title: Choosing a Tax Treatment for New Financial Products
title: Taxing New Financial Products: A Conceptual Framework
titleType: AlternativeTitle
Creators: name: Strnad, Jeff
Publisher: name: California Institute of Technology
Year: 1994
Subjects: Taxes, Taxation systems, Cash flow, Taxation, Tax law, Stock prices, Zero coupon bonds, Call options, Tax payments, Debt

description: Two desirable properties for a tax system that must specify tax treatments for new financial instruments are consistency and universality. A tax system is universal if the system can designate a tax treatment for any cash flow pattern. Consistency requires that the tax treatment for each cash flow pattern be unique. A third property, linearity, holds if dividing the cash flow into different combinations of securities will not affect the tax treatment.
One way to achieve consistency and universality is to construct a tax system with a single systematic pattern of taxation, such as cash flow taxation or accretion taxation. But this extreme degree of homogeneity is not necessary. Consistent and universal tax systems can harbor radically different treatments for different types of transactions. "Bifurcation approaches" divide a new financial instrument into certain prototype transactions with known tax treatments. The tax treatment for the new instrument is the sum of the tax treatments of the prototypes that sum up to the instrument. "Integration approaches" use rules that tax aggregates of instruments within the taxpayer's portfolio.
Bifurcation methods have a natural connection to linearity. These methods will not achieve consistency and universality in a nonlinear setting unless they are accompanied by elements of an integration approach. All universal and linear tax systems can be generated by "the spanning method," a specific kind of bifurcation.
Spanning method approaches are only a subclass of a broader set of integration approaches that achieve consistency and universality. In evaluating integration approaches, a key property is continuity, the requirement that tax treatments do not jump in response to small changes in any given portfolio. Continuity is a generalization of consistency. The existence of jumps leads to the possibility of serious tax manipulation of the same sort that would arise from inconsistencies.
The current U.S. tax system includes some direct inconsistencies. That is, the same transaction can be packaged different ways to achieve different tax results. These inconsistencies can only be eliminated by fundamental reform. Even the most powerful integration approaches cannot address the problem of direct inconsistencies.
This fact raises difficulties for authorities such as the Treasury Department and the courts who have only low level reform at their disposal. In promulgating regulations or deciding cases that involve new financial instruments, these authorities must choose rules using a second best approach. Loose ends in the form of inconsistencies or lack of universality are inevitable.
description: Revised version. Original dated to August 1993. 

I am grateful for valuable comments from participants in the Harvard Tax Policy Workshop, participants in the Southern California Tax Policy Group and, outside the workshop context, from Don Brown, Tom Griffith, Henry Hu, Louis Kaplow, Bill Klein, Mike Knoll, Ed McCaffery, Roberta Romano, Ted Sims and Al Warren. All errors are my own responsibility. 

Published as Strnad, Jeff. "Taxing new financial products: a conceptual framework." Stanford Law Review (1994): 569-605.
description: Submitted - sswp819_-_revised.pdf