Taxation stands at the heart of many financial transactions, and is the full employment act for an army of accountants and lawyers whose sole job is to minimize the tax paid by their clients. A new report from the US Joint Committee on Taxation looked at the interconnected relationships between types of financial transactions and how different tax rules influence the desire to employ one strategy over another. The implication is that tax rules should be harmonized across transaction types. This would mean substantial change for securities financing activities.
According to the Dec 2 report, Present Law And Issues Related To The Taxation Of Financial Instruments And Products:
“Different tax treatment of otherwise economically equivalent transactions also creates opportunities for adverse selection by taxpayers against the fisc. That is, if taxpayers to some extent can choose their tax treatment, they are likely to choose arrangements that result in a lower combined tax bill for all parties involved in a transaction. As alternative investment portfolios become more readily accessible to retail investors and provide more opportunities for them to replicate various positions at lower costs, investors may gravitate towards tax- advantaged forms of investment, thus reducing overall tax revenues. To raise a given amount of revenue, the government may need to increase tax rates elsewhere. This could lead to efficiency losses in the economy if these taxes distort the decisions of taxpayers to work or invest.”
The report also discussed 1256 Contracts, which are meant to encompass all sorts of derivatives but were specifically exempted in Dodd-Frank from covering:
(A) any securities futures contract or option on such
a contract unless such contract or option is a dealer securi- ties futures contract, or
‘‘(B) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.’’.
(Title XVI, Sec 1601(2))
The long and short of this tax talk is that regulators are aware of the differences in tax rates between economically equivalent transactions. Reviewing the swap exemption on 1256 Contracts will be a first step in harmonizing tax rates between products. Market participants should expect that securities financing will be a central part in this conversation.
The Joint Committee on Taxation report is here.