New Proposal for Financial Insitutions

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Title of proposal;  Progressive Mark to Market Tax

Date  Feb 23 2008

Version 1.01

One paragraph overview:  

   A Progressive System of Mark-to-Market Taxation
Current Law
              Our current system of federal income taxation is based upon “realization.” Under a realization-based system, tax is not imposed on a taxpayer until that taxpayer actually “realizes” a gain or loss by selling property for cash or exchanging the property for other property that differs materially, either in kind or extent.
An income tax need not be based on realization. In fact, economists agree that a theoretically perfect income tax would annually value each taxpayer’s assets and liabilities and would tax each person’s “Haig-Simons” income, or their net accretion to wealth.
                          However, there are good reasons for the realization requirement. First, prior to a sale or exchange, taxpayers may not have the cash to pay the tax, but upon a sale for cash, cash to pay the tax is available. (This is the “liquidity” concern.) Second, the value of the property is obvious upon a sale for cash, but the property may be difficult to value prior to sale. (This is the “valuation” concern.) And, finally, even if a taxpayer has cash to pay a tax and the value of his or her property is clear prior to sale, it is regarded as unfair to impose a tax on “paper gains” that may evaporate. (This is the “psychological” concern.) These three concerns apply with greatest force to low- and middle-income taxpayers who do not have liquid cash to pay tax liabilities absent a sale, and to all taxpayers that have unique or thinly-traded property (which is not susceptible to ready valuation).
The realization requirement has an inadvertent benefit for taxpayers — deferral. Under a realization system, because tax is not paid until property is sold, the longer a taxpayer waits before selling his or her property, the less tax that the taxpayer pays on a present value basis.
The deferral benefits of our realization system of taxation are not lost on taxpayers with appreciated property. All other things being equal, taxpayers with appreciated assets hold that property and avoid paying tax rather than sell the assets and pay tax. Moreover, almost since the beginning of our tax code, sophisticated (and usually wealthy) taxpayers enter into transactions that eliminate or reduce the risk in their appreciated property without giving rise to a sale (or “constructive sale”) of that property for tax purposes.
This disincentive to sell is one inefficiency of our realization system of taxation (It is referred to as the “lock-in” effect.) There are others. Taxpayers in a realization system can engage in “strategic trading”: that is, they may hold appreciated assets and defer gains but sell depreciated assets and claim their losses. This, in turn, encourages taxpayers to make riskier investments (because the government subsidizes realized losses but doesn’t tax unrealized gains). Moreover, because a realization system imposes immediate tax on interest and dividends but allows deferral for appreciation, our realization system of taxation inadvertently encourages taxpayers to invest in growth stocks (which tend to pay lower dividends) over “income” stocks.
Also, because our realization system of taxation does not measure “economic” gains and losses, it is susceptible to manipulation. Thus, almost since the beginning of the tax code, taxpayers have attempted to eliminate their risk with respect to appreciated property and “monetize” (or receive cash for it) without triggering realization. Conversely, taxpayers have attempted to sell their depreciated property and claim tax losses without changing their economic exposure to the property. This conduct, in turn, has led to a slew of anti-abuse rules, including the capital loss limitation rules, wash sale rules, straddle rules, conversion transaction rules, and constructive sale rules, as well as complicated sets of accounting rules for “contingent payment debt instruments” and “contingent swaps.” These rules create enormous complexity in our tax code.
Despite these rules, the uneconomic nature of our realization system invites tax planning to develop new financial instruments and transaction that capitalize on realization.
One category of financial instruments permits taxpayers to defer future gain. “Exchange traded notes” are the latest financial product to attract attention because of their deferral properties. Other financial instruments permit taxpayers to reduce their risk in appreciated property and extract cash without triggering realization (and, consequently, tax). A third category of transaction permits taxpayers to trigger realization in depreciated property and claim their losses without changing their economic position.
Our federal income tax system is often said to be progressive, meaning that taxpayers in higher income tax brackets are subject to a higher rate of tax on their realized income, and President Bush has called progressivity “fundamental to fairness in taxation.” But, because no tax is imposed on unrealized gains, our realization-based tax system also has the effect of imposing a much higher effective rate of tax on wage earners than investors, calling into question the fundamental fairness of the tax system and its progressive nature.
