Professor Raskolnikov Testifies at Joint Hearing on Reform of Derivatives Tax

Professor Raskolnikov Testifies at Joint Hearing on Reform of Derivatives Tax


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New York, Dec. 7, 2011Speaking at a joint meeting of the House Ways and Means Committee and the Senate Finance Committee on Dec. 6, Columbia Law School professor Alex Raskolnikov called for broad, immediate reform of the U.S. government’s policies on the taxation of financial products.
“Derivatives have been used to game every aspect of our tax system,” Raskolnikov said at the hearing, which was televised. “There is a lot of money at stake, the incentives facing taxpayers and financial engineers are extremely powerful, and the results are in: The taxation of financial instruments is in dire need of reform.”
Professor Raskolnikov testified on Dec. 6 in Congress. Photo by Rick Reinhard
The hearing, “Tax Reform and the Tax Treatment of Financial Products,” was convened to explore alternatives by which Congress might adapt the tax code to the evolution of sophisticated financial products. Legislators are looking at possible reforms such as eliminating tax breaks or changing underlying tax rules.
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.
The session was led by House Ways and Means Chairman Dave Camp, a Republican from Michigan, and Senate Finance Committee Chairman Max Baucus, a Democrat from Montana. It was only the second hearing by the two committees since 1940. The first, on treatment of debt and equity, was held in July.
The other witnesses who testified were Thomas Barthold, chief of staff of the Joint Committee on Taxation; Andrea Kramer, a partner at McDermott Will & Emery; and David Miller, a partner at Cadwalader, Wickersham & Taft.
In his detailed remarks, Raskolnikov emphasized the importance of differentiating between a variety of reforms under consideration in Congress, some of which are likely to reduce the urgency to reform taxation of financial products, while others are likely to increase that need.
“If we drop the corporate tax rate substantially, there is going to be a greater case for reforming the taxation of derivatives, because the flaws will become more costly,” he explained, citing one example. A switch from worldwide to territorial taxation is also likely to increase the need for reform, he said, while eliminating the special treatment of capital gains and losses is certain to make the need for reform less urgent.
In their questions, many Congressional members focused on a proposal that would require “mark-to-market” taxation of derivatives at ordinary income tax rates. Mark-to-market is a system of accounting which aims to provide a realistic appraisal of a company’s financial situation by recording the current market value of specific assets, rather than recording them at their original purchase price.
Raskolnikov repeated his previously stated support for mark-to-market taxation of derivatives at ordinary income tax rates.

“Mark-to-market is a very plausible alternative” for most trades, Raskolnikov said, noting that hedge transactions should be subject to a separate regime.
A shift to mark-to-market accounting for derivatives should not be perceived as too complicated, he said. While it would require some “line-drawing issues” to determine what is and is not a derivative subject to mark-to-market taxation, he explained, many more line-drawing problems would disappear, including defining the difference between a swap, an option, and a swaption, among others.
At that point, the room fell silent, as many were unfamiliar with the term “swaption.”
“There is such a thing!” Raskolnikov continued “It’s an option to enter into a swap!”
As questioning of the witnesses continued, Senator Carl Levin, a Democrat from Michigan, was curious about the implications of a limited alternative known colloquially as “plugging loopholes.” He asked Raskolnikov if he thought plugging loopholes would give Congress enough added revenue to implement broad tax reform.
“By plugging some of the loopholes, you will obtain some revenue temporarily,” Raskolnikov answered. “Incremental reform is good as far as it goes, but you have been plugging loopholes already, and even for those that worked, people found new loopholes.”
Noting that financial products are taxed differently based on which “cubbyhole” they fit into, Senator Orrin Hatch, a Republican from Utah, asked Raskolnikov how that distorts investment.
“It can distort investment and lead to tax avoidance, because given a choice between different forms of investment, taxpayers will choose the form that results in the lowest tax liability, even if they would have chosen a different alternative without taking taxes into account,” Raskolnikov answered. “In the real world, when I’m a business and there are two alternatives and alternative two has a greater tax benefit, I take alternative two.”
Representative Dave Reichert, a Republican from Washington, quizzed Raskolnikov about his call for the Internal Revenue Service (IRS) to share financial information with analysts, asking why the IRS is opposed to such a change.
“The standard answer is taxpayer protection, and this is of course of paramount concern, but the IRS now has an enormous amount of data in electronic form,” Raskolnikov answered. He noted that taxpayers’ privacy could be preserved by stripping out identifying information.
“This is an opportunity for you to urge them, to just give them a little nudge, to release the information,” he continued. “The analysts will be delighted to do the work for free.”
Representative Reichert then asked what Congress would gain by acquiring such information.
“You will have a much better idea of revenue estimates,” the professor responded quickly.
Toward the end of the hearing, the questions became more expansive.
Representative Rick Berg, a Republican from North Dakota, asked whether any other countries have figured out the best way to tax derivatives.
“With the few exceptions of major financial centers such as London, Hong Kong, and Tokyo, there are not many countries that face the pressures that we do, where the volume of trades is comparable,” Raskolnikov answered. “That’s because New York is a major financial center of the world and there are an incredible number of highly talented people here focused on derivatives trading.”
Representative Charles Rangel, a Democrat from New York, questioned the likelihood of Congress ever achieving the broad reforms Raskolnikov is calling for, considering the special interests in Washington and the political risk for any legislator who takes a stand on the issue.
“Somebody will be hurt,” Rangel said.
Shifting the focus to the presidential candidates, Representative Richard Neal, a Democrat from Massachusetts, said that if the candidates don’t address the issue in a serious way next year, “voters will continue to feel very sour about the tax system.”
Senator Baucus posed the final question, asking the witnesses what advice they would give to wealthy investors, in light of the European debt crisis. None of the panelists ventured an answer, whereupon Baucus closed the hearing, saying, “Let’s hope that Europe doesn’t tank!”
The hearing was covered by Bloomberg, Reuters, and the Wall Street Journal.
For Raskolnikov’s written testimony, click here.
Raskolnikov is Charles Evans Gerber Professor of Law and co-chair of the Charles E. Gerber Transactional Studies Program at Columbia Law School.
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