[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
DERIVATIVES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
of the
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
MARCH 5, 2008
__________
Serial No. 110-73
__________
Printed for the use of the Committee on Ways and Means
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COMMITTEE ON WAYS AND MEANS
CHARLES B. RANGEL, New York, Chairman
FORTNEY PETE STARK, California JIM MCCRERY, Louisiana
SANDER M. LEVIN, Michigan WALLY HERGER, California
JIM MCDERMOTT, Washington DAVE CAMP, Michigan
JOHN LEWIS, Georgia JIM RAMSTAD, Minnesota
RICHARD E. NEAL, Massachusetts SAM JOHNSON, Texas
MICHAEL R. MCNULTY, New York PHIL ENGLISH, Pennsylvania
JOHN S. TANNER, Tennessee JERRY WELLER, Illinois
XAVIER BECERRA, California KENNY HULSHOF, Missouri
LLOYD DOGGETT, Texas RON LEWIS, Kentucky
EARL POMEROY, North Dakota KEVIN BRADY, Texas
STEPHANIE TUBBS JONES, Ohio THOMAS M. REYNOLDS, New York
MIKE THOMPSON, California PAUL RYAN, Wisconsin
JOHN B. LARSON, Connecticut ERIC CANTOR, Virginia
RAHM EMANUEL, Illinois JOHN LINDER, Georgia
EARL BLUMENAUER, Oregon DEVIN NUNES, California
RON KIND, Wisconsin PAT TIBERI, Ohio
BILL PASCRELL JR., New Jersey JON PORTER, Nevada
SHELLEY BERKLEY, Nevada
JOSEPH CROWLEY, New York
CHRIS VAN HOLLEN, Maryland
KENDRICK MEEK, Florida
ALLYSON Y. SCHWARTZ, Pennsylvania
ARTUR DAVIS, Alabama
Janice Mays, Chief Counsel and Staff Director
Jon Traub, Minority Staff Director
______
Subcommittee on Select Revenue Measures
RICHARD E. NEAL, Massachusetts, Chairman
LLOYD DOGGETT, Texas PHIL ENGLISH, Pennsylvania
MIKE THOMPSON, California THOMAS M. REYNOLDS, New York
JOHN B. LARSON, Connecticut ERIC CANTOR, Virginia
ALLYSON Y. SCHWARTZ, Pennsylvania JOHN LINDER, Georgia
JIM MCDERMOTT, Washington PAUL RYAN, Wisconsin
RAHM EMANUEL, Illinois
EARL BLUMENAUER, Oregon
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
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C O N T E N T S
__________
Page
Advisory of February 27, 2008, announcing the hearing............ 2
WITNESSES
Michael J. Desmond, Tax Legislative Counsel, United States
Department of the Treasury..................................... 6
Alex Raskolnikov, Associate Professor of Law, Co-Chair, Charles
E. Gerber Transactional Studies Program, Columbia Law School... 15
Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, University
of Michigan Law School......................................... 27
Keith A. Styrcula, Chairman, on behalf of Structured Products
Association.................................................... 34
George U. ``Gus'' Sauter, Chief Investment Officer, The Vanguard
Group; Managing Director, Quantitative Equity Group............ 54
William M. Paul, Covington & Burling LLP, on behalf of Investment
Company Institute (ICI)........................................ 59
Leslie B. Samuels, Partner, Cleary Gottlieb Steen & Hamilton LLP,
on behalf of Securities Industry and Financial Markets
Association (SIFMA)............................................ 68
Michael B. Shulman, Partner, Shearman & Sterling LLP............. 81
DERIVATIVES
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WEDNESDAY, MARCH 5, 2008
U.S. House of Representatives,
Committee on Ways and Means,
Subcommittee on Select Revenue Measures,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10:00 a.m., in
room 1100, Longworth House Office Building, Hon. Richard E.