Consider two taxpayers. The first is a wage earner who is subject to tax at a 15% rate. The second is a billionaire investor who earns no wages. His long-term capital gains are also subject to tax at a 15% rate. Assume that the wage earner earns $18,000 and the billionaire’s investments increase in value by $18,000 but he does not sell them. Economists would conclude that the economic (or Haig-Simons) income of these two taxpayers for the year is the same – $18,000. However, only one of these taxpayers will pay any tax. The wage earner will pay $2,700 in tax and will be left with $15,300 after tax. The investor will pay no tax and will keep all $18,000 of his economic income. Moreover, the investor could enter into derivatives that eliminate at least 80% of his economic risk with respect to his investments, and provide him with $18,000 of cash, all without triggering realization. And, as illustrated above, if the billionaire waits ten years before selling his property, he could reduce the present value of his tax rate to 7.13% (or, if he waited long enough, zero). Thus, the present value of the billionaire’s effective tax rate would be less than half the tax rate of a wage earner with an $18,000 salary.
This disparity exists because low-income taxpayers earning wages are taxable on all of their economic income (except what they are able to contribute to a section 401(k) or other retirement plan), but wealthy taxpayers benefit from deferral with respect to their unrealized gains, and this deferral dramatically reduces the effective rate of tax on their economic income.
Moreover, although the tax system ignores unrealized appreciation, GAAP now requires mark-to-market treatment for most publicly-traded securities and many derivatives. Thus, corporations may treat appreciation in the securities they hold as earnings for account purposes but exclude them for tax purposes.
The realization requirement of our federal tax system is not immutable. In fact, Congress has demonstrated an increasing willingness to depart from it.
For example, section 1256 imposes tax on the gains from certain options and futures contracts as if they were disposed of for fair market value on the last business day of the year and then immediately repurchased.
Section 475 of the Code provides that securities dealers must “mark to market” their securities at the end of the taxable year. Section 475 was enacted, in part, because Congress concluded that the “lower of cost or market” method of accounting used by securities dealers tended to understate their income.
Finally, in 1997, Congress enacted section 1259, which requires a taxpayer to recognize gain if the taxpayer eliminates substantially all of the economic benefits and burdens in certain appreciated financial positions, even if the position is not sold.
Reasons for Change
The President, Barack Obama, and Hillary Clinton believe that the federal tax system should be progressive, and John McCain, Barack Obama and Hillary Clinton all believe that our federal tax system should be fair. A progressive and fair system means, at the very least, that the very wealthiest investor should pay tax on his or her economic income at the same present value rate as the poorest wage earner.
However, that is not true under our current system of tax. Deferral under our current realization system of taxation permits the wealthiest investors to avoid all tax on the appreciation in their securities. This ability results in wealthy taxpayers paying a lower effective rate of tax on their economic income than the very poorest taxpayers, which undermines the fairness of our tax system and its progressive nature. The proposal would level the playing field, by assuring that the wealthiest taxpayers pay tax on their economic income at the same effective rate as the poorest wage earner, and enhance the progressivity and fairness of our federal tax system.
Fairness also means that wealthy taxpayers and corporations cannot exploit the tax rules to reduce their taxes. Even with the various anti-abuse rules, wealthy taxpayers and large corporations can still use stocks, securities and derivatives to exploit the realization tax system and obtain deferral and tax savings that are not available to lower-income taxpayers. Because the proposal would tax economic income, abuse is all but impossible.
Deferral also permits large corporation to report earnings to their shareholders, but avoid tax on those earnings. The proposal would ensure that large corporations pay tax on the earnings reported to their shareholders from publicly-traded securities and derivatives.
President Bush, John McCain and Barack Obama all call for a simpler tax system. Our realization system of taxation requires no fewer than five separate regimes of anti-abuse rules, and several complicated accounting systems to address manipulation of our realization systems of taxation. The proposal would moot those anti-abuse provisions for the lowest income taxpayers (who would pay no tax on investment income), and , the highest income taxpayers, and large corporations (who would be on mark-to-market) and permit significant simplification.
The historic reasoning underlying our realization system of taxation — liquidity, valuation, and psychology — does not apply to the publicly-traded securities of the highest earning and wealthiest individuals, and large corporations. These taxpayers are fully capable of borrowing against their liquid securities and therefore do not generally have liquidity concerns. Also, because publicly-traded securities are easy to value, valuation concerns are not present. And, finally, there is less of a psychological concern for these liquid and sophisticated taxpayers who have access to derivatives to hedge their market risk and lock-in their “paper gains,” and can borrow against or otherwise monetize their appreciated securities.
Thus, the proposal, by eliminating deferral on publicly-traded securities for the wealthiest individuals and corporations, would help make our tax system fairer, simpler, and more progressive, without raising current tax rates or imposing any new taxes.
