Financial derivatives are globally used financial products that unbundle exposure to an underlying asset and transfer risks—the exposure to financial loss caused by adverse changes in the values of assets or liabilities—from entities less able or willing to manage them to those more willing or able to do so. The values of financial derivatives are based on an underlying reference item or items, such as equities, debt, exchange rates, and interest rates. Since 2001, interest rate contracts have made up the vast majority of all financial derivative contracts, on average 80 percent of all derivatives in terms of notional amount outstanding, and are used to hedge against changes in the cost of capital. Parties involved in financial derivative transactions do not need to own or invest in the underlying reference items, and often do not. The most common purpose of financial derivatives is to manage the holder’s risk, and this is often accomplished by constructing financial derivative contracts that produce more favorable rather than unfavorable tax results. Financial derivatives are sold and traded either on regulated exchanges or in private, over-the-counter markets that allow highly customized transactions specific to the needs of the parties. Financial derivatives are bilateral agreements that shift risk from one party to another but can be used to structure more complicated arrangements involving multiple transactions and parties. Simple financial derivatives act as building blocks for more complex products, and can be broken down into three general categories of products, described in figure 1. Credit derivatives, depending on their structure, fall into one of these three categories, but are often measured as a separate category by government agencies. Dealers participate in the financial derivatives market by quoting prices to, buying derivatives from, and selling derivatives to end users and other dealers. They also develop customized derivative products for their clients. Commercial banks, which most often act as dealers, are typically one of the two parties involved in financial derivative transactions. In 2010 the holdings of five large commercial banks represented over 95 percent of the banking industry’s notional amounts outstanding. End users, including commercial banks, securities firms, hedge funds, insurance companies, governments, mutual funds, pension funds, individuals, commercial entities, and other dealers, often use derivatives to protect against adverse change in the values of assets or liabilities, called hedging. Hedgers try to protect themselves from risk by entering into derivatives transactions whose values are expected to change in the opposite direction from the values of their assets or liabilities. According to a 2009 survey conducted by the International Swaps and Derivatives Association, over 94 percent of the largest companies’ worldwide use financial derivatives to manage and hedge risks. End users can also use derivatives for speculation by taking on risk in an attempt to profit from changes in the values of derivatives or their reference items. Derivatives are attractive to speculators because they can be more cost-effective than transactions in the underlying reference item, due to reduced transaction costs and the leverage that derivatives provide. Financial derivatives transactions are generally leveraged since parties to these transactions most often initiate the transaction with little money down relative to the expected outcome of the transaction. In any financial transaction, the degree of permissible leverage is determined by the collateral required to secure the transaction. While a high degree of leverage has the potential for large gains, it also carries risks of large losses. As we and others have reported, the risk exposures resulting from derivatives were one of many factors that contributed to the systemic risk that led to the recent financial crisis. The market for financial derivatives has grown considerably in size over the past two decades. Two common ways to measure the size of financial derivative markets overall are total notional amount and fair market value. Total notional amount represents the value of the reference items underlying financial derivative transactions, and is the amount upon which payments are computed between parties of derivatives contracts. Notional amount does not represent money exchanged, nor does it represent the risk exposure. The second measure, fair market value, can be either the gross positive fair value or the gross negative fair value. The gross positive fair value represents the sum of the fair values of the financial derivative contracts where the commercial bank is owed money by the other party in the contract and represents the maximum losses the bank could incur if all other parties in the contracts default. According to the OCC, between the first quarter of 1999 and the fourth quarter of 2010, the total notional amount outstanding used to calculate payments for derivatives contracts held by insured U.S. commercial banks and trust companies grew over six times, from $32.7 trillion to $231.2 trillion. For those same institutions, gross positive market value grew nearly seven- and-a-half times, from $0.46 trillion to $3.87 trillion (see fig. 2). The difference in these numbers is due to the fact that the notional amount is used to calculate payments from the contracts, which are typically a small percentage of the notional amount. The net present value of these payments determine, in part, gross positive market value. Because commercial banks are one of the parties involved in over 95 percent of