The first quarter of this year has brought a bombshell from Capitol Hill that could cause structured products bankers to remember 2013 as the year when tax issues took centre stage in the industry.
Released on January 24, US representative Dave Camp's financial products tax reform discussion draft argues for the greatest overhaul in the taxation of financial products ever to hit the US. Long the pipedream of academics, the draft envisions uniform mark-to-market treatment of derivatives, including options, forward contracts and swaps. Any derivative held by a taxpayer would be treated as if it were sold on the final business day of the year, and any gain or loss taken into account that taxable year. What's more, any gain or loss would be treated as an ordinary gain or loss, thereby removing the preferential long-term capital gains (LTCG) treatment investors have grown accustomed to. On April 10, the Barack Obama administration announced it is proposing a comparable programme that would move derivatives to a mark-to-market regime.
It is difficult to tell at this stage whether Camp's proposal has much legislative potential. Comprehensive tax reform is an ambitious goal, even in a US Congress not as bitterly divided as the current one. The last comprehensive reform of the US tax code was pushed through in 1986. Still, in the words of one former Republican congressman: "Tax reform seems to be the one area in the fiscal arena where we are having constructive discussions. It's the one area that doesn't seem totally stymied." The US House of Representatives Committee on Ways and Means, of which Camp is the chair, did not return a call seeking comment.
The tax treatment of structured products lies in a peculiar - and perhaps a precarious - position, as far as the aims of the draft are concerned. It is analogous to the situation surrounding derivatives such as swaps. "A jumble of rules lacking unifying principles," is how one witness described it at a recent hearing about the proposals. This jumble is what the world's biggest banks have built a huge and hugely profitable business upon - and which the Camp proposal is aiming to tidy up.
There aren’t two instruments, there’s only one note. Who says that for tax purposes you can start bifurcating and creating all sorts of derivative instruments that don’t exist in reality?
A derivatives ‘hodgepodge'
"If enacted, the proposals would resolve the uncertainty around structured notes," says Remmelt Reigersman, New York-based partner at law firm Morrison & Foerster. That is because the thinking among tax lawyers is that structured products such as reverse convertibles and exchange-traded notes (ETNs) would fall under the definition of "derivatives" - a definition that stretches to nearly 800 words in the draft and includes instruments as disparate as credit default swaps, short positions and convertible debt. An investor holding one of these products would have to come up with a value for it at the end of the year and pay tax on any gain, even if they hold on to the instrument. Without LTCG treatment, certain wealthy investors would pay tax at a rate of nearly 40% on their structured products.
As commentators have pointed out, the proposals raise a welter of questions the draft so far leaves unaddressed. For instance, where are investors expected to raise the cash to pay tax on their paper gains? More fundamentally, how should an ordinary investor who holds a few structured notes in his portfolio go about valuing that product every year? Valuing derivatives is notoriously difficult, as the US Securities and Exchange Commission (SEC) has acknowledged. The Internal Revenue Service (IRS) has also had its own issues with valuation. In the 1990s, the IRS set about developing computer software to help it to value derivatives, something they dubbed the "Los Alamos project", according to William Paul, a Washington-based lawyer at Covington & Burling who testified at a recent House subcommittee hearing. Even though it involved the efforts of nuclear physicists who were engaged at the real-life Los Alamos National Laboratories, the project failed.
The tax rules for derivatives are a "hodgepodge," says Paul, compounding the difficulties facing Camp and his team. To date, neither the US Congress nor the IRS has ever laid down any rules or guidance on how investors ought to be taxed on structured products. Instead, the tax treatment of these instruments has largely been the invention of a group of highly creative and well-paid tax lawyers. The IRS declined to comment due to the pending nature of the legislation.
Take reverse convertibles, one of the earliest and most popular examples of structured products in the US. These notes, which are extremely popular in equity bull markets, are of short duration and pay investors a high quarterly or annual coupon. The notes are linked to the share price of a single stock, and as long as that stock trades up or within a range, investors will continue to receive hefty coupons, or at the very least receive their principal back when the notes mature. If the stock tanks, however, the notes convert into shares of the stock at the end of the term, sticking investors with hugely depreciated shares. It is the economic equivalent of an investor entering into a debt instrument with the issuer and writing a put option.