By imposing mark-to-market taxation on high-income and high-net-worth taxpayers only, exempting low-income taxpayers from tax on investment income or expanding tax-free retirement plans, and retaining the realization system for all other taxpayers, the proposal would use the incidence of tax on investment assets to achieve progressivity: no tax for low-income taxpayers, mark-to-market for high-net-worth and high-income individuals and large corporations, and realization for everyone else. In short, the proposal would expressly use realization as a subsidy for those who need it and deny it to those who do not. By eliminating tax on the investment income of low-income taxpayers, the proposal also would encourage savings for the most important segment of the population. By eliminating deferral, lock-in/lock-out, and strategic trading for mark-to-market taxpayers, the proposal would enhance the efficiency of the tax system and the capital markets. And, by conforming the tax and GAAP treatment of most publicly-traded securities and derivatives, the United States would join the United Kingdom in what is likely to become a global trend toward increased book tax conformity.
Explanation of Proposal
Overview
Under the proposal, all public companies, all private companies with $50 million or more of net assets, and all individuals and married couples with $1.6 million of adjusted gross income or $5 million of publicly-traded property would be required to mark to market their publicly-traded property, derivatives with respect to publicly-traded property, and certain publicly-traded debt and other liabilities.
Married individuals with annual taxable income of $58,100 (or unmarried individuals with annual taxable income of $29,050) and investment assets of $50,000 or less (excluding assets held in tax-exempt retirement accounts) would be exempt from tax on all capital gains, dividends, and interest. All other taxpayers would remain on the realization system. Realization taxpayers would be permitted to elect mark-to-market treatment for any publicly-traded property they hold.
Mark-to-market gains of corporations would be subject to tax at the current marginal rate of 35%. Mark-to-market losses of corporations would be fully deductible against ordinary income or capital gain. Mark-to-market gains (and qualified dividends) of individuals would be subject to tax at the long-term capital gains rate of 15%, and the interest and other ordinary income of individuals would remain subject to tax at the ordinary income rate of 35%. Individuals who are securities dealers, or who receive allocations of gains for performing investment services, would not benefit from the reduced rates of tax.
Individuals’ mark-to-market losses would be fully deductible to the extent of prior mark-to-market gains, could then be used to offset capital gains, and then could offset 43% (15%/35%) of ordinary income or could be carried forward indefinitely.
The proposal would generally bifurcate financial instruments into a debt component and a nondebt mark-to-market component and, for corporations, isolate any section 1032 component. The proposal would also generally accelerate the recognition of deferred compensation that is measured by reference to publicly-traded property.
The proposal would apply to all changes in value in publicly-traded property that occur after the date of enactment.
Mandatory Mark-To-Market Taxpayers
Public corporations. Under the proposal, publicly-traded corporations would be subject to mark-to-market taxation on their publicly-traded securities and derivatives. Publicly-traded companies are required under GAAP to annually mark to market their marketable equity securities, debt securities that are not intended to be held until maturity, and some of their derivatives, and use those valuations to report their earnings or other comprehensive income.
Large private C corporations. Mark-to-market taxpayers would also include ‘‘large’’ private subchapter C corporations that report shareholder equity of $50 million or more on audited financials, or have net assets (that is, assets less liabilities) with a fair market value of $75 million or more. Those thresholds correspond roughly to the requirements for listing on the NASDAQ and Amex stock exchanges.
Mark-to-market thresholds for individual taxpayers and trusts. The proposal would impose mandatory mark-to-market treatment on any individual, married couple, or trust with annual adjusted gross income (including tax-exempt income) in excess of $1.6 million, and on any individual, married couple, or trust with $5 million or more of publicly-traded property, cash, or cash-equivalent investment assets. The $1.6 million threshold roughly corresponds to the highest 0.1% income-earning individual taxpayers and married couples (roughly 290,000 households), and would be adjusted annually in sizable increments (for example, $500,000) to track the taxable income of the 0.1% highest-income individual and married couples.
The $5 million threshold roughly corresponds to the wealthiest 0.1% of taxpayers and also mirrors the $5 million threshold that establishes a ‘‘qualified purchaser’’ under the Investment Company Act of 1940. Under the proposal, the threshold would be presumed to be satisfied for any taxpayer in any tax year if the taxpayer represents (or is the beneficiary of a trust or the 10%-or-greater equity holder of any vehicle that represents) that it is a ‘‘qualified purchaser’’ for purposes of the Investment Company Act of 1940 in connection with the purchase of a security and the security is not directly used in, and reasonably necessary for, an active trade or business.
            Also, for purposes of determining whether an individual satisfies the $5 million gross asset test, assets in qualified retirement plans (for example, 401(k)s, HR10s, and IRAs) and assets generated by up to $1 million of premiums paid for insurance policies or annuities would be excluded from the asset test. However, if an individual had paid more than $1 million in insurance or annuity premiums, a proportionate amount of the assets corresponding to the excess would be included for purposes of the asset threshold.
