Sen. Ron Wyden (D-OR) has introduced a series of proposals that may be considered in the budget reconciliation process, including two bills that would change the tax treatment of financial services: derivatives and carried interest. Notably, both proposals would enact “mark-to-market” taxation for derivatives and carried interest, which could be a precursor to broader taxation of capital gains on a mark-to-market basis, i.e., annually based on the market value of assets.

Policymakers should approach the construction of a mark-to-market system within financial services carefully, as it can entail a new set of complexities and compliance costs for taxpayers and subject them to tax on unrealized (or phantom) income, ultimately reducing saving and investment to the detriment of the broader economy.

Wyden’s proposal on derivatives changes the tax treatment of financial contracts that are used to hedge against risk or expose traders to certain underlying markets, such as options, forwards, and swaps. Under current law, derivatives are subject to a morass of complicated tax rules, with the exact rules on how certain derivatives are taxed depending on transaction timing, sourcing rules (where the taxpayer resides), and how the contract was disposed (e.g., whether it was exercised, lapsed, or terminated).

Wyden’s proposal seeks to simplify the tax treatment by moving to a single rule for timing (by imposing mark-to-market taxation) and taxing all derivatives at ordinary income tax rates based on the taxpayer’s country of residence. The Joint Committee of Taxation (JCT) estimated the proposal would raise about $16.5 billion over ten years

While this simplification effort has its benefits, taxing derivatives on a mark-to-market basis entails its own set of complexities, compliance costs, and other risks. Wyden’s bill would tax derivatives as if they were sold and re-acquired at the end of the year at their fair market value. However, some of these transactions may not have a readily available fair market value, a concern JCT raised in its evaluation of the idea in 2008. Wyden proposes using book value in these cases, which may be an imperfect proxy for the market value of these contracts.

The proposal also creates complicated rules for taxpayers who participate in derivatives contracts and own the underlying investment, an arrangement known as an investment hedging unit (IHU). The bill would require taxpayers to calculate the “delta” between the two items, which is the “ratio of the expected change in the fair market value of the derivative to a very small change in the fair market value of the underlying investment.” These rules help preserve hedging transactions, but the IHU and delta calculations would be quite complicated in practice.

More fundamentally, the general challenge with any mark-to-market system is fairness and the ability to pay, since it levies tax on accrued income or “paper gains” that have not yet been realized. This phantom income cannot be used to pay the tax liability, so the taxpayer must find the cash elsewhere, which could entail liquidation of other assets and even financial distress in some cases. This is not worth the risk for many taxpayers, so the general effect is to suppress saving and investment via the instruments that are subject to mark-to-market taxation.  

Wyden would apply mark-to-market to carried interest as well, which is most commonly used by hedge funds and private equity firms. Investment managers at hedge funds and private equity firms are traditionally paid according to a “two and twenty” system, where they receive 2 percent of all assets invested, plus 20 percent of additional profits. The 20 percent of additional profits is known as carried interest.

Under current law, carried interest is taxed like a long-term capital gain, at a top rate of 23.8 percent, if it has been held for more than three years. Managers can also choose to not realize carried interest until a firm sells an investment, allowing them to defer tax.

The core of the carried interest debate is whether carried interest constitutes labor income or investment income. Under savings-consumption neutral taxation, investment income should go untaxed, as it is the returns to past labor income. At the very least, it should face a lower tax rate relative to labor income. However, if carried interest is a form of labor income, then it should be taxed just like wage compensation. Both perspectives have some merit, and changes made under the Tax Cuts and Jobs Act of 2017 tried to balance these perspectives by requiring taxpayers with carried interest to hold onto investments for at least three years to get qualified tax treatment.

Wyden’s carried interest proposal would tax carried interest as ordinary income, as has been proposed by the Biden administration and others in the past. However, Wyden’s approach would go one step further by requiring managers to pay tax annually on accrued carried interest, based on an assumed rate of return on assets, regardless of whether or not the managers realized gains.

The proposal would apply to all partnerships with carried interest income. This could pose a challenge for smaller partnerships which have limited liquidity available to pay the tax on phantom income, and make it harder for these smaller partnerships to compete with larger firms.

JCT estimates this proposal would raise $63 billion over a decade, considerably more than the administration’s more limited proposal to tax carried interest as ordinary income. This represents tax on phantom income, so taxpayers would need to raise funds from other sources to pay the tax liability, i.e., approximately $6 billion per year.

While Wyden’s proposals will be of most concern to taxpayers working in the financial services and financial services-adjacent industries, the inclusion of mark-to-market proposals suggests that they may be used to illustrate how a mark-to-market system may work for capital gains more broadly. As these proposals illustrate, mark-to-market is not simple to implement, as it involves new administrative and compliance challenges for taxpayers. Most concerning, mark-to-market levies tax on phantom income, requiring some taxpayers to engage in some degree of liquidation, ultimately suppressing incentives to save and invest. The limited tax revenues that could result from these proposals are not worth the risk.