Neal (Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 225-5522
FOR IMMEDIATE RELEASE
February 27, 2008
SRM-8
Neal Announces Hearing on
Tax Treatment of Derivatives
House Ways and Means Select Revenue Measures Subcommittee Chairman
Richard E. Neal (D-MA) announced today that the Subcommittee on Select
Revenue Measures will hold a hearing on the tax treatment of certain
derivatives. The hearing will take place on Wednesday, March 5, 2008,
in the main Committee hearing room, 1100 Longworth House Office
Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be limited to invited witnesses
only. However, any individual or organization not scheduled for an oral
appearance may submit a written statement for consideration by the
Committee and for inclusion in the printed record of the hearing.
FOCUS OF THE HEARING:
The hearing will focus on various forms of derivatives. Interest in
certain types of derivatives has increased over the last few years as
many innovative structures have reached the financial markets. The
hearing will examine the tax treatment of some of these products.
BACKGROUND:
A derivative is a financial instrument which derives its value from
the value of an underlying asset. Generally, two parties place a bet
about a particular stock price, interest rates, or some other financial
fact. Derivatives are used to spread risk through hedging or
speculating about a specific contingency, and may take the form of an
option, forward contract, swap, or contingent bond.
In the case of an option, the holder receives the right, but not
the obligation, either to buy or to sell the underlying property for a
specified price during a specified period. A ``call'' is an option to
buy and a ``put'' is an option to sell. Unlike an option, a forward
contract obligates the parties to either buy or sell the underlying
property for a specified price during a specified period as reflected
in the contract. Under a prepaid forward contract, the contract buyer
generally makes a payment at the time the contract is executed and is
not required to make any additional payment when the contract expires.
A swap is in effect a series of cash-settled forward contracts. In some
swaps, differences in the value of the underlying property are settled
up every governing period while in other swaps, these changes are not
taken into account until a final, nonperiodic payment is made at the
maturity date. Under a contingent debt instrument, the borrower pays
interest (and sometimes a portion of the principal) based on some
financial fact. From an economic perspective, contingent debt is
sometimes viewed as the synthesis of a standard loan with a derivative
such as an option.
The tax consequences for different derivative instruments can be
very different even though the instruments are economically similar.
The hearing will examine whether there is a need for more uniform tax
treatment for various derivative structures.
In announcing the hearing, Chairman Neal stated, ``The expanding
derivatives market is already a $516 trillion global enterprise, only
some of which is subject to regulation and transparency. I think it is
appropriate for Congress to review the tax rules as they apply to these
complex financial products and determine whether changes may be
necessary.''
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Chairman NEAL. Let me call this meeting to order, and I
would invite all to take their seats. I want to welcome
everyone to this hearing on the taxation of derivatives by the
Subcommittee on Select Revenue Measures.
This topic is not for the faint of heart. Just explaining
the different types of derivatives can fill volumes, plus the
market is constantly evolving and growing. The Bank for
International Settlements recently estimated that the market
for derivatives has now exceeded $500 trillion in notional
amounts just for the first half of last year. For those taking
notes, $500 trillion is half a quadrillion.
Complexity is the name of the game in the derivatives
market, but I believe that it is important for Congress to
understand how this market operates and for the Committee to
understand how these products are taxed. In that sense, this is
a learning opportunity for all today.
It would be easy for us to assume the regulators are taking
care of this. Some of us who have long-term memories in
Congress, we know that that is not always the case. It would be
easy for us to dismiss these products as ones that only
sophisticated investors use, minimizing any impact to our
economy. It has been said that the road to success is dotted
with many tempting parking places. But this morning, we plan to
keep on driving.
No doubt, derivatives play an important role for businesses
and investors to minimize or control risk. But they are also an
attractive tool for speculators. Warren Buffett has referred to
derivatives as ``financial weapons of mass destruction.'' If we
think back to the collapse of Enron, or even farther back to
long-term capital management, we understand how the abuse of
derivatives can have a negative impact not only on the parties
to the contract but also on the market and the economy.
Just last Friday, the market took a hit when one insurer
devalued its holdings by $5 billion in one derivative, the
credit default swap. As we will hear today in testimony,
investors and regulators deserve some certainty and, perhaps
more importantly, clarity with respect to derivatives. I
believe we set up inherit conflicts when derivatives enjoy a
better tax treatment than the underlying asset.
