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. 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. In certain instances, financial derivative transactions can be used to  produce equivalent economic outcomes that have different tax results  because one financial derivative can fall under numerous tax rules. The current tax treatment is not the only possible method of taxing  financial derivatives, and experts have suggested a number of  alternatives that they believe would adopt a more consistent view of  financial derivatives and potentially reduce abuse. When application of the law is complex or  uncertain, as is often the case for financial derivatives, guidance is an  important tool for addressing tax compliance and emerging abusive tax  schemes. However, Treasury and IRS face  a number of challenges that are discussed below that may delay the  completion of guidance. This example and others have made Treasury and IRS aware of the  importance of weighing the need for guidance with the potential that new  guidance may also provide new opportunities for taxpayers to  aggressively reduce their tax liability by altering the structure of a  transaction. Opportunities Exist for IRS to Leverage Information from SEC and CFTC on Financial Derivatives

		IRS Does Not Systematically or Regularly Communicate with SEC or CFTC on Financial Derivatives

Currently, IRS does not systematically or regularly communicate with  SEC or CFTC on financial derivatives. IRS’s 2009-2013 Strategic Plan  lists strengthening partnerships across government agencies to gather  and share additional information as key to enforcing the law in a timely  manner to ensure taxpayers meet their obligations to pay taxes. According to IRS officials, such a process could help IRS ensure  they are fully using all available information to identify and address  compliance issues and abuses related to financial derivatives. These best practices suggest that agencies should look  for opportunities to enhance collaboration in order to achieve results that  would not be available if they were to work separately. Conclusions

Although financial derivatives enable companies and others to manage  risks, some taxpayers have used financial derivatives to take advantage  of the current tax system, sometimes in ways that courts have later  deemed improper or Congress has disallowed. Because  of their unique role in defining policy and administering the tax code,  Treasury and IRS are best positioned to study and recommend an  alternative approach to the taxation of financial derivatives. However, challenges  that IRS and Treasury face in developing guidance for financial  derivatives, including the risk of adverse economic effects of guidance  changes and the complexity of financial derivative products, have resulted  in some PGP projects taking longer than the 12-month period established  in the plan. IRS sometimes identifies new financial  derivative products or new uses of existing products long after they have  been introduced into the market. To provide more useful and timely information to taxpayers on the status  of financial derivative guidance projects, the Secretary of the Treasury  and the Commissioner of Internal Revenue should consider additional,  more frequently updated reporting to the public on ongoing projects listed  in the PGP, including project status, changes in priorities, and target  completion dates both within and beyond the 12-month PGP period. To more quickly identify new financial derivative products and emerging  tax issues, IRS should work to improve information-sharing partnerships  with SEC and CFTC to better ensure that IRS is fully using all available  information to identify and address compliance issues and abuses related  to the latest financial derivative product innovations. IRS agreed with our third recommendation to improve information-sharing  partnerships with the SEC and CFTC. We reviewed the projects included on the PGP from 1996 to 2010, the  years for which IRS had electronic records available. For each of the four case studies, we interviewed IRS and  Treasury officials and other tax experts, and analyzed research on the  taxation of derivatives, to discuss the identification and progression of  these transactions as guidance projects, the challenges IRS and Treasury  face issuing guidance on these transactions, and the consequences IRS  and taxpayers face from a lack of guidance.
Why GAO Did This Study

Recently, concerns have arisen about the use of certain financial derivatives to avoid or evade tax obligations. As requested, this report (1) identifies and evaluates how financial derivatives can be used to avoid or evade tax liability or achieve differing tax results in economically similar situations, (2) evaluates Internal Revenue Service (IRS) actions to address the tax effects of investments in financial derivatives through guidance, and (3) evaluates IRS actions to identify financial derivative products and trends through information from other agencies. GAO reviewed research and IRS documents and interviewed IRS and, Department of the Treasury (Treasury) officials and other experts. GAO analyzed the completion of financial derivative projects on the agencies' Priority Guidance Plans (PGP) from 1996 to 2010.

What GAO Found

Taxpayers have used financial derivatives to lower their tax liability in ways that the courts have found improper or that Congress has disallowed. Taxpayers do this by using the ease with which derivatives can be redesigned to take advantage of the current patchwork of relevant tax rules. As new products are developed, IRS and taxpayers attempt to fit them into existing "cubbyholes" of relevant tax rules. This sometimes leads to inconsistent tax treatment for economically similar positions, which violates a basic tax policy criterion. While the tax rules for each cubbyhole 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. Some experts have suggested alternate methods to the current approach for taxing financial derivatives. IRS and Treasury, because of their unique position to define policy and administer the tax code, are best positioned to study and recommend a new approach. When application of tax law is complex or uncertain, as is often the case for financial derivatives, guidance to taxpayers is an important tool for IRS to address tax effects and potential abuse. However, between 1996 and 2010, Treasury and IRS did not complete 14 out of 53 guidance projects related to financial derivatives that they designated as a priority on their annual PGP. While completing guidance is important in providing certainty to taxpayers and IRS and reducing the potential for abuse, challenges like the risk of adverse economic impacts of guidance changes and the transactional complexity of financial derivatives may delay the completion of guidance. Since challenges may prevent IRS from finalizing guidance within a 12-month PGP period, taxpayers need to be aware of ongoing guidance projects' status, some of which may span a number of years. IRS sometimes identifies new financial derivative products or new uses of them long after they have been introduced and gained considerable use. This slows its ability to address potential abuses. IRS's 2009-2013 Strategic Plan lists strengthening partnerships across government agencies to gather and share information as key to identifying and addressing new products and emerging tax schemes more quickly. Through their oversight roles for financial derivative markets, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) may have information on financial derivatives that is relevant to IRS. Similarly, bank regulators may gain relevant knowledge of derivatives' use. IRS officials said such routine communications in the early 1990s did provide relevant information. Although IRS communicates with SEC and CFTC on derivatives, it does not do so systematically or regularly. Strengthening partnerships would increase opportunities for IRS to gain information on new financial derivative products and uses. Studies of interagency coordination suggest that agencies should look for opportunities to enhance collaboration in order to achieve results that would not be available if they were to work separately, and a number of best practices exist to help agencies meet this goal.

What GAO Recommends

GAO recommends that (1) Treasury determine whether alternatives to the current approach to taxing financial derivatives would promote consistent treatment of economically similar positions and be beneficial, that (2) Treasury and IRS provide more public information on the status of PGP projects, including those related to financial derivatives, and that (3) IRS strengthen information-sharing partnerships with relevant agencies. IRS agreed with the third recommendation and disagreed with the second; Treasury disagreed with the first two recommendations. GAO continues to believe its recommendations would be beneficial.