United States

Proposed adjustment to IRC Section 1256 Taxation may have unintended consequences to the trading world

Act might deal a blow to commodities and derivatives trading


The current debate taking place in Washington and across the news media about the effective tax rates paid by some high-profile public figures may have some unintended consequences to people in the trading world. The ensuing outcry from the public has elevated the debate about the "fairness" of some wealthy taxpayers paying effective tax rates below 15 percent. Riding this sentiment, Senator Carl Levin (Democrat from Michigan), on Jan. 23, 2012, introduced a new bill called the Closing the Derivatives Blended Rate Loophole Act. This Act is only about a page and a half long but could deal a mighty blow to the commodities and derivatives trading world if passed.

The Act calls for the elimination of any long term capital gain/loss treatment on IRC Section 1256 contracts and would treat all gain/loss as short term. Currently Section 1256 allows the capital gain/loss from regulated futures contracts, certain foreign currency contracts, non-equity options, dealer equity options and any dealer securities futures contract to be treated as 40 percent short term and 60 percent long term, regardless of holding period; in essence, a capital gain from a 1256 contract of $100 would yield a tax on that gain of $23 (assuming the individual is in the 35 percent bracket).

Senator Levin believes that Section 1256, as it stands today, "encourages and rewards short-term speculation in complicated financial products and does little, if anything, to help our economy grow and create jobs." And he's not alone in this thinking. The Tax Section of The American Bar Association said this past December that "whatever merits of extending preferential rates to derivative financial instruments generally, we do not believe that there is a policy basis for providing those preferential rates to taxpayers who have not made such long-term investments." President Obama's call for the elimination of the long-term capital portion of Section 1256 has also been included in his annual General Explanations of the Administration's Fiscal Year Revenue Proposals (also known as theGreen Book).

One could argue that changing the statutory classification of Section 1256 instruments from the current 40 percent short-term/ 60 percent long-term split does not create a new tax. Still the proposed characterization as short-term only raises a significant amount of revenue. Which begs the question: Shouldn't it be treated as a security with a holding period like any other instrument so as not to adversely affect the derivatives market? It isn't likely that the bill, in its present form, will pass both houses of Congress. The push for new tax revenues by the Democrats has been met with strong resistance from the Republicans. This impasse is sure to continue through the remainder of 2012.

Along the lines of the preferential tax rates offered to traders in commodities and derivatives, carried interest is another hot topic on Capitol Hill. Various bills have been introduced to do away with the preferential tax rates enjoyed by private equity fund managers and hedge fund managers. While none of these bills has had enough momentum to pass into law, one did pass the House in 2009 and went on to be narrowly defeated in the Senate. Although only a relatively small portion of a carried interest, rather than the entire interest, may actually receive a preferential tax rate, continued media coverage and public outcry may add momentum to the passage of a law changing the treatment and taxation of carried interests.

For more information, please contact Daniel Wall, Partner, 312.634.4628, Noah Ginsburg, Partner, 312.634.4601, Richard Nichols, Partner, 212.372.1135, or your local RSM financial services representative.