The recently released tax-reform plan by outgoing House Ways and Means Committee Chairman Dave Camp seeks to simplify the overall tax code by lowering rates and eliminating loopholes and deductions. But the provisions related to derivatives remain complex, although still mostly beneficial to corporate end-users.
The long-awaited plan, released February 26, 2014, is considered unlikely to progress toward a vote during an election year. Rep. Camp, however, is leaving office at year end and clearly wants to at least initiate the debate. Mark Leeds, a tax partner at Mayer Brown, said the provisions likely to have the greatest impact on corporates are those related to hedging—and it’s mostly good.
For example, the plan proposes ways to expand the definition of hedging. Current law requires hedges to be designated as tax hedges by the close of the day they’re entered into, but that deadline is often missed and corporate tax payers instead identify the hedge in after the fact. “In fact, it’s honored more in breach than in practice, because most corporates are unaware of this tax designation requirement,” Mr. Leeds said.
Mr. Leeds added that the proposal would allow corporates to rely on designations for hedge accounting also for tax purposes, instead of requiring the separate tax hedge designation.
Another provision would be a huge boon to insurance companies. Current law only permits hedge accounting to apply to ordinary income items, so if an insurance company buys an asset that may result in a capital gain, any hedge of that asset can’t be treated as a hedging transaction for tax purposes. The Camp plan, however, would create an exemption to the ordinary income rule and allow insurance companies to treat risk mitigation transactions entered into with respect to their bond portfolios as hedges.
“It’s a big deal, because currently hedges resulting in a loss can only offset capital gains, and insurance companies rarely have such gains,” Mr. Leeds said, adding, “By allowing the insurance companies to treat the losses on hedges as ordinary losses, they can offset the hedge loss against interest income in the bond portfolio.”
In a similar vein but for US companies with foreign subsidiaries, if the subsidiary today enters into a hedging transaction with respect to a hard asset, because that asset is generally a capital asset the foreign subsidiary can’t treat the risk-mitigation transaction as a hedge for tax purposes. Consequently, that capital loss cannot be used against the subsidiary’s Subpart F income, which is subject to US tax. The Camp proposal, instead, would allow that offset.
“So the Camp proposal would more accurately measure the amount of income that should be included by the US parent, by allowing it to reduce Sub Part F inclusion by the loss on the risk mitigation transaction,” Mr. Leeds said.
The Camp plan isn’t completely rosy for corporates. Investors in corporate-issued convertible debt accept lower coupons because they attach additional value to the feature converting debt to equity. The Camp proposal, however, would tax them on the coupon plus the value of the imbedded option, making preferred stock less attractive for investors and likely impairing convertible debt as a corporate financing tool.
The plan also introduces a complicated formula for corporations to allocate interest expense to tax-exempt bonds in their portfolios that Mr. Leeds said could dissuade them from investing in such assets.
Mr. Leeds noted that passage of major reform legislation after the first year of a president’s election or re-election is rare. Nevertheless, he said, the Camp plan represents the general direction in which Capitol Hill is headed in terms of tax reform. For example, it would require mark-to-market treatment of many derivatives and repeal the hodgepodge of tax law provisions currently in place, although corporates would be largely exempt from such requirements.