Derivatives-Tax Plan Concerns Industry

By JOHN D. MCKINNON And SIOBHAN HUGHES for the Wall St. Journal write: The Obama administration's proposal this week to change the way some derivatives are taxed signals common ground with Republicans on a potentially difficult and divisive tax issue that could have far-reaching implications for investors.

Some affected business groups are voicing concern, saying the idea will create complexity and could hurt investors in some widely available financial products, including exchange-traded notes, exchange-traded funds and mutual funds.

That could foreshadow a lobbying fight over the proposal, despite support from GOP Rep. Dave Camp of Michigan, chairman of the tax-writing Ways and Means Committee who floated a similar proposal in unfiled draft legislation in late January.

Derivatives include a broad range of products that derive their value from another financial instrument. They have become widespread and complex. That has resulted in a hodgepodge of tax rules that sometimes treat similar derivatives differently.

Some derivatives even have multiple tax characteristics, for instance mimicking debt in some circumstances and equity in others. With fewer of these financial tools fitting neatly into a particular tax category, there are more chances for mistakes and abuse, the Government Accountability Office found in a 2011 report.

In the case of derivatives known as structured notes, a category that includes many exchange-traded notes, the tax rules are simply "unclear," the administration said Wednesday in budget documents. These notes have become popular among investors as a way to mimic the economics of long-term investments, say, a 30-year investment in high-yielding blue-chip stocks, according to a 2011 congressional report. A traditional investment is subject to tax along the way, for example for dividends. But exchange-traded notes often aren't subject to tax until the contract settles.

The administration proposal would impose a uniform standard on derivatives such as structured notes, requiring them to be "marked to market" for tax purposes each year. That means that gains or losses on the derivative contract would be calculated and reported annually as if the contract were sold for its fair market value. Gain or loss would be treated as ordinary income.

Other categories of investment could be affected. ETF's and mutual funds sometimes use derivatives to create exposure to certain classes of assets.

The administration's proposal brought criticism from the Securities Industry and Financial Markets Association, a trade group.

"We have concerns that the mark-to-market proposal to require individual retail investors to pay tax on unrealized annual appreciation in a wide array of assets at ordinary income tax rates, before receipt of cash, would reduce the current incentives for savings and investment, particularly with respect to assets held outside retirement accounts," said Ken Bentsen, Sifma's acting president.

The administration proposal would apply only to contracts for which a ready market exists. The Camp proposal would go further applying to all types of contracts, raising difficult valuation issues, according to some in the industry. Both proposals would exclude legitimate hedging.