Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
United States Federal Taxation of Derivatives: One Way or Many?
*Visiting Professor at the University of Michigan Law School and an Adjunct Professor at Georgetown Law Center and American University Washington College of Law. He is also an Of Counsel at Greenberg Traurig LLP. He specializes in United States taxation of financial products and institutions. He received his M.P.A. and I.T.P (International Taxation) from Harvard, LL.M. (Taxation), and S.J.D from the University of Michigan.
While derivatives have been utilized for almost a century, the use of derivatives has been exploding in the last two decades. The development of the tax rules, however, could not keep pace with the development of derivatives in the markets. While the use of derivatives have become common in many countries, except for the United States, only a handful of countries, including England, Australia, Canada, and New Zealand, have developed comprehensive sets of rules for taxation of financial instruments.
Congress and the Treasury have “devoted considerable energy to developing specific rules for taxing [derivative financial instruments].” Today, the taxation rules for derivative instruments in the United States do not follow a consistent pattern. The current tax regime for derivatives consists of a “cubbyhole approach” and is determined in accordance with various factors including: (1) the identity of the derivative, the underlying property, and the associated cash flows; (2) the identity of the taxpayer; (3) the purpose for which the transaction is entered into by the particular taxpayer; and (4) any applicable anti-abuse rules. Ideally, the tax treatment of a particular instrument should be determined by considering all four elements. Nevertheless, as a practical matter, it is very hard to apply all elements at the same time.
Specifically, while some rules emphasize the identity of the instrument ( e.g., notional principal contracts regulation and section 1256), other rules emphasize the identity of the taxpayer (for example, section 475). In addition, some rules focus on the purpose of the transactions (for example, hedging rules). Furthermore, several statutory anti-abuse rules for transactions in securities, including derivatives, mandate a particular treatment. Finally, some current regimes apply more than one approach to some extent but incoherently.This article discusses the three key tax issues involved with any type of transaction including derivative instruments: (1) timing; (2) character; and (3) source. For each of these three tax issues, the United States has developed several variations of rules pertaining to derivatives.