financial derivative contracts, these measures are good indicators of the entire U.S. market. The volatility seen in figure 2 during the latter part of 2007 and 2008 is attributed in part to turmoil in financial markets and banking consolidation. In part because different types of financial derivatives are reported differently to IRS by taxpayers and third parties, and in most cases are not clearly identified as financial derivatives, IRS told us that data are not available to estimate overall gains and losses of income earned from financial derivatives. announcements, and technical advice memorandums. Regulations, which provide taxpayers with directions on complying with new legislation or existing sections of the tax code, hold more legal weight than IRS’s other forms of guidance. Generally, regulations are first published in draft form in a Notice of Proposed Rulemaking, and final regulations are issued after public input is fully considered through written comments and potentially a public hearing. Where new or amended regulations may not be published in the immediate future, notices are often used to provide substantive interpretations of the tax code and other provisions of the law. In addition, IRS issues revenue rulings to provide official interpretations of the tax code, related statutes, tax treaties, and regulations. These interpretations are specific to how the law is applied to a particular set of facts. Revenue procedures provide return filing or other instructions concerning an IRS position. Private letter rulings are written statements issued to a single taxpayer that interpret and apply tax laws to that taxpayer’s specific set of facts. They are not officially published and may not be relied on as precedent by other taxpayers or IRS. Announcements, which generally have only immediate or short-term relevance, summarize laws and regulations without making any substantive interpretation; state what regulations will say in the future; or notify taxpayers of the existence of an approaching deadline. Finally, technical advice memorandums are developed in response to technical or procedural questions that develop during an examination or a processing in Appeals. Unique characteristics of financial derivatives make them particularly difficult for the tax code and IRS to address. The tax code’s current approach to the taxation of financial derivatives is characterized by many experts as the “cubbyhole” approach. Under this approach, the tax code establishes broad categories for financial instruments, such as debt, equity, forwards, and options, each with its own rules governing how and when gains and losses are taxed. As new instruments are developed, IRS and taxpayers attempt to fit them into existing tax categories by comparing the new instrument to the most closely analogous instruments for which tax rules exist. However, a new financial instrument could be similar to multiple tax categories, and therefore IRS and taxpayers must choose between alternatives. This could result in inconsistent tax consequences for a transaction that produces the same economic results. Derivative contracts, particularly those traded over-the-counter, are highly flexible, allowing taxpayers to structure transactions to take advantage of the different tax rules for each tax category. Derivatives can also be coupled with each other and with other types of financial instruments, like more traditional debt or equity instruments, to create hybrid securities. Because hybrid securities often do not clearly fall within a single tax category, it can be challenging for IRS and taxpayers to determine which tax rules are appropriate, and whether the hybrid should be treated as a single instrument or broken up into multiple instruments. While the tax rules for each tax category represent Congress’s and Treasury’s explicit policy decisions, some of these decisions were made long before today’s complex financial derivative products were created. The cumulative effect of these decisions combined with the fact that many financial derivatives do not fit neatly in any one tax category can result in mistakes or opportunities for abuse by taxpayers. Tax rules governing financial derivatives can be broken down into rules governing the timing, character, and source of gains and losses, as described in table 1. These rules vary depending on a number of factors, including the type of financial derivative product, the underlying reference item, the transaction’s cash flows, the type of taxpayer, the taxpayer’s purpose for using the transaction, and applicable anti-abuse rules. Over time, as financial derivative products have been developed that do not fit neatly into existing tax categories, numerous tax rules have been created to address new financial products, sometimes without anticipating the relationship between those transactions and others. Therefore, tax rules for financial derivatives can vary widely from one transaction to another. While the source of gains and losses resulting from financial derivatives is generally that of the residence of the recipient, the tax rules for timing and character are more complicated. As stated above, some of these tax rules depend on the type of financial derivative product. For example, nonequity options not held to hedge a transaction are taxed under section 1256 of the Internal Revenue Code (IRC), which requires that the timing of gains and losses are marked-to-market at the end of the tax year, and that the character of gains and losses is treated as 60 percent long-term capital and 40 percent short-term capital. Equity options held by dealers are also taxed under section 1256.