A US budget proposal that would change how derivatives are taxed could, if agreed, increase portfolio risk and damage both the derivatives and underlying markets, investor bodies and analysts claim.
"Writing a call will become a taxable event - and that could have a dramatic impact on the liquidity of the options market," said Andy Nybo, head of derivatives research at TABB Group, a financial consultancy.
He said the likely consequence would be significantly to curtail the use of options in hedging. "In certain cases, investors will say the strategy no longer works," he said, pointing to likely damage to the underlying equity market.
The current draft contains a number of measures including the levy of capital gains tax on derivatives and treatment of profits and losses as ordinary income.
The relationship between the derivative and the underlying could prove difficult to regulate, according to Wholesale Markets Brokers' Association (WMBA) chairman David Clark. "If you're trying to tax based on mark to market and you're taxing profits, what happens if the derivative makes a profit but the underlying makes a loss? Will the loss be discounted?" he said.
"If you're using it as a hedge for the purposes of risk management, why would anyone expect you to pay a tax on it?" he added. "It will affect not just the buy-side but banks, which use derivatives to hedge balance sheets and client positions. It isn't clear whether the intention is to tax firms for their risk management activities or their open positions."
Debate in the US Congress is likely to focus on the definition of derivatives that legislators choose to adopt. The draft includes all derivatives except corporate price hedges and some property derivatives, although Clark said exemptions were likely to be loaded on.
Although the details have yet to be worked out, there appears to be bipartisan support for tweaks to derivatives' treatment as part of a wider package of tax reform. In the US, commentators have pointed to the Democratic administration's more-or-less wholesale backing for reforms first drafted by the Republican chairman of the Congressional Committee on Ways and Means, Dave Camp.
In a written submission to Camp's committee, the Investment Company Institute (ICI) questioned the decision to treat marked gains and losses as ordinary, and the plan to tax non-derivatives in mixed-straddles involving a derivative.
However, Karen Gibian, associate counsel, tax law, said the Washington-based buy-side representative group would welcome more uniform tax treatment of financial products.
"Among our members there's a general view that some more uniform regulation would be good for funds and investors because it's often difficult to figure out the tax implications of various financial products," she told theTRADEnews.com. "When choosing between derivatives with similar economic results, more uniform taxation would remove tax considerations from a fund's investment decisions."
In the meantime, Nybo said the fact that the proposal was still in its early stages "should give some comfort - but the idea that it could end up in the budget is troubling".
A period of consultation is expected to be followed further discussions in Congress.