On 5 August 2021, United States (US) Senate Finance Committee Chairman Ron Wyden introduced the Modernization of Derivatives Act (MODA), which would change the tax treatment of financial derivative transactions. Senator Wyden has previously introduced similar bills.

Background

Financial derivatives instruments (Derivatives, as defined under MODA) are contracts that have a value based on underlying property or benchmarks. The most common types of Derivatives are options, forwards, futures, and notional principal contracts (NPCs or "swaps").

The current tax rules governing Derivatives were developed in a piecemeal fashion over time, in tandem with the development of new financial derivative instruments. This piecemeal development resulted in complex tax rules, which create tax-planning opportunities. The applicable character and timing rules may depend on:

Certain tax attributes of the taxpayer executing the derivative, whether executed as an ordinary-course transaction related to a trade or business or for investment purposes

The character of the underlying property with respect to the taxpayer (e.g., a capital asset)

Whether the derivative is exchange-traded or an over-the-counter (OTC) transaction

The application of other overriding rules (e.g., 60/40 character treatment for Internal Revenue Code¹ Section 1256 contracts, tax hedging or straddle rules)

Given the patchwork design of applicable tax regimes, derivatives can be structured or combined to be economically similar to other types of derivatives but with different tax consequences.

Proposals under MODA 2021

The proposed legislation generally aims to replace many of the current statutes and regulations addressing the tax treatment of specific Derivatives with a new regime that uses one timing rule, one character rule and one sourcing rule for all transactions. Under the proposed legislation, MODA would make the following changes to Derivatives:

Require annual mark-to-market accounting for all transactions

Treat all gains or losses from Derivatives and certain related assets as ordinary

Determine the source of tax items based on the taxpayer's country of residence, incorporation or organization

Introduce the Investment Hedging Units (IHUs) concept²

Specifically, MODA would repeal Sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259 and 1260 (and associated regulations). In their place, MODA would add Section 491, Rules for Treatment of Derivatives; Section 492, Investment Hedging Units (IHUs); Section 493, Derivative Defined; and Section 494, Tax Treatment of Contract Similar to Derivatives.

Definition of Derivative: MODA defines a Derivative as including any contract (e.g., any option, forward, futures, short, swap, or similar contract) the value of which, or any payment or other transfer, is determined by reference to (1) stock; (2) a partnership interest; (3) debt; (4) any real property (subject to certain exclusions); (5) any actively traded commodity; (6) any currency; (7) any rate, price, amount, index, formula or algorithm; and (8) any other item prescribed by the Treasury. The term Derivative also includes any embedded derivative component of a contract that consists of both derivative and non-derivative components.

Under MODA, Derivatives do not include the following contracts: (1) American depository receipts; (2) certain contracts with respect to real property; (3) hedging transactions; (4) certain financing transactions; (5) options received in connection with the performance of services; (6) insurance contracts issued by an insurance company; (7) derivatives with respect to stock of members in the same worldwide affiliated group; and (8) commodities used in the normal course of a trade or business.

Taxation of Derivatives: Provisions under MODA would require gains or losses on Derivatives to be subject to taxation upon termination or transfer at ordinary tax rates with certain adjustments. If a Derivative remained outstanding (i.e., no termination of or transfer during a tax year), it would be marked-to-market, with gains or losses taxed at ordinary rates with certain adjustments. Taxpayers could rely on book valuation to determine the fair market value of the Derivative for this purpose. Items of income, deduction, gain or loss realized on Derivatives would generally be sourced to the taxpayer's country of residence. Sourcing of income from the underlying property would continue to follow current law.

IHUs: MODA would require taxpayers to identify positions in Derivatives and investments in the underlying as IHUs if the positions have a sufficient delta relationship (between minus 0.7 and minus 1.0). Delta is defined as the ratio of the expected change in the fair market value (FMV) of the Derivative(s) to any change in the FMV of the associated underlying investment(s). IHUs would be subject to special timing rules that apply when the position comprising the IHU is established and upon any modification, sale or exchange of any portion of the component positions. IHUs could be formed in three ways and could be governed by two different accounting methods. Specifically, an IHU would be formed when one or more Derivatives and underlying investments or parts thereof (1) meet the delta test and are identified by the taxpayer, (2) are treated as an IHU by election of the taxpayer, or (3) meet the delta test without taxpayer identification.

Coordination with existing rules: MODA would simplify the straddle rules of Section 1092 to apply only to offsetting positions in Derivatives that have a delta between minus 0.7 and minus 1.0. MODA would also allow regulated investment companies (RIC) to indefinitely carry net operating losses forward to lessen the impact of MODA on certain RIC hedging transactions. MODA would extend ordinary tax treatment to debt instruments held by insurance companies.

Effective date: The new regime would generally apply to financing derivative contracts qualifying as Derivatives for purposes of MODA and underlying investments held 90 days after the date of enactment. Transition rules are provided for Derivatives and relevant investments held when the proposals become effective.

Implications

Proposals to reform the rules governing the taxation of Derivatives were first introduced as part of the Tax Reform Act of 2014.³ Earlier versions of MODA proposals were introduced by Chairman Wyden in 2016 and 2017.

While the certainty of a unitary character and timing regime described in the MODA proposals may seem appealing, the definition of Derivative is quite broad and appears to include transactions not historically viewed as financial derivative transactions. The rules for IHUs, particularly their concept of "delta," would be quite complex to implement.

The broad scope of MODA would require newly affected taxpayers to: (1) develop and implement policies and systems to compute gain or loss that is based on valuations in the absence of a transfer or termination; and (2) comply with the annual mark-to-market requirement or determine the a delta relationship between two positions for purposes of the IHU and revised straddle rules proposals under MODA. In addition, it is not entirely clear whether the sourcing rule applies to ordinary income or expense items attributable to periodic payments on swaps. As described, the sourcing rule would appear to apply to such periodic payments on a swaps, but further clarification is needed.

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For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United States), International Tax and Transaction Services – Capital Markets Tax Practice

Menna Eltaki, Chicago | menna.eltaki@ey.com

Robert Contreras, Houston | robert.contreras@ey.com

Lee Holt, New York | lee.holt@ey.com

Lena Y. Hines, Los Angeles | lena.hines@ey.com

Matthew Stevens, Washington, DC | mattew.stevens@ey.com

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ENDNOTES

1. All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.
2. Earlier versions of the proposed bill were limited to insurance companies and their risk-mitigation strategies. The IHU concept, however, seems to have been expanded in the most recent version.
3. See Tax Reform Act of 2014, proposals introduced by Representative Camp of the House Ways and Means Committee; Obama administration Fiscal Year Revenue Proposals for 2013 — 2017.