Treasury Seeks Advice on Financial Instrument Taxation

The agencies look into equity swaps and commodity swaps among other things. StaffJuly 6, 2001

The U.S. Treasury and Internal Revenue Service, perplexed as to how a certain type of swap arrangement should be taxed, are calling for help on that question and seeking advice on a much wider issue: the appropriate taxation of financial instruments generally, according to Dow Jones Newswires.

Among other things, the agencies want to know if broad new regulations or even legislation is needed before more rules for individual products are drafted.

While controversy over the appropriate taxation of debt, equity and all manner of financial derivatives is nothing new, the timing of the agencies’ current call for comment is significant, says Dow Jones.

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The Treasury has started work on a set of proposals aimed at simplifying the administration of the current tax code and the Bush administration is also considering proposing fundamental tax reform. Responses to the current call for comment could tie in to either of those initiatives as well as help resolve the immediate problem, says the news service.

According to the Congressional Joint Committee on Taxation (JCT), which recently published a major study on tax code complexity, financial instruments are currently covered by an inconsistent patchwork of laws and regulations that can easily lead to abuse.

“For well-advised taxpayers, the existing rules provide opportunities to structure synthetic financial instruments and transactions that achieve desired tax results with little or no impact on the underlying economics of the instrument or transaction,” the JCT said.

“There is almost limitless flexibility in the design of derivatives, and tax rules that provide for differences in tax treatment that do not reflect economic differences may produce inappropriate tax consequences,” quoted Dow Jones from a Treasury and IRS notice scheduled for publication in the July 23 Internal Revenue Bulletin.

Immediately at issue are something known as notional principal contracts (NPCs) with contingent non-periodic payments.

Typically, experts say, they are equity swaps where the size of a final payment depends upon what happens to the price of a particular company’s shares. But contingent NPCs can also be used to insure against the default of a bond, or for various other purposes, says Dow Jones.

Other types of NPCs include interest rate and commodity swaps.

“Equity swaps are a common thing,” David S. Miller, a member of Cadwalader, Wichersham & Taft and an expert on such matters, told Dow Jones. They are often used, he expolained to the news service, by wealthy individuals, insurance companies, corporations and others as an economically efficient means of obtaining a highly leveraged position in a company’s stock.

Current regulations cover NPCs that provide for periodic, non- periodic and termination payments, but all of a fixed nature, says Dow Jones. The prevailing lack of guidance for payments that are contingent on some event taking place has had two effects, the Treasury and IRS explained.

“For some, this uncertainty adds a considerable burden to the tax compliance process and may discourage some taxpayers from entering into NPCs. Other taxpayers welcome the ability to pick and choose among various tax law theories as to the character and timing of NPC payments, but this can lead to a whipsaw of the government,” the two agencies said.

“Both,” they continued, “result in lack of confidence in the tax system and inefficiencies in the capital markets.”

Successfully resolving the situation won’t be easy because solutions involve questions of tax policy rather than just administrative mechanics, the JCT concluded. Because of that, the panel, which provides technical advice to Congressional tax writers, didn’t make any recommendations for reform, reports Dow Jones.

For those interested in weighing in on the appropriate taxation of NPCs, the Treasury and IRS provided something of a tax policy primer in their latest notice. Possible solutions should be weighed against a number of fundamental principles, the two agencies said, listing and explaining them.

That, it turns out, is where the problem begins.

“It is clear that these principles are frequently in conflict and there is no method of accounting that would satisfy all the criteria,” the Treasury and IRS said.

By way of illustration, the agencies themselves proposed four alternative methods of taxing contingent NPCs then dissected the shortcomings of each.

Comments are being solicited not just on the relative merits of those four options and on any alternatives, but also on whether the U.S. tax administrators are empowered to implement a fix, says Dow Jones.

“The Treasury and IRS are interested in what authority taxpayers believe exists for mandating any and each of these methods,” the notice says.

Potential commentators are cautioned that solutions focused too narrowly on contingent NPCs many be inappropriate – except possibly in the case of short term or standardized contracts, says Dow Jones.

Because of the need for proper coordination, the Treasury and IRS are interested in knowing whether taxpayers think new rules should be first developed for a much wider range of financial instruments before contingent NPCs are addressed separately, says Dow Jones.

As matters currently stand, “the existing rules for various financial instruments are so inconsistent with each other that it is difficult to decide, when developing rules for new instruments that can mimic many types of instruments, which set of existing rules should be followed,” the two agencies said.

Along with reviewing issues relating to the timing of NPC payments and expenses, the U.S. tax authorities said they are also considering whether any payments should be characterized as capital gains rather than ordinary income.

The issues in question are particularly important to Wall Street and as such, the tax section of the New York State Bar Association, is expected to weigh in with a major submission – as it has done in the past when such matters have come up for review.

Miller, who co-chairs the group’s tax policy panel, told Dow Jones the new effort would be lead by David Hariton, a member of Sullivan and Cromwell.