While your typical investor would likely be loath to write a put option and sell it to a bank, they nevertheless perform an economically equivalent act when they buy reverse convertibles. But although the two scenarios are economically equivalent, that doesn't mean they are the same thing, says Reigersman. He explains how the tax treatment of reverse convertibles arose. "In the late 1980s and early 1990s, bankers would explain what was effectively happening. So, people said, ‘Okay, let's do that for the treatment under tax law. Let's split the structured product into two instruments and treat it as debt plus a put option.'
"But the issue is that there aren't two instruments, there's only one note. Who says that for tax purposes you can start bifurcating and creating all sorts of derivative instruments that don't exist in reality?"
The reality is that once a consensus builds, it is lawyers who decide how a structured product ought to be treated for tax purposes. This is permitted to happen because of the lack of rules or guidance from the US authorities. And in the same way an initial consensus is reached - as it was in the early days of reverse convertibles - it can sway if enough influential practitioners weigh in. Structured Products recently reported on a shift in the treatment of reverse convertibles, which is to classify them as "single income-bearing derivative contracts" for tax purposes, rather than bifurcated instruments - a change that can cause investors' tax bills to balloon.
A similar act of guesswork occurred with ETNs. Like other structured products, ETNs typically track a benchmark or a strategy, subject the investor to issuer credit risk and can provide outsized returns. However, unlike most unlisted products, they do not pay a coupon - a key distinction, as it turns out. When Barclays came up with the idea for the products, the bank turned to a prominent New York law firm for tax advice, and what that firm came up with has held for nearly a decade.
According to Barclays, when you buy an ETN, you are buying what is for tax purposes a "pre-paid executory contract". It is the lack of a coupon that helps move these instruments out from under the definition of "debt". What this means is that income you earn from the note, which so long as the underlying co-operates will accumulate every year, is not taxed until you sell the ETN or the issuer redeems it. That means the investor - as long as he holds the note long enough - can convert all that income into LTCG rather than ordinary income. In this way, investors get the benefit both of tax deferral and lower rates.
An early Fortune article flatly called ETNs a "tax shelter". The mutual fund industry has also nursed a long-standing grievance against the products. In testimony about the discussion draft, a senior counsel for mutual fund provider Vanguard pointed out to the committee that ETNs "allegedly involve no tax until they are sold or mature, which could be 30 years in the future, and then they convert all income to long-term gain." He went on to call them "an example of a product whose popularity is likely in part explained by gaps in current tax law." It is these gaps that the Camp proposal, by the committee's own admission, is seeking to fill.
A transparent approach
To the delight of many observers - Reigersman included - Camp and his committee have gone about drafting the proposals and soliciting feedback with complete transparency. The result is that academics and practitioners have been and will be able to add their voices to the debates surrounding the proposals. One suspects that many of the practical kinks could be hammered out in this way. As an example, when asked about the valuation difficulties, Reigersman is quick to proffer a solution. "I can imagine the government looking to brokers to do it. The government could tell brokers who prepare a 1099 tax reporting form each year to also report the fair market value and send a copy to the IRS and a copy to the taxpayer. Broker-dealers are in the business of making markets in these products, so they should be able to come up with a price." Witnesses at the recent hearing offered up their own solutions.
As for the difficulty of getting investors to pay taxes on paper gains - so-called "phantom income" - Shawn Travis, senior counsel at Vanguard, points out that millions of investors in mutual funds already do this. "[I] suspect anyone who would otherwise buy ‘retail derivatives' for non-tax reasons would still do so and pay their taxes from other sources," he said.
But no matter how many clever commentators weigh in, they may not be able to calm the nerves of structured products bankers monitoring the draft's progress in Washington. One New York-based managing director and head of retail structured products distribution admits to losing sleep over the discussion draft. "This will kill any product that is a stock alternative. It's going to put synthetic instruments at a significant disadvantage to cash instruments," he says.
It is true that holders of structured products such as ETNs would face stiffly higher rates. And even if the administrative burden associated with yearly valuation is solved, investors would still be required to pay taxes on paper gains, regardless of whether they sell the product or the product matures. These could become considerable headwinds facing the industry should the proposals move beyond the discussion draft phase and towards serious legislative consideration. The White House proposals, while still sketchy on details, could lead to a similar result.
The tax treatment of structured products was dreamt up by clever lawyers upon cracks and gaps in the US tax code. Camp's proposal is a legislative cement truck rumbling towards a previously untrammelled corner of the financial world. In the real world, this counts as the steady march of progress, but given the policies the industry has already written on its own, many bankers would probably be just as happy keeping things the way they are.
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