For purposes of determining whether a taxpayer satisfies the gross asset test, a taxpayer would be treated as owning her distributive share of the publicly-traded assets held through a subchapter S corporation or any non-publicly-traded partnership, trust, registered investment company, real estate investment trust, and any non-mark-to-market domestic C corporation that satisfies the asset or income test for a passive foreign investment company or is organized (or marketed) with a principal purpose to avoid mark-to-market treatment. Those vehicles would be required to provide each mark-to-market partner, shareholder, and beneficiary with her share of the gross value of its publicly-traded property. (Those vehicles are referred to as reporting vehicles.)
Exempt Taxpayers
Unmarried individuals with annual taxable income of $29,050 or less, and married individuals with annual taxable income of $58,100 or less who hold investment assets of $50,000 or less (excluding assets in tax-exempt retirement accounts and assets generated by up to $50,000 of premiums paid for insurance polices or annuities), would be exempt from all tax on investment income as long as they are not otherwise mandatory mark-to-market taxpayers.
Realization Taxpayers
All taxpayers that are not mandatory mark-to-market taxpayers or exempt from tax on investment income would remain realization taxpayers. Realization taxpayers would be permitted to irrevocably elect mark-to-market treatment for any of their publicly-traded property on acquisition.
Treatment of Mark-to-Market Corporations
Under the proposal, all mark-to-market corporations would be required to mark to market (that is, treat as sold and repurchased) their mark-to-market positions (and the positions attributed to them through reporting entities), report the resulting gains or losses, and adjust their basis accordingly. Corporations would treat their mark-to-market gains as ordinary income.
Because a mark-to-market system eliminates the ability of taxpayers to “cherry-pick” losses, the proposal would treat any mark-to-market losses as ordinary losses. Accordingly, mark-to-market losses would be fully available to offset both capital gains and ordinary income of corporations.
Special Rules for Individuals
Overview. Mark-to-market gains of individuals would be subject to tax at the long-term capital rate of 15%. Qualified dividends received by individuals would also be taxed at 15%, but the holding period requirement would be eliminated for stock that is mark-to- market property. Interest and other ordinary income of individuals would remain subject to tax at ordinary rates.
Mark-to-market losses of individuals could offset mark-to-market and other capital gains, and then 43% (15%/35%) of any remaining mark-to-market losses would be available to offset ordinary income, or could be carried over indefinitely. The straddle rules and section 263(g), the wash sale rules, the constructive ownership and constructive sale provisions, the foreign currency rules, and the PFIC rules would not apply to mark-to-market property whose gain is fully recognized.
The proposal would bifurcate prepaid forwards, convertible bonds, and contingent payment debt instruments (CPDIs) into a nonconvertible/noncontingent debt component that would accrue original issue discount (taxable at the ordinary income rate of 35%), and a mark-to-market component (taxable at the long-term capital gains rate of 15%).
Convertible bonds, contingent payment debt instruments, and prepaid forwards and swaps. The proposal would change the treatment of individual mark-to-market holders of convertible bonds, CPDIs, and prepaid forward contracts, swaps, and other derivatives. Under the proposal, a mark-to-market individual that holds a mark-to-market convertible bond or CPDI that is itself publicly-traded or references mark-to-market property would deconstruct the convertible bond or CPDI into a nonconvertible/noncontingent debt instrument with a yield equal to the issuer’s comparable yield and a non-debt option or other derivative contract (that is, the convertible bond or CPDI would be treated as the equivalent unit).
Also, the taxpayer would deconstruct a prepaid forward, deep-in-the-money option, or prepaid swap into a debt instrument (or deposit) with an issue price equal to the prepayment or premium and a yield equal to the counterparty’s comparable yield, and a mark-to-market derivative. The taxpayer would accrue original issue discount (taxable at 35%) on the debt instrument component, add any accrual to its basis, and treat the difference between the fair market value of the instrument and its adjusted basis as mark-to-market gain or loss taxable at the 15% rate. The issuer of a debt instrument or the financial institution counterparty on a derivative would be responsible for the bifurcation, and a designated position mark provider (as described below) would be responsible for the valuation of each component.
The Scope of Mark-to-Market
Publicly-traded property. Mark-to-market property would be defined broadly to include any property for which price quotations are readily available, so long as there exists a reasonable basis for determining fair market value. Mark-to-market property would include stocks, securities, publicly-traded partnership interests, commodities, foreign currency, and potentially any other publicly-traded property.
