Disparate Tax Treatment and Information Gaps Create Uncertainty and Potential Abuse
GAO-11-750: Published: Sep 20, 2011. Publicly Released: Oct 20, 2011.
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Recently, concerns have arisen about the use of certain financial derivatives to avoid or evade tax obligations. As requested, this report (1) identifies and evaluates how financial derivatives can be used to avoid or evade tax liability or achieve differing tax results in economically similar situations, (2) evaluates Internal Revenue Service (IRS) actions to address the tax effects of investments in financial derivatives through guidance, and (3) evaluates IRS actions to identify financial derivative products and trends through information from other agencies. GAO reviewed research and IRS documents and interviewed IRS and, Department of the Treasury (Treasury) officials and other experts. GAO analyzed the completion of financial derivative projects on the agencies' Priority Guidance Plans (PGP) from 1996 to 2010.
Taxpayers have used financial derivatives to lower their tax liability in ways that the courts have found improper or that Congress has disallowed. Taxpayers do this by using the ease with which derivatives can be redesigned to take advantage of the current patchwork of relevant tax rules. As new products are developed, IRS and taxpayers attempt to fit them into existing "cubbyholes" of relevant tax rules. This sometimes leads to inconsistent tax treatment for economically similar positions, which violates a basic tax policy criterion. While the tax rules for each cubbyhole represent Congress's and Treasury's explicit policy decisions, some of these decisions were made long before today's complex financial derivative products were created. Some experts have suggested alternate methods to the current approach for taxing financial derivatives. IRS and Treasury, because of their unique position to define policy and administer the tax code, are best positioned to study and recommend a new approach. When application of tax law is complex or uncertain, as is often the case for financial derivatives, guidance to taxpayers is an important tool for IRS to address tax effects and potential abuse. However, between 1996 and 2010, Treasury and IRS did not complete 14 out of 53 guidance projects related to financial derivatives that they designated as a priority on their annual PGP. While completing guidance is important in providing certainty to taxpayers and IRS and reducing the potential for abuse, challenges like the risk of adverse economic impacts of guidance changes and the transactional complexity of financial derivatives may delay the completion of guidance. Since challenges may prevent IRS from finalizing guidance within a 12-month PGP period, taxpayers need to be aware of ongoing guidance projects' status, some of which may span a number of years. IRS sometimes identifies new financial derivative products or new uses of them long after they have been introduced and gained considerable use. This slows its ability to address potential abuses. IRS's 2009-2013 Strategic Plan lists strengthening partnerships across government agencies to gather and share information as key to identifying and addressing new products and emerging tax schemes more quickly. Through their oversight roles for financial derivative markets, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) may have information on financial derivatives that is relevant to IRS. Similarly, bank regulators may gain relevant knowledge of derivatives' use. IRS officials said such routine communications in the early 1990s did provide relevant information. Although IRS communicates with SEC and CFTC on derivatives, it does not do so systematically or regularly. Strengthening partnerships would increase opportunities for IRS to gain information on new financial derivative products and uses. Studies of interagency coordination suggest that agencies should look for opportunities to enhance collaboration in order to achieve results that would not be available if they were to work separately, and a number of best practices exist to help agencies meet this goal. GAO recommends that (1) Treasury determine whether alternatives to the current approach to taxing financial derivatives would promote consistent treatment of economically similar positions and be beneficial, that (2) Treasury and IRS provide more public information on the status of PGP projects, including those related to financial derivatives, and that (3) IRS strengthen information-sharing partnerships with relevant agencies. IRS agreed with the third recommendation and disagreed with the second; Treasury disagreed with the first two recommendations. GAO continues to believe its recommendations would be beneficial.
Recommendations for Executive Action
Comments: Treasury disagreed with this recommendation based on the fact that many outside studies already exist and IRS did not comment. The Tax Cuts and Jobs Act enacted in December 2017 did not include any requirements that Treasury study alternative approaches for the taxation of financial derivatives. However members of Congress have released proposals for a mark-to-market tax system, which would include financial derivatives. GAO continues to maintain that further study is needed in coordination with IRS and will continue to monitor the climate for such a study.
Recommendation: To better ensure that economically similar outcomes are taxed similarly and minimize opportunities for abuse, the Secretary of the Treasury should undertake a study that compares the current approach to alternative approaches for the taxation of financial derivatives. To determine if changes would be beneficial, such a study should weigh the tradeoffs to IRS and taxpayers that each alternative presents, including simplicity, administrability, and economic efficiency.
Agency Affected: Department of the Treasury
Status: Closed - Not Implemented
Comments: IRS and Treasury disagreed with this recommendation, citing the difficulty of estimating completion dates. GAO still maintains that taxpayers would benefit from additional information on financial derivative Priority Guidance Plan (PGP) projects and that dates can be estimated. Some changes have been made with the PGP but project status, changes in priorities, and target completion dates are still not included.
Recommendation: To provide more useful and timely information to taxpayers on the status of financial derivative guidance projects, the Secretary of the Treasury and the Commissioner of Internal Revenue should consider additional, more frequently updated reporting to the public on ongoing projects listed in the PGP, including project status, changes in priorities, and target completion dates both within and beyond the 12-month PGP period.
Agency Affected: Department of the Treasury
Status: Closed - Implemented
Comments: During our review of the use of certain financial derivatives to avoid or evade tax obligations, we evaluated the Internal Revenue Service's (IRS) actions to identify new financial derivative products and emerging tax issues through information from other federal agencies. We recommended that IRS work to improve information-sharing partnerships with the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to better ensure that IRS is fully using all available information to identify and address compliance issues and abuses related to the latest financial derivative product innovations. We also recommended that IRS should also consider exploring whether such partnerships with bank regulatory agencies would be beneficial. In April 2012, IRS told us that they had begun work to initiate the information sharing relationships in response to our recommendation and were considering ways to improve information sharing partnerships with SEC and CFTC regarding financial derivatives, particularly in the area of new products. IRS told us that they were also considering whether partnerships with other federal regulatory agencies would be beneficial. IRS officials met with SEC, CFTC and other bank regulatory agencies in March 2012 and May 2012 to evaluate information sharing possibilities and joint collaboration. Two meetings were held in March 2012 to discuss existing projects and ways to leverage SEC and CFTC expertise about financial derivatives. On May 11, 2012, IRS officials from the LB&I Financial Services, PFTG, LB&I Division Counsel, and the Office of Associate Chief Financial Institutions and Products met in person with officials from the OCC, FDIC, and Federal Reserve to share information and discuss current tax issues that relate to financial transactions in the banking industry, specifically debt losses from the 2008 market downturn. IRS officials plan to reach out to CFTC in the future. As a result of these meetings, as of January 4, 2013, IRS LB&I Financial Services/Financial Products had evaluated and initiated information sharing relationships with SEC, CFTC and other regulatory agencies. IRS told us that they intend to continue the information sharing meetings in the future.
Recommendation: To more quickly identify new financial derivative products and emerging tax issues, IRS should work to improve information-sharing partnerships with SEC and CFTC to better ensure that IRS is fully using all available information to identify and address compliance issues and abuses related to the latest financial derivative product innovations. IRS should also consider exploring whether such partnerships with bank regulatory agencies would be beneficial.
Agency Affected: Department of the Treasury