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Balance in the Taxation of Derivative Securities: An Agenda for Reform


David Schizer


Columbia University - Law School

March 4, 2004

Columbia Law and Economics Working Paper No. 247

Abstract:     
By now, it is well understood that aggressive tax planning among high-income individuals and corporations represents a grave threat to the U.S. tax system, and that derivatives are staples of this planning. In response, the usual recommendation is consistency, which means that the same tax treatment should apply to economically comparable bets, regardless of what form is used. Yet because consistency is unattainable, this Article develops an alternative theory: Policymakers should strive instead for balance. This means that for each risky position, the treatment of gains should match the treatment of losses. For example, if the government bears 15% of losses, it has to share in 15% of gains. On a different derivative, if the government bears 35% of losses, it should share in 35% of gains.

As long as this matching is achieved across the board for all risky bets, the admittedly counterintuitive reality is that taxpayers need not prefer, or engage in planning to attain, a low effective rate. A low rate obviously is appealing for gains, but it is correspondingly unappealing for losses (i.e., since deducting the loss is less valuable). Moreover, even if a low rate is desired, taxpayers can get the same aftertax return by increasing the size of their bet. The main advantage of this reform agenda is flexibility. To prove this point, this Article outlines three ways to match gains and losses on derivatives: mark-to-market accounting; a novel reform called the stated-term approach, in which gains and losses are deferred until the scheduled maturity date of the derivative, even if the contract is terminated earlier; and a zero tax rate. The provocative conclusion is that these thoroughly inconsistent approaches can coexist for economically comparable derivatives, without prompting planning. Yet this flexibility is not free, so the limitations of this reform agenda are considered as well, along with implications for cutting edge problems in the taxation of derivatives, including the timing and character rules for swaps, Section 1032, and the wash sale rules.

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Date posted: March 12, 2004  

Suggested Citation

Schizer, David, Balance in the Taxation of Derivative Securities: An Agenda for Reform (March 4, 2004). Columbia Law and Economics Working Paper No. 247. Available at SSRN: http://ssrn.com/abstract=516543 or http://dx.doi.org/10.2139/ssrn.516543

Contact Information

David M. Schizer (Contact Author)
Columbia University - Law School ( email )
435 West 116th Street
New York, NY 10025
United States
212 854 2675 (Phone)
212 854 9740 (Fax)
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