More specifically, mark-to-market property would include all actively traded personal property as defined under Treasury regulations section 1.1273-2(f)(4) and all property for which price quotations are “readily quotable” within the meaning of Treasury regulations section 1.1273-2(f)(5) (but determined without regard to the exclusions in Treasury regulations section 1.1273-2(f)(5)(ii)). Also, property would be treated as mark-to-market property if quotations are available from the issuer (that is, a registered investment company (RIC) or hedge fund that redeems interests periodically) or persons other than dealers, brokers, or traders.
Property would qualify as mark-to-market property if price quotations are available at least quarterly; less frequent valuations would be determined on a case-by-case basis, governed by the inclusive “reasonable basis for determining fair market value” standard. Also, any nontraded property that is convertible into publicly-traded property and any nontraded property that is substantially similar to publicly-traded property would qualify as mark-to-market property. The IRS would have the power to treat any non-publicly-traded property as publicly-traded if restrictions are imposed to avoid characterization of the property as publicly-traded.
It is anticipated that, under those rules, stocks that appear on the NASDAQ bulletin boards would be treated as publicly-traded, and stock traded only on the “pink sheets” would not generally be treated as publicly-traded. However, if trading on the pink sheets is sufficiently robust to permit a reasonable basis to determine fair market value, then even pink-sheet-traded stock could be treated as mark-to-market property.
Finally, if a mark-to-market taxpayer reports earnings under GAAP, any property required to be marked to market under GAAP would be presumed to be mark-to-market property.
Treatment of debt and other liabilities of a mark-to market taxpayer. Under the proposal, a mark-to-market taxpayer would not be required to mark to market the “plain vanilla” fixed-rate debt instruments and variable-rate debt instruments (VRDIs) that it issues (including plain vanilla — non-CPDI — convertible debt), even if the debt is actively traded, unless the taxpayer so elects.
Nevertheless, the issuer of those instruments would be permitted to mark them to market. A convertible debt instrument that is marked to market by its issuer would be bifurcated into a nonconvertible debt instrument issued at a discount and an option on the issuer’s equity (that is, a convertible debt instrument would be treated as the equivalent unit). The issuer would be permitted to deduct the OID attributable to the discount debt instrument (as adjusted for the market value of the deemed instrument), but would not recognize gain or loss on the section 1032 component. However, if an issuer did elect to mark to market a convertible debt instrument, all holders (and not only mark-to-market holders) would be required to treat the instrument as if it were the equivalent unit. (That treatment would maximize the issuer’s interest deductions and holders’ inclusions; however, that treatment is already effectively elective under current law.)
All other debt instruments and other liabilities of a mark-to-market taxpayer (other than fixed-rate debt instruments and VRDIs that the taxpayer has not elected to mark to market) for which price quotations are “readily available” would be treated as mark-to-market positions, and would be required to be marked to market. Moreover, if a mark-to-market taxpayer has actively traded debt outstanding for which price quotations are readily available, all nontraded debt of the taxpayer (other than fixed-rate debt instruments and VRDIs that the taxpayer has not elected to mark to market) would be treated as a mark-to-market position so long as there exists a reasonable basis to determine the fair market value of the nontraded debt (or a portion of the debt) by reference to the traded debt. Finally, all privately traded CPDIs that reference actively traded property (including the issuer’s stock or dividend rate) issued by a mark-to-market taxpayer would be subject to mark-to-market treatment.
All mark-to-market debt instruments issued by a taxpayer that reference the equity of the taxpayer or a related party or are payable or convertible into the equity of the issuer or related party would be deconstructed into a debt instrument that does not reference the taxpayer’s (or the related person’s) equity and one or more section 1032 derivatives (and possibly one or more non-section-1032 derivatives). The taxpayer would be entitled to interest deductions only with respect to the debt instrument, section 1032 would apply to the section 1032 derivatives, and section 163(l) could be repealed for mark-to-market taxpayers.
A mark-to-market CPDI issued by a mark-to-market taxpayer directly or through a reporting vehicle would be deconstructed into a plain vanilla fixed- or variable-rate debt instrument and one or more other mark-to-market property interests. The plain vanilla debt component would accrue interest or OID (and would not be marked to market absent a specific election by the taxpayer), and the mark-to-market components would be marked to market (that is, the treatment will be identical to the treatment of the issuer under current law that issues a unit consisting of a discount obligation and one or more derivatives). That bifurcation rule would create complexity but appears necessary to achieve parity between an issuer of a plain vanilla debt instrument and an independent CPDI, on one hand, and an issuer of a single CPDI that is the economic equivalent of the two instruments, on the other.