The first panel today will discuss the area of derivatives
more broadly, while the second panel will focus on prepaid
forward contracts. I believe we have assembled a diverse group
of witnesses today to help us navigate this complex area. There
is an African proverb that says that smooth seas do not always
make skillful sailors. I expect the testimony today will show
some divergent viewpoints, but hopefully at the end Mr. English
and I will be more skillful sailors.
With that, I would like to recognize my friend Mr. English
for his opening statement.
Mr. ENGLISH. Mr. Chairman, I first of all want to thank you
for calling this hearing today. I am looking forward to another
active year for this Subcommittee dealing with many of the
extraordinary issues confronting Congress with respect to the
Tax Code. I want to thank you in advance, Mr. Chairman, for
remaining receptive to input from our side of the aisle on the
Subcommittee's agenda, as you were all last year.
While I look forward to the nuances of all the testimony
today, I am particularly interested in the second panel's
framing of the complex issue of exchange traded notes, as well
as their views on whether the current tax treatment of these
products is appropriate or warrants change.
Mutual funds have sought for some time the ability to defer
some or all of the gains that currently must be distributed and
taxed at the investor level, and I have been sympathetic with
that project.
Additionally, some of the same companies that offer mutual
funds have developed a product that provides many of the
benefits of a mutual fund, including diversification and
exposure to a variety of types of risk, without requiring
annual distributions of income. In my view, this demonstrates
that clever minds can always find a way through and around the
Tax Code to achieve a desired result.
In light of this, it may prove in the long run perhaps more
fruitful to look at the labyrinth of rules currently on the
books for financial products generally and determine whether
wholesale revision is needed. Yet today's hearing, I think, in
embarking on the narrower mission of determining whether a
change in our Tax Code relative to ETNs is warranted, is a
worthwhile endeavor.
Given the fundamental difficulty of undertaking a more
complicated reform, I sympathize with the Chairman's desire to
examine this narrower tax issue on its own. Nevertheless, I
want to raise the concern, having reviewed the legislative
approach favored by the Chairman, that we not simply serve to
replace one area of examination for another. After all, the
same ingenuity and creativity that creates innovative financial
products in capital markets will continue to evolve.
I favor solutions philosophically that provide for less
taxation on capital overall rather than more. In the 109th
Congress, I joined many of my Ways and Means colleagues in
cosponsoring the GROWTH Act, introduced by Representative Paul
Ryan, that would allow some deferral of gains on mutual funds
for investors who reinvest those amounts.
Generally speaking, if an issue of equity between two
functionally similar financial products arises, I tend to favor
reducing taxes on one rather than raising taxes on the other.
But I do think the notion of tax equity is something that we
can fruitfully pursue today.
With that, Mr. Chairman, I look forward to the testimony
and I look very much forward to getting the guidance from these
panels that we will need to parse this issue.
Chairman NEAL. Thank you, Mr. English.
Let me welcome our witnesses today. On the first panel we
will hear from Michael Desmond, Tax Legislative Counsel in the
Office of Tax Policy at the Treasury Department. Mr. Desmond is
a veteran of Ways and Means hearings, and we look forward to
his comments today.
Next we will hear from two tax law experts, Professor Alex
Raskolnikov from Columbia Law School and Professor Reuven Avi-
Yonah from the University of Michigan Law School.
Finally, on Panel 1 we will hear from Keith Styrcula,
Chairman of Structured Products Association, a trade group with
expertise in derivatives.
With that, I would call upon Mr. Desmond to proceed.
STATEMENT OF MICHAEL J. DESMOND, TAX LEGISLATIVE COUNSEL,
UNITED STATES DEPARTMENT OF THE TREASURY
Mr. DESMOND. Mr. Chairman, Ranking Member English, and
distinguished Members of the Subcommittee, thank you for the
opportunity to discuss with you today the Federal tax treatment
of certain derivative products, including prepaid forward
contracts.
With the growing complexity and sophistication of our
financial markets, the tax treatment of derivatives plays an
increasingly important role in the efforts of the Treasury
Department and the IRS to administer the Nation's tax laws. We
appreciate the Subcommittee's focus on these important issues.
