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It is well understood that aggressive tax planning with derivatives threatens the U.S. income tax system. The conventional solution to this threat has been consistency, meaning that the same tax treatment should apply to all economically comparable bets, regardless of the form used. Yet familiar political and administrative barriers stand in the way of achieving this lofty goal.

This Article develops a reform agenda to eliminate tax planning without requiring consistency. Policymakers should strive instead for a new goal, which this Article calls "balance": For each risky position, the treatment of gains should match the treatment of losses. For example, if the government bears 15 % of losses, it should share in 15 % of gains. On a different derivative, f the government bears 35 % of losses, it should share in 35 % of gains. As long as this balance is achieved across the board for all risky bets, the admittedly counterintuitive reality is that taxpayers need not prefer – or engage in planning to attain – a low effective rate. An important caveat is that this analysis works only for risk-based returns, but not for wages or timevalue returns.

In a nutshell, if policymakers separate risk-based returns from any interest or wages embedded in derivatives, balanced taxation of risk-based returns will eliminate planning, with or without consistency. This Article provides policymakers with a detailed reform agenda, critically analyzes the strengths and weaknesses of the strategy, and applies this agenda to several cutting-edge issues in the taxation of derivative securities.


Law | Tax Law

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