When you mark something to market you pretend you sell that something at the end of your tax year for the value it would have gotten if it had really been sold. It’s a fiction that makes sure when you hear the gong you pay your tax, or at least calculate how much tax you owe.
People always complain about mark to market in the same ways: that they don’t have the cash to pay the tax (liquidity) and they don’t know what price to use in the pretend sale (valuation).
As to the first complaint — liquidity — mark to market is just another example of a rule that makes people pay tax even when they have no cash, such as the original issue discount rules. OID has been in the code a long time and no one has lost life, limb, or a good business over it. And over the 20 years section, 475 has been in the code, no dirge has been sung for a securities dealer because it had to mark its portfolio to market for tax purposes.
As to the second complaint — valuation — which price to use in the pretend sale — for that we can get help from every financial discipline. It’s simply
disingenuous to say you don’t know what mark to use. The accountants are required to mark a vast number of things. The risk managers mark the regulators mark. People use guesstimations in tax all the time, for estate tax and for like-kind exchanges and for charitable donations.
And I have a challenge: taxpayers get your mark to market wrong, try it! Because 3 years later you’re going to have to justify how you got the mark number on the tax return when the next year turned out to be so different. The marvelous thing about mark to market is that it’s self-correcting and fast.
Tax is moving in the direction of everyone else: if it doesn’t want to be left behind, mark to market is inevitable. Tax has required more and more things to be marked for tax in the last 33 years, starting with futures contracts on U.S. exchanges then over-the-counter foreign exchange contracts then securities by dealers, and so on.
The Chair of the Ways and Means Committee Dave Camp decided early in his tenure that financial transactions were a poster child for disorganized tax law in need of good policy. The taxation of derivatives has not been addressed in a coherent manner by Congress.
Not only does this state of affairs lose money for the Treasury, but it also does so in a way that is unfair to taxpayers, both those who use derivatives and don’t understand the laws, and those who are paying taxes on wages and have no opportunities for planning, the ones who bear the heaviest tax burden.
So on January 24, 2013, Mr. Camp released a Discussion Draft proposing mark-to-market for derivatives — only derivatives — not stocks, bonds, or anything else. The tax community had talked so long about this idea it was almost a homecoming but also a surprise. The witnesses in the Hearing
following the release were in favor, even though they came from sectors that you would not expect to support such an idea. (4) But would Congress have the courage, the vision to implement mark to market? People enjoying the benefits of the current unfair, disorganized system got upset.
Nevertheless, after significant revisions (including a new elegant definition of derivative), the Ways and Means draft Tax Reform Act of 2014 also required derivatives to be marked to market, with ordinary income treatment for all gain and loss. I have some questions about Mr. Camp’s Draft:
• What do you do with the premium on an option? Is it included in the mark in the first year the option is written, in the year the option ceases to be, or should the premium be spread over all the years the option is in existence?
• Has the Draft proposed the best method to tax hybrids — contracts that combine elements of derivatives and non-derivatives?
• Is the Draft’s bifurcated method the best way to tax portfolios that mix derivatives and non derivatives, one for straddles and one for hedges?
• Does the Draft subject the correct instruments to mark to market — the definition of derivatives has been greatly improved from the 2013
to the 2014 proposals — but there is still uncertainty as to whether some contracts like repos and securities lending fit into the definition of derivatives.