The tax treatment of prepaid forward contracts is of
particular current interest to the Treasury Department. Last
December we issued a formal notice announcing that we are
considering the subject and requesting public comments.
Although we have not determined how to proceed with respect to
the notice, for purposes of today's hearing I thought it would
be helpful to describe the context in which we have seen the
tax issues associated with prepaid forward contracts arise, and
some of the challenges that we see in addressing those issues.
Historically, forward contracts developed as a means for
parties to hedge against the risk of price fluctuations in
their ordinary business transactions. By fixing the price at
which some asset will be acquired or sold in the future, a
forward contract can reduce the business risk of adverse price
movements.
Forward contracts have grown beyond their historical
origins as business hedges, however, and are now commonly used
not only to manage risk but also by investors to speculate on
the future value of a referenced asset.
A traditional forward contract is an agreement in which one
party agrees to purchase and the other party agrees to sell and
deliver a specific referenced asset at a specific time for a
specific price. So-called prepaid forward contracts require the
purchasing party to pay the purchase price upon execution of
the contract rather than on the later delivery date.
Because the buyer pays in advance, the price is less than
it would be in a standard forward contract. A question for the
tax system is whether the buyer of a prepaid forward contract
should recognize ordinary income over the period of the
contract on the grounds that the prepayment is analogous to a
loan from the buyer to the seller.
The Federal tax law contains a number of specific rules
governing the tax treatment of stock, debt, options,
traditional forward contracts, futures contracts, certain
swaps, and various other financial instruments. Different rules
may apply to identical instruments depending on the
circumstances, including whether the taxpayer that is a party
to the contract is an investor, a trader, a dealer, or a
business hedger; whether the taxpayer is domestic or foreign;
and whether the referenced asset triggers specific tax
treatment, as happens with foreign currency.
The resulting set of complex rules reflects various policy
choices that Congress and the Treasury Department have made
over the years with respect to the timing, character, and
source--that is, foreign or domestic--of income or loss.
Financial innovation challenges the current system of
taxing derivatives because that system has historically
approached new financial instruments by assigning them to
various categories or cubbyholes for which there are
established rules.
Without clear guidance about which category is appropriate
for a new transaction, taxpayers are left to deal with
uncertainty in structuring their affairs, and the IRS is
presented with challenges in administering the tax law.
Because this cubbyhole approach often responds not to the
substance of the transaction but to its formal attributes, the
approach results in different tax consequences for economically
equivalent transactions.
In my written testimony, I give three examples to
illustrate this inconsistency in the context of prepaid forward
contracts. The first example in my written testimony involves a
simple purchase of stock for $100, and the sale of that stock 2
years later when the price has risen to $125.
In the second example, there are two separate agreements
entered into by the investor. In the first agreement, the
investor buys a zero coupon bond for $100. That bond matures 2
years later for $112, reflecting an interest rate of
approximately 6 percent.
In the second agreement in that second example, also
entered into on the first day, X, the taxpayer, enters into a
cash-settled forward contract to purchase a share of stock in 2
years for $112. In that second example, X receives $125 after 2
years, consisting of $112 from redemption of the bond and $13
from settlement of the forward contract on the stock which has
risen in value to $125.
In the third example, involving a prepaid forward contract,
on day one X enters into a prepaid forward contract, to
purchase a share of stock in 2 years. Under the contract, the
taxpayer pays $100 on the first day and receives, after 2
years, $125.
These three examples each involve economically equivalent
transactions. In each case, the investor or the taxpayer paid
$100 on the first day and received $125 2 years later for an
economic return of $25. However, on an aftertax basis, the
transactions differ considerably.
In the first example, the taxpayer pays tax on its entire
$25 economic return on a deferred basis at the long-term
capital gain rate.
In the second example, our tax rules require the taxpayer
to accrue $12 in interest income into taxable income on a
current basis and pay tax on those accruals in the first and
second year at ordinary tax rates. The taxpayer pays an
additional $13 attributable to the forward contract on a
deferred basis at long-term capital gain rates.
