US tax proposal targets derivatives’ ‘phantom income

A tax proposal released by the US House of Representatives would require investors to determine the fair market value of their derivatives holdings once a year and pay tax on any gains at ordinary income rates.

The discussion draft, which was released by the Committee on Ways and Means on January 24, seeks to “modernise the country’s tax code” and “minimise Wall Street’s ability to hide and disguise potentially significant risks through the abuse of derivatives”, according to a press release. The committee says it is soliciting comments from stakeholders on the draft.

The definition of derivatives in the draft is broad and includes any embedded derivatives component of a debt instrument.

While the tax would not affect most large financial institutions directly, it could cause the financial products they manufacture and sell to become less attractive to investors. Taxpayers holding structured products, for example, would have to comply with the proposed tax on the embedded derivatives component, thus creating “phantom income” for holders.

“It would put synthetic instruments at a significant disadvantage to cash instruments,” says a New York-based managing director and head of structured products at one bank. “If you single out a product and put it at a clear disadvantage to other products, it’s pretty clear you’re going to have pretty big contraction in activity there.”

It is not clear whether the definition of derivatives in the draft would cover other financial products such as exchange-traded funds.

Under the proposed rules, derivatives held by a taxpayer would be treated as sold on the last business day of the year, with the resulting gain or loss taken into account that year. Any gain or loss would be taxed at the ordinary income rate, which currently ranges from 10% to 39%.

The discussion draft also proposes changes to the treatment of hedging transactions and harmonises the treatment of bonds acquired at discounts on the secondary market.

The New York-based managing director says his bank is analysing the proposals together with various industry bodies, including the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association (Sifma).

Both Isda and Sifma declined to comment.


This article was first published on Risk

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