U.S. lawmakers seeking to overhaul the Internal Revenue Code are examining how derivatives and other financial products can be used to exploit the tax system.
Financial instruments, including exchange-traded notes and options, are susceptible to manipulation, according to a report by the nonpartisan Joint Committee on Taxation. Taxpayers can structure transactions to defer income, accelerate deductible losses and take advantage of lower capital gains rates.
“Because our system of taxation has no basis in the reality of economics, sophisticated taxpayers are free to choose a tax treatment that minimizes their taxes, and choose they do,” said David Miller, a partner at Cadwalader, Wickersham & Taft LLP in New York, at a joint hearing of the House Ways and Means and Senate Finance committees in Washington Dec. 6.
Another witness at the hearing, Alex Raskolnikov, a professor at Columbia Law School, said the tax treatment of financial products must be overhauled and can’t be changed piecemeal.
“Derivatives have been used to game every aspect of our tax system,” he said.
The Dec. 6 session was the second joint hearing of the two tax-writing panels since 1940. The first, on treatment of debt and equity, was held in July. The hearing is part of discussions on a tax-code overhaul. Ways and Means Chairman Dave Camp, a Michigan Republican, wants to restructure the code to reduce the corporate and individual rates to 25 percent without lowering tax collections.
Achieving that goal will require eliminating tax breaks or changing underlying tax rules, such as the way derivatives are taxed.
Camp said at the hearing that he hoped to resolve some of the murkiness surrounding financial instruments.
“Today’s marketplace features a wide array of products that can result in different tax or financial accounting treatment of economically similar products, including debt, equity, mixtures of the two and financial derivatives,” he said.
Senate Finance Committee Chairman Max Baucus, a Montana Democrat, last week said that new financial instruments may lead to “mischief.”