Over the last couple of years, Dave Camp (Republican, Michigan), the chairman of the House Ways and Means Committee has released discussion drafts of several bills addressing reform of various part of the Internal Revenue Code.  As discussed in our December 2011 column, in October 2011 Chairman Camp introduced a discussion draft of a bill addressing international tax reform that would move the United States to a territorial system for the taxation of foreign income. More recently, in January 2013, Chairman Camp released a discussion draft of a bill that would reform the taxation of derivatives and other financial products. The Ways and Means Committee held hearings on that bill in March.  Also, in March Chairman Camp released a discussion draft of a bill addressing small business tax reform. Even though the prospect for bipartisan action on tax reform does not appear rosy at this time, Chairman Camp hopes to stimulate serious discussion of significant U.S. federal income tax policy and technical issues and build consensus for change over the longer term.
 
Discussion draft on derivative financial instruments
 
The discussion draft on derivatives would require most taxpayers to move to an annual mark-to-market regime for a broadly defined class of financial instruments, which the draft refers to as “derivatives.” It also would change the tax treatment of some common financial instruments and transactions, including certain debt instruments, certain business hedging transactions and investments in shares of stock.
 
While this discussion draft may be of only passing interest to non-US investors, the proposed changes to the taxation of “market discount” should be of particular interest. Market discount arises when a debt instrument is purchased after its date of original issue and has declined in value (either because of a rise in interest rates or a decline in the creditworthiness of the issuer). The discussion draft would require a holder of a bond with market discount to accrue the market discount ratably just as it would original issue discount (“OID”). The discussion draft also states that market discount would be treated as interest, except for purposes of, inter alia, sections 871 and 1441. These provisions relate to withholding on interest paid to foreign persons.
 
Under current IRS regulations, market discount is not considered fixed or determinable, annual or periodical income and so is not subject to withholding tax when paid to a foreign person.^[1] The discussion draft there would appear not to change the treatment of market discount when earned by foreign persons. However, under current law, OID is subject to withholding at the time a payment is made to the owner of the debt instrument (e.g., upon retirement or sale of the debt instrument).^[2] The discussion draft's treatment of market discount in the same manner as original issue discount strongly suggests that market discount would become subject to US tax should the discussion draft become law.^[3]
 
Discussion draft on small business tax reform
 
Last month, in March 2013, the Ways and Means Committee released a discussion draft of a bill addressing small business tax reform. The discussion draft addresses a number of small business tax issues, including a number of provisions intended either to provide incentives for new small business formation or to reduce the complexity of tax compliance for small business owners.
 
This discussion draft has certain provisions for reforming the tax rules for S corporations^[4] in order to more closely align those tax rules with the tax rules for partnerships.  In general, income of S corporations is subject only one level of U.S. federal income tax because S corporations generally pass through all items of income and deductions to their shareholders. However, in certain cases, S corporations are subject to a corporate level tax. S corporation are suitable for closely held businesses only because S corporations may have no more than 100 shareholders.
 
Under current law, a nonresident alien may not be a shareholder of an S corporation directly, and he may not be the beneficiary of an electing small business trust (“ESBT”). The draft bill would allow a nonresident alien to be a beneficiary of an ESBT. In order to collect U.S. tax, the trustee of the ESBT would be required to withhold U.S. income tax from the nonresident alien's share of the income of the S corporation.  Thus, should this provision become law, nonresident aliens could co-invest with US persons in an S corporation or acquire interests in such corporations.