dominated by the realization model of taxation. We wait to see, he said, the results of contingent payments on stock, payments on swaps, and many contingencies on debt. We wait until an option is closed before taxing even the cash received earlier.

Within this large 'sea,' however, there are islands where financial instruments are taxed under a mark-to-market method or under an 'expected return'method. Examples of the mark-to-market method include section 475 (which taxes securities dealers on their unsold inventory of corporate shares as the value of those shares increases) and section 1256 (which taxes dealers on futures contracts and options by taxing increases in market value, albeit at a reduced tax rate). Examples of the expected return method are found in the imputation of interest on OID bonds or on variable rate debt instruments that taxes investors (and allows deductions) by accruing interest at expected rates before any payments take place.

Gergen argued that the real economic return from a financial instrument should be reduced by the intended tax rate, and that only mark-to-market methods provide a promising way to reach that result. Instruments that avoid mark-to-market methods under current law are sold at a premium on Wall Street. Merrill Lynch, for instance, replaced its MITT securities with SMART (stock market annual reset term) securities because of market fears that the MITTs would be subject to mark-to-market taxation. He calculated that the effect of mark-to-market on a typical transaction increased real taxes by 160 percent over the tax-delayed, realization model tax, even in the face of reduced nominal tax rates. Gergen also argued that expected return methods could easily be defeated by selective realization of losses on volatile investments -- he found, for example, for a 30-year sample of real stocks, that the delayed-tax-realization method and the expected-return method yielded essentially the same real results, at least if losses can be realized and deducted as soon as they accrue.

Shuldiner described recent trends in the taxation of financial instruments. He supported the moves to mark-to-market illustrated in sections 475, 1256, and 1293 (which relates to passive foreign investment companies). He supports the Treasury's move to integrating business hedges so that the losses on market hedges can be treated as offsetting future ordinary income. He also applauded the replacement of rigid, cookbook rules with more flexible rules -- for example, the guidelines contained in the contingent interest regulations. Finally, he argued that the tax law needs to describe the taxpayer accurately as to the taxpayer's own economic position, and that it is foolish for the Treasury to rely on the taxation of the party on the other side of the transaction to 'fix' an error in the taxation of the investor. (See Shuldiner, 'Consistency and the Taxation of Financial Products,' 70 Taxes 781, 1992.)

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-- Calvin H. Johnson

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Calvin H. Johnson is a professor of law at the University of Texas Law School.

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