In attempting to assign the third example to one of the
traditional cubbyholes for which the tax system has prescribed
rules, investors in the taxpayer's position often conclude that
the transaction is not debt under common law tax principles
since there is no guaranteed return of principal.
Investors in that taxpayer's position often also conclude
that their counter party in the transaction is not required to
hold any stock, and the counter party is therefore not acting
as their agent holding the stock on their behalf. These
taxpayers, rejecting both debt and agency characterizations,
generally assert that the transaction should be treated as a
forward contract taxed on a deferred basis only upon
realization.
The Treasury Department and IRS have been aware for some
time of the difficult issues raised with respect to the tax
treatment of prepaid forward contracts. To date, we have not
issued published guidance on these contracts with referenced
assets other than foreign currency.
In 2006, we began to learn of significant growth in the
number of prepaid forward contracts, often referred to as
exchange traded notes or ETNs, being offered to retail
investors. The growth of ETNs and the migration of prepaid
forward contracts into the portfolios of retail investors was
an occasion for us to revisit the core issue presented, that
is, whether the Federal Income Tax System should require a
current accrual of income on these instruments.
Although it would be very desirable for us to clarify the
law in this area, and we are actively looking to do so in the
context of the notice we published, to date we have reached no
conclusion about how to proceed, about what the right result
is, and about whether that result can be researched through
administrative guidance or through legislative action.
Thank you, Mr. Chairman, Ranking Member English, and
Members of the Subcommittee for providing an opportunity for us
to participate in today's hearing on this important subject. I
am pleased to take any of your questions on this important
issue.
[The prepared statement of Michael J. Desmond follows:]
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Chairman NEAL. Thank you, Mr. Desmond.
Mr. Raskolnikov.
STATEMENT OF ALEX RASKOLNIKOV, ASSOCIATE PROFESSOR OF LAW, CO-
CHAIR, CHARLES E. GERBER TRANSACTIONAL STUDIES PROGRAM,
COLUMBIA LAW SCHOOL
Mr. RASKOLNIKOV. Mr. Chairman, Ranking Member English,
Members of the Committee, thank you for inviting me to testify
here today on the increasingly important subject of taxation of
derivatives.
The debate about taxation of derivatives is largely the
debate about income tax and consumption tax. There is hardly
any doubt that derivatives are business-driven, socially useful
products of financial innovation.
Yet they also have an undesirable side effect. They offer
unprecedented opportunities to reduce or eliminate taxation of
capital income. Without it, an income tax will become a
consumption tax. If the United States were to switch to a
consumption tax, Congress and not individual taxpayers or
groups of taxpayers should make this decision.
So, what could be done about taxation of derivatives? In
the absence of comprehensive reform, the options are limited.
Three criteria have been developed as benchmarks of an
effective and efficient capital income tax.
Unfortunately, symmetry, a system in which both sides of
every transaction are taxed under the same timing rule and
rate; consistency, a system in which economically similar
transactions are taxed the same regardless of the labels
attached by taxpayers; and balance, a system in which gains and
losses from each derivative are treated alike, are all
unattainable without a fundamental revision of the existing
rules.
This does not mean, however, that Congress shouldn't act.
When financial innovation creates a potential for a self-made
consumption tax reform, Congress should defend its choice of
the tax base. In evaluating proposed legislation, three
inquiries should be the focus of congressional analysis, while
two other commonly raised considerations are less important.
First, and quite obviously, Congress should focus on the
amount of revenue at stake. What is the tax effect of a
particular derivative? Is it deferral of income, conversion of
high taxed returns into low taxed ones, or both? Are there non-
tax constraints that limit the number of taxpayers who can take
advantage of this tax planning? In short, not all tax abuses
should be pursued. Rather, it is worth focusing on the largest
ones.
Second, Congress should ensure that new legislation is
effective in constraining tax planning, or in other words, is
difficult to game. Otherwise taxpayers will expend even more
resources to reduce their tax bills and little new revenue will
be raised.
