A Realization-Based Approach to the Taxation of Financial Instruments

Abstract

In recent years, a consensus has emerged among tax scholars that financial product innovation poses significant challenges to the federal tax system. These challenges are thought to stem from opportunities that new financial instruments create to exploit the realization rule, which generally defers tax on an asset's risk-based returns until the asset is sold. Many commentators have argued that because the realization rule is fundamental to the tax system, innovations in financial instruments inevitably will lead to either abandonment or wholesale revision of the income tax.

I make three arguments about this view. First, it presupposes that the realization rule should extend to risk-based returns generally. For both historical and pragmatic reasons, however, there is ample basis to confine the rule's application to the narrower class of risk-based returns that result from ownership of capital assets, as these assets traditionally have been defined. Taking financial instruments that do not fall into this class off of realization accounting would eliminate many tax arbitrage opportunities without requiring wholesale tax reform. Second, for financial instruments that generate both returns historically entitled to realization treatment and other types of returns, the tax law should adopt a bifurcation regime. Such a regime would significantly improve consistency and continuity in the tax system, again without disturbing settled tax rules for more common instruments such as stock and debt. Third, a bifurcation regime that applies time-value-of-money principles and the dynamic hedging theory of option pricing best achieves these objectives.