If a mark-to-market taxpayer is subject to mark-to-market treatment with respect to debt or the debt component of a CPDI, the mark-to-market taxpayer would accrue interest or OID on the debt (or debt component) as under current law, and would adjust the adjusted issue price of the debt instrument accordingly. Differences between the fair market value of the debt instrument and its adjusted issue price at the end of the year would be reported as ordinary income or loss to the extent attributable to increases or decreases in the credit quality of the issuer and as mark-to-market gain or loss to the extent attributable to external market factors (such as interest rate changes or the value of property referenced in the debt instrument). The adjusted issue price of the debt instrument would be adjusted accordingly.
Mark-to-market gains on debt or other liabilities of a mark-to-market issuer that are attributable to a decrease in the creditworthiness of the issuer would be treated as ordinary income and would benefit from cancellation of indebtedness (COD) relief under section 108 only if the taxpayer is insolvent or bankrupt at the time of the mark.
Mark-to-market losses that are attributable to an increase in the creditworthiness of the mark-to-market issuer would give rise to ordinary deductions to the extent of prior “credit” inclusions.
Issuers of mark-to-market indebtedness would be responsible for deconstructing it into its components, but primary responsibility for the valuations of the components would lie with the financial institution that is designated as the mark provider for the particular instrument, as described below.
Treatment of derivatives and compound instruments held by a mark-to-market taxpayer. Any derivative or compound instrument that directly or indirectly references mark-to-market property would be treated as mark-to-market property to the extent its value changes based on changes in the mark-to-market property. Thus, an on-market equity swap referencing publicly-traded stock would be treated entirely as mark-to-market property.
For that purpose, an interest rate swap would be treated as mark-to-market property unless it is identified as a hedge with respect to non-mark-to-market property.
A swap that provides for a significant upfront payment to the taxpayer would be bifurcated into a fixed-rate debt instrument or a VRDI issued by the taxpayer, and an on-market swap. The mark-to-market taxpayer would not be required to mark to market the fixed-rate debt instrument or VRDI component, but could elect to do so.
If a compound derivative or debt instrument references both mark-to-market and non-market-to-market property, the derivative would be bifurcated into a derivative that references solely mark-to-market property and a derivative that references solely non-mark-to-market property, based on relative fair market values. Thus, a nontraded CPDI held by a mark-to-market taxpayer with a redemption price equal to the greater of par and a portion of the appreciation in a publicly-traded index would be treated as a zero coupon bond plus a mark-to-market property interest in the index. Because positions in publicly-traded foreign currency are treated as mark-to-market property, the proposal would require a taxpayer that purchases a nontraded debt instrument denominated in a foreign currency to bifurcate the instrument into a mark-to-market foreign currency swap and a non-mark-to-market dollar-denominated debt instrument. (However, as described below, if the foreign currency swap or the debt instrument functions as a hedge, the taxpayer could exclude it from mark-to-market treatment.)
All derivatives that reference the issuer’s stock or dividend rate would also be bifurcated into a section 1032 derivative and a non-section-1032 derivative and the taxpayer would recognize gain or loss only on the mark-to-market value of the hypothetical derivative that does not reference the issuer’s stock or dividend rate. (In that respect, section 1032 would be expanded along the lines recommended by the Tax Section of the New York State Bar Association. ) Also, members of the issuer’s consolidated group would recognize gain but not loss on any section 1032 gains relating to the issuer’s stock.
Deferred compensation and compensatory options. Under the proposal, if a mark-to-market taxpayer is entitled to deferred compensation and the deferred compensation directly or indirectly references mark-to-market property, the mark-to-market taxpayer would be subject to tax on the fair market value of the deferred compensation if (and when) it is no longer subject to substantial risk of forfeiture. Also, if a mark-to-market taxpayer receives a compensatory option with respect to the stock of a publicly-traded employer (or a compensatory option with respect to any other entity if 25% or more of the entity’s gross assets consist of mark-to-market property), the mark-to-market taxpayer would be subject to tax on the fair market value of the option to the extent it is in-the-money and not subject to a substantial risk of forfeiture. If such an option is issued by a nonpublic employer, it would be bifurcated into an option on the mark-to-market property of the employer and an option on the non-mark-to-market property, and the deemed mark-to-market option would be subject to mark-to-market treatment based on its fair market value when it is not subject to a substantial risk of forfeiture.
The initial tax would be imposed on the employee at the 35% rate, and the employer would be entitled to an ordinary deduction when the mark-to-market employee reports the income. Thereafter, the mark-to-market employee would be subject to mark-to-market taxation on the deferred compensation or option (that is, the option would be valued) at mark-to-market rates (that is, 15% for mark-to-market individuals) and the employer would not report any gain or loss.