Of course, opponents of any new rule will argue that it
will be easy to avoid. These arguments should be put to a
serious test. Congress should require these opponents to
demonstrate with some specificity how this easy avoidance will
take place. If they do, Congress will have an opportunity to
improve the proposed legislation. If it can't be improved, the
proposal should be abandoned.
Third, policymakers should consider administrative and
compliance costs of any proposal. These are real social costs,
even when they are incurred by private parties and are
invisible in the budget process. The factors here are the
complexity of the new legislation, the number and financial
sophistication of the taxpayers involved, and the existence of
relevant information in the marketplace.
On the other hand, Congress should take reasoning by
analogy and arguments about additional complexity with a grain
of salt, especially in this area. As for complexity, tax rules
for derivatives are already extremely complex. Adding yet
another regime not entirely consistent with what we have now
may not make much of a difference. As for reasoning by analogy
to the existing instruments or investments, this approach does
not illuminate any of the three important issues I just raised,
so it only confuses the debate.
These suggestions about incremental reforms should not
obscure the larger issue. All such reforms leave much to be
desired. In contrast, a comprehensive yet limited reform is
possible, and I urge this Committee to give it serious
consideration. All derivatives, with the exception of business
hedges, should be subject to a mark to market regime, and gains
and losses from derivatives should be taxed at the top
individual or corporate marginal rate.
If adopted, this regime will create balance in taxation of
derivatives, assure appropriate taxation of labor income and
time value returns disguised as risky returns, put an end to
the mind-numbing complexity of the current rules, end the waste
of time and effort currently spent on devising new ways to game
the system, and eliminate the need for Congress, the Treasury,
and the IRS to endlessly monitor and respond to financial
innovation.
As all reforms, this mark to market regime will come with
some costs. Yet some of these costs are not as serious as they
may first appear. In any case, these costs are well worth
incurring in light of the great benefits this reform will
bring.
Thank you, and I look forward to your questions.
[The prepared statement of Alex Raskolnikov follows:]
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Chairman NEAL. Thank you.
Mr. Yonah.
STATEMENT OF REUVEN S. AVI-YONAH, IRWIN I. COHN PROFESSOR OF
LAW, UNIVERSITY OF MICHIGAN LAW SCHOOL
Mr. AVI-YONAH. Thank you, Chairman Neal, and thank you,
Representative English and Members of the Subcommittee, for
inviting me to testify before you today.
Professor Raskolnikov has addressed two of the three
aspects of derivatives that are of interest, namely, the
character of the income and the timing of the income. I want to
focus on the third characteristic mentioned by Mr. Desmond
earlier, namely, the source of the income.
It has been well known for a long period of time that
derivatives can be used in some circumstances to avoid the U.S.
withholding tax that is applied to foreigners who invest in our
markets. The combination of treaty rules and exemptions in the
Code, in particular the portfolio interest exemption that was
enacted in 1984, mean that the main type of income on which we
levy the withholding tax are dividends, and it is that type of
income that can be--that type of tax that can be avoided by
using derivatives.
In particular, there is a derivative called the total
return equity swap, which involves a foreigner entering into an
agreement with a U.S. investment bank under which there is an
investment up front, and at the end of the contract there is a
return either of the capital appreciation or a payment by the
foreigner of the depreciation of the instruments, that is
linked to the performance of a particular U.S. stock.
But in addition to that, there is an agreement that the
U.S. investment bank will pay a dividend equivalent amount to
the foreigner every time that the U.S. corporation pays an
actual dividend. Then the investment bank turns around and
makes an investment in the actual stock of the company.
The tax result is, as opposed to a direct investment in the
stock of the company where there will be withholding tax of at
least 15 percent and sometimes 30 percent of the dividend, in
this case the payment by the company to the investment bank is
not subject to withholding tax because it is not to a
foreigner, and the payment by the investment bank to the
foreigner is not subject to withholding tax because, under
regulations issued in the early 1990s, those payments are
sourced to the residence of the recipient, and the recipient
being a foreigner, the taxation does not apply.
