Financial Products and Sources Basis Taxation : U.S. International Tax Policy at the Crossroads

The increasing use of derivatives to manage financial risks raises significant challenges for legislators and tax administrators in forging a coherent U.S. tax regime. Through the creative use of derivatives, taxpayers can transform a highly taxed return into an economically equivalent but lower taxed return. In the cross-border setting, the adroit use of derivatives by foreign investors can transform, for example, a U.S. source dividend taxed at thirty percent into an equivalent swap return taxed at zero percent. Although there are valid arguments to tax synthetic returns similarly as the returns to which they relate, This article argues that the United States should eschew such an approach with respect to cross-border users of financial products. Given the current exemption for foreign investors for capital gains and interest, any attempt to tax synthetic returns would require rules that would be frightfully complex, may violate tax treaty obligations, and could actually cost the United States tax revenue if other countries followed suit. Instead, The growth in derivatives may present an opportune time for tax administrators to re-evaluate U.S. international tax policy and consider, at least in the treaty context, the exemption from source basis taxation of all investment returns earned by foreign investors