Exceptions From Mark-to-Market Property
Greater-than-50%-owned publicly-traded subsidiaries of publicly-traded corporations. The proposal excludes greater-than-50% owned subsidiaries of mark-to-market corporations from mark-to-market treatment.
REMIC residuals. Although REMIC residuals are rarely, if ever, publicly-traded property, the proposal would exclude them from mark-to-market treatment as the regulations under section 475 currently do.
Hedging transactions. Under the proposal, a taxpayer could elect to exclude any mark-to-market position (including mark-to-market components) that is used in a hedging transaction (as defined in Treasury regulations section 1.1221-2) with respect to non-publicly-traded property from mark-to-market treatment. Thus, if a farmer were to purchase futures contracts to hedge price movements for his crops, the farmer would not be required to mark to market the futures contract. Similarly, a taxpayer that enters into an interest rate swap to hedge non-mark-to-market debt could treat the interest rate swap as a hedge and would not be required to mark to market either the swap or the debt. Finally, a mark-to-market taxpayer would be permitted to identify one mark-to-market position (including a component of a financial instrument that is subject to mark-to-market treatment) as a hedge of another and mark the two positions as a unit so long as the integration reflects economic income at least as clearly as separate marks.
Intrayear Transfers
If a mark-to-market taxpayer ceases to be the owner of a mark-to-market position at any time during the year (including by reason of death), the taxpayer would immediately recognize gain or loss on the property as if it were sold for its fair market value immediately before the taxpayer ceased to be the owner (even if the transfer would not be subject to tax under current law). Thus, mark-to-market taxpayers would recognize gain or loss immediately on the contribution of mark-to-market property to a partnership or corporation, or on a gift of mark-to-market property.
Reporting by Entities
Under the proposal, a mark-to-market taxpayer would be required to mark to market its distributive share of the mark-to-market property held by any non-publicly-traded non-mark-to-market trust, partnership, S corporation, RIC, real estate investment trust (REIT) REIT, qualified electing fund (QEF), PFIC, CFC, or foreign insurance company (even if the foreign insurance company is not a PFIC).
Also, mark-to-market taxpayers would be required to mark to market their distributive share of the mark-to-market property of any non-mark-to-market domestic C corporation that satisfies the asset or income test for a PFIC, or is organized (or is marketed) with a principal purpose to avoid mark-to-market treatment. Shareholders in those domestic C corporations would be taxable on those mark-to-market gains at the mark-to-market rate (that is, 15% for individuals) and would be permitted to deduct mark-to-market losses to the extent of prior mark-to-market gains from the corporation. Mark-to-market gains from those corporations would increase (and mark-to-market losses would decrease) the shareholder’s basis in the stock.
Those domestic entities would be required to supply each of their mark-to-market shareholders, partners, and beneficiaries their distributive shares of the entity’s mark-to-market gains and losses; however, mark-to-market shareholders would be required to obtain that information from foreign entities. A mark-to-market taxpayer that fails to obtain monthly marks would be taxable at ordinary income rates and would be subject to a deferral interest charge, based on the constructive ownership rules, on their share of the gain on sale that is attributable to mark-to-market property (and all gain would be presumed to be attributable to mark-to-market property unless the taxpayers could demonstrate some lesser amount).
Administration and Valuation
Under the proposal, a financial institution would be designated as the “position mark provider” for each mark-to-market position and would provide valuations to mark-to-market taxpayers. Also, each mark-to-market taxpayer could designate one or more “taxpayer mark providers” to value their mark-to-market positions under alternative valuation conventions, or on a hedged or portfolio basis. A taxpayer that relies on the valuation of a mark provider in good faith would be subject to tax on any gain resulting from the misvaluation, and interest at a market rate, but would not be subject to penalties.
Dealers in securities, traders in securities electing under section 475(f), mutual funds, qualified institutional buyers, and other large taxpayers that receive approval from the IRS would be permitted to value their own positions. However, those taxpayers could be subject to penalties for improper valuation.
Annual valuations by mark providers. Under the proposal, a position mark provider would be designated for each mark-to-market position issued by a U.S. taxpayer, marketed to U.S. persons, or for which a U.S. withholding agent exists, unless monthly valuations are widely available to the public. Position mark providers would be required to provide annual calendar-year valuations to mark-to-market holders and, on request, monthly valuations. Mark-to-market taxpayers would report the values determined by the position mark provider unless the mark-to-market taxpayer is permitted to value its own positions or has designated a taxpayer mark provider that values the taxpayer’s position under some other acceptable method. Position mark providers would include financial institutions described in Treasury regulations section 1.165-12(c)(iv) and other approved persons.
