Joint Congressional Hearing Addresses Derivatives and Tax Reform

Baucus quotes Buffett on limiting ‘potential for mischief;’ witnesses criticize Congress’ piecemeal approach to taxing financial products

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A joint Senate Finance Committee and House Ways and Means Committee hearing on tax reform and the tax treatment of financial products on Tuesday prompted a Warren Buffett quote from a senator and a lecture on Ptolemy’s geocentric worldview from a witness, both in the service of finding ways to reform the tax code so as to increase tax revenue while not constricting the capital markets.

Sen. Max BaucusChairing the session on the tax treatment of financial products, Sen. Max Baucus, D-Mont. (left), quoted Buffett as saying to his shareholders, “No financial instrument is evil per se; it's just that some variations have far more potential for mischief than others,” then said this potential for mischief was “one of the reasons we are holding this joint hearing.”

Another reason is that the derivatives market has grown hugely in both the U.S.–Baucus put the notional value of derivatives at $230 trillion–and that a lack of transparency around many financial instruments helped cause the financial crisis. Furthermore, Baucus said “financial advisors have created a complex web of new products that mix debt, equity and derivatives. The only purpose of some of these new products is to avoid taxes, or at least defer taxes, which is tantamount to an interest-free loan.” 

Ways and Means Chairman Dave Camp, R-Mich., expressed the hope that a report published for the hearing by Joint Committee on Taxation on tax reform and financial products would “help demystify much of the murkiness" that surrounds financial products while highlighting the complexity of tax rules around these products. Camp said that he was “encouraged” by work done on the issue by the tax section of the American Bar Association, and expressed hope that “others will add their voices to the discussion.”

Thomas Barthold, chief of staff for the Joint Committee on Taxation, formally delivered his 104-page report and illustrated what he called the essential issue using an example of two people who bought two different financial instruments. One of them purchased a zero coupon bond of a publicly traded company and the other bought options on the stock of that company. Both showed the same profit after two years, but one paid capital gains tax and the other paid tax on ordinary income. “The bottom line result,” Barthold said, “is that while the underlying economics of two different financial situations may be equal, their tax treatment is not equal.”

Witness Alex Raskolnikov, a professor at Columbia Law school, said that ‘there’s a lot to like about derivatives, but they’ve also been used to game every aspect of our tax code.” He added that the taxation of financial instruments “is in dire need of reform.” He followed up by laying out three possible conceptual approaches to that reform when it came to derivatives, all of which already have a place in the tax code: 1) marking to market; 2) anticipatory taxation; and 3) retroactive taxation.

It was witness David Miller, a partner at Cadwalader, Wickersham & Taft LLP in New York, who used the Ptolemaic reference to describe how Congress has written tax law to cover financial instruments. “As Ptolemy’s system was geocentric, our federal tax system is based on the equally archaic system of realization—the concept that income is not earned, and therefore not taxed, until a taxpayer actually sells property for cash or exchanges it for materially different property.”

He contrasted that approach with the modern capital markets’ understanding that “true economic income is measured by the increase in the value of assets, regardless of when they are sold … And yet our tax system remains grounded in the antiquated system of realization.”

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