Traders’ advocates say a tax proposal now in Congress is bad news for investors and would do serious harm to the options industry.
A draft proposal before the U.S. House of Representatives Committee on Ways & Means calls for taxing unrealized gains and losses on options positions, rather than waiting until any gain or loss is realized as is the current practice. It would also apply ordinary income taxes to any gain rather than capital gains taxes.
“The draft proposal will certainly hurt investors,” said James Toes, president and CEO of the Security Traders Association, which has been lobbying against the plan.
The proposal calls for unrealized gains from hedging strategies to be taxed in the same tax year. That would end the ability to defer taxation until contracts are exercised or expired. Another sore point between the trading industry and draft proposal supporters is the higher rate these options gains would be taxed at. Capital gains are generally taxed at a lower rate than ordinary or earned income tax rates.
Others see change as necessary.
Rep. David Camp, R-Mich., chairman of the committee, and author of the proposal, told Traders Magazine, “Updating these tax rules to reflect modern developments in financial products is something that is long overdue, because the tax code has not typically kept up with the innovation in this industry.” He added, “This discussion draft represents an attempt to provide that simplicity and uniformity, but it is also important to be mindful that this is a discussion draft. So we welcome the expertise of those who are most familiar with these products as we work to revise and refine the draft.”
Central to the plan is the introduction of mark-to-market accounting for derivatives trades. It would also require options contracts—including futures forwards, derivatives and notional principal contracts—to be subjected to mark-to-market rules at the end of each tax year. That means adjusting the value to reflect current market positions.The plan also calls for applying ordinary income tax rates to the gain or loss on these products, rather than the generally lower capital gains tax rate, as is current practice. That would radically change listed options business, trading industry officials are saying in various filings and comments.
“The proposal,” wrote Security Traders Association of New York president Patrick Armstrong in a letter to the House Ways & Means committee, “would effectively impose a tax penalty on individuals who buy covered calls and protected puts—two of the most common options trading strategies for retail options investors.”
The essence of the debate over the six-part financial products draft proposal is thus: Does the draft proposal represent a simpler, fairer way of taxing options contracts, which would reduce speculation? Or does the draft proposal impose a new tax on options exchanges, one that will hurt both individual and institutional investors, who will be stuck with higher costs because they are trying to protect against down markets?
The authors of the draft proposal also argue that one of their goals is to discourage the “speculators” partly blamed for the 2008 market meltdown.
“A contributing factor to the 2008 financial crisis was the ability to hide and disguise potentially significant risks through Wall Street’s use of derivatives and other novel products,” said a committee overview of the draft proposal. “The rapid growth and abuse of these derivatives contributed to an environment that led to the seizure of our financial system, from which the U.S. economy still has not fully recovered.”
The proposal in its current form would require taxpayers engaged in speculative financial activity—but not business hedging against common risks—to mark certain financial derivative products listed at fair market value at the end of each tax year, thus triggering the recognition of gain or loss for tax purposes. Broadly extending the mark-to-market standard, the committee said, would provide a better way of taxing these products. It would also lead to markets, it said, “less susceptible to abuse, without affecting most small investors who normally do not invest in these products.”
Critics have complained that these sometimes complex hedging vehicles were often difficult to price during the market crisis.
Still, that doesn’t mean Congress is close to passing a measure to increase taxes on hedging products. Indeed, committee officials, who at presstime emphasized the proposal has yet to be put into bill form, said it is also designed to update the “arcane and often inconsistent tax rules governing these investments used to reduce risk,” according to a summary of the plan offered by the committee. Ways & Means is the committee where new tax legislation must originate in Congress.
The financial products draft is part of a broader tax reform plan designed to make the entire tax code fairer and to reduce maximum tax rates. However, “nothing has been decided,” a committee spokeswoman said. “We are working to make sure that we hear from everyone on the issue.”
Nevertheless, the trading industry is worried.
Since the meltdown of 2008, the trading industry has has heard some public comments that it should help defray some of the costs of the bailout of various banks and brokerages. But it has defeated numerous proposals to raise taxes on trading. It has effectively made the case that new taxes on trades and products would amount to a cost that would be passed on to the average investor.
So what is different this time?
Camp, who is considered friendly to the trading industry, is now believed to be ready to seriously consider these new ways of taxing financial products, industry officials privately complained to Traders Magazine. Some feared that members of Congress seem ready to follow the lead of their European counterparts and levy new investment taxes.
So the industry is preparing for a battle over new taxes, while still hoping these tax proposals never come out of committee. At presstime, trading industry lobbyists said the new securities tax plan would do more than hurt exchanges—it would also harm the individual investor who wants to protect against another downturn.
The major options exchanges have formed a coalition to lobby against it.
“This will be terrible for options. It will overturn long-standing tax law regarding the taxation of options, hurt the options exchanges, and it will make it very difficult for the retail investor to hedge,” said David Franasiak, a Washington lobbyist for the STA. Franasiak said the whole draft proposal is unlikely to pass this session.
The draft proposal would be part of a comprehensive package of tax reform legislation that may or may not be passed by Congress this year. Trading industry officials have said that, although the entire draft proposal probably will not pass, some piece of the draft proposal could be attached to legislation that does.
Part of the plan was based on the testimony of securities attorney Andrea Kramer. “The current tax hedging provisions need to be expanded to include various risk management transactions that are not hedges under current tax law,” Kramer, a partner with Washington law firm McDermott Will & Emery, said at a congressional hearing in January.
Today, she said, product gains are generally taxed at capital gains rates “in the hands of an investor or a trader.” And gains are presently not taxed when one enters a position, but when one sells the position, Kramer said. Both provisions have helped the options business and, if changed, would radically change the economics of the business.
In an interview with TRADERS MAGAZINE, Kramer said Congress should “be careful” about making options tax changes. She agreed that the draft proposal, in its present form, could hurt the options exchanges.
“If you change the rules, the way that they’re proposing,” she said, “it would in fact, make it a disadvantage for those who do enter into options transactions, to enter into them going forward.”