Although the issuer of a compound debt instrument would be responsible for deconstructing it into its components, the position mark provider for the instrument would be responsible for valuing the components.
Position valuations would be based on fair market value, with specific adjustments. For example, the values of “long” positions would not be permitted to take into account blockage, minority, marketability (or illiquidity), fragmentation, or investment company discounts.
Also, each mark-to-market taxpayer could designate one or more taxpayer mark providers. Taxpayer mark providers would value (i) positions for which no position mark provider has been designated (for example, foreign securities not offered to U.S. persons), (ii) hedged positions, and (iii) positions on a portfolio basis.
Taxpayers would be permitted to instruct their taxpayer mark providers to use some averaging conventions (for example, over the 30-day period preceding the tax year) that are consistent with the method used by the position mark provider and do not systematically understate or overstate value. If a taxpayer adopts an averaging convention other than closing value on the last day of the taxpayer’s tax year, the taxpayer would be required to use the method consistently. Taxpayer mark providers also would not be permitted to take into account blockage, minority, marketability (or illiquidity), fragmentation, or investment company discounts.
The IRS would establish broad principles by revenue procedure or other guidance to value derivatives, and methods could be subject to specific approval by the IRS (analogous to advance pricing agreements). For example, it would be anticipated that the method described above for GAAP reports could also be used for taxpayers that are not GAAP reporters.
As long as a taxpayer relies in good faith on a mark provider’s valuation, the taxpayer would not be subject to penalties for reporting an inaccurate value; instead, the taxpayer would be subject only to additional tax based on the correct value and a market rate of interest on any deferral. However, a taxpayer could not rely in good faith on the valuations provided by a mark provider that represents or implies that its valuation method results in lower tax liability than a competitor. Taxpayers that value their own positions could be subject to penalties for improper valuation.
A mark provider (or a taxpayer valuing its own positions) that complies in good faith with the published guidance or an approved method would not be subject to penalties, even if a valuation is inaccurate. However, a mark provider would be presumed to be acting in bad faith if it attempted to gain a competitive advantage by claiming or implying that its valuation method results in a lower tax liability than a competitor.
Mark providers (and taxpayers valuing their own positions) would be required to disclose to the IRS any differences between the methods used to determine valuations for mark-to-market purposes and the valuations used for the mark provider’s (or taxpayer’s) own internal purposes (for example, compensation), for purposes of the mark provider’s financial reports under GAAP, or other mark providers’ valuations of the same or substantially similar positions. The disclosure of the differences would permit the IRS to choose between competing valuation methods, but those differences would not imply bad faith.
Taxpayers maintaining ‘reliable financials’. Under the proposal, any taxpayer maintaining “reliable financials” could elect to use GAAP valuations (subject to specific adjustments) in lieu of using the valuations provided by a mark provider to value any position that is marked to market both for tax and GAAP purposes. An election to use GAAP valuations would be irrevocable and would apply to all of the taxpayer’s mark-to-market positions that are marked to market both for tax and GAAP purposes. A taxpayer that makes a GAAP valuation election would be required to disclose differences between the GAAP valuation and the valuation provided by the taxpayer’s mark provider.
Penalty for Failure to Mark
Any mark-to-market taxpayer that did not report a mark-to-market position on a mark-to-market basis would be required to report any gain as ordinary income and would be subject to a deemed interest charge based on the amount of interest (at the underpayment rate) that would have resulted if the gain had accrued at a constant rate equal to the AFR over the taxpayer’s holding period.
Illiquidity Loans
Under the proposal, the government would make or guarantee loans to permit taxpayers to pay their taxes on illiquid or restricted mark-to-market property. The loans would be administered by mark providers for a standard fee. The loans would bear market rates of interest (or market rate plus a spread); in all events, that rate of interest would be less than the penalty rate for deferral. The loans would be secured by the publicly-traded property.
Taxpayers That Flip In and Flip Out
A taxpayer that becomes subject to mark-to-market taxation in a particular year would be subject to mark-to- market treatment for that entire tax year. The taxpayer would have until the date its tax return is due to designate mark providers for the taxpayer’s mark-to-market property and liabilities; the mark provider would be required to mark the taxpayer’s mark-to-market property as of the first day and the last day of the tax year.
A taxpayer that was a mark-to-market taxpayer in a previous year but is no longer subject to mark-to-market treatment would return to realization taxation at the beginning of the tax year with an adjusted basis in its assets that reflects prior mark-to-market taxation.