A more modern version of this is the type of more
complicated derivative that was issued in the recent deals
involving the sovereign wealth funds of Abu Dhabi and China,
investing respectively in Citigroup and in Morgan Stanley. What
those deals involved are a combination of investment that is
denominated in notes, that instrument, as a unit, with what is
essentially a prepaid forward contract that is convertible into
stock at the end of some period.
Even though these investments are denominated, for example,
for bank regulatory purposes and also for purposes of the
scrutiny of foreign investment into the U.S. as equity, for tax
purposes the IRS has issued the ruling in 2003 that results in
bifurcating the instrument into two. One is simply a forward
contract that has no consequences until it is executed; and the
other one is a debt instrument that results in current interest
being paid, and that interest is exempt from tax under the
portfolio interest exemption.
So, the question is: What can be done about these kind of
circumstances? Well, one, a possibility is simply to close
these particular loopholes. For example, in the case of
payments on securities lending transaction, the IRS knows very
well to treat dividend equivalents as equivalent to dividends
and subject to the withholding tax. In the case of the
Citigroup and Morgan Stanley transactions, it is possible to,
instead of bifurcating and treating a unit as a single
instrument, treat it as an equity investment consistent with
its treatment for banking purposes.
But the problem is that stopping these particular loopholes
and only focusing on them will then lead to other loopholes.
You can imagine, for example, a total return equity swap that
links to a basket of stocks rather than a particular stock. I
am sure you can invent derivatives that will bypass any
loophole-closing device that applies specifically to the unit
investments.
So, what can be done more broadly? Well, one possibility
for this Subcommittee to consider is to change a source rule
that was adopted by the Treasury in the early 1990s. I don't
know of any other example where a major source rule was adopted
by regulation. Most of the source rules are in the Code, and
they are considered by Congress and thought out. This
particular one, which involved a potential avoidance of tax on
billions of dollars of investment, was adopted by regulation. I
think the Committee should consider aligning the source rule
for derivative payments to the source rule for dividends and
interest, both of which are taxed based on the residence of the
payor.
More extensively, I think, because derivatives can be used
to convert equity into that and vice versa, the Committee
should think about a possibility of looking at the portfolio
interest exemption, at least in situations where the payment is
made to a country with which we don't have a tax treaty or a
tax haven. In that circumstance, there is already authority in
the Code that is given to the Treasury to suspend the portfolio
interest exemption if there is not adequate exchange of
information, and I think the Committee might look into that as
well.
Thank you very much.
[The prepared statement of Reuven S. Avi-Yonah follows:]
Prepared Statement of Reuven S. Avi-Yonah,
Irwin I. Cohn Professor of Law, University of Michigan Law School
My name is Reuven S. Avi-Yonah. I am the Irwin I. Cohn Professor of
Law and Director of the International Tax Master of Law Program at the
University of Michigan Law School. I hold a JD (magna cum laude) from
Harvard Law School and a PhD in History from Harvard University. I have
19 years of full and part time experience in the tax area, and have
been associated with or consulted to leading law firms like Cravath,
Swaine & Moore, Wachtell, Lipton, Rosen & Katz and Cadwalader,
Wickersham & Taft. I have also served as consultant to the U.S.
Treasury Office of Tax Policy and as member of the executive committee
of the NY State Bar Tax Section. I am currently Chair of the ABA Tax
Section Committee on VAT, a member of the Steering Group of the OECD
International Network for Tax Research, and a Nonresident Fellow of the
Oxford University Center on Business Taxation. I have published 11
books and over 80 articles on various aspects of U.S. domestic and
international taxation, and have 14 years of teaching experience in the
tax area (including basic tax, corporate tax, international tax and tax
treaties) at Harvard, Michigan, NYU and Penn Law Schools.
I would like to thank Chairman Neal and the Committee staff for
inviting me to testify today on the international aspects of the tax
treatment of derivatives.
1. The Use of Derivatives To Avoid Withholding Taxes
Since the beginning of the income tax, the U.S. has imposed a
withholding tax (currently 30 percent) on payments of ``fixed or
determinable, annual or periodical'' (FDAP) U.S. source income to
nonresidents. However, recent developments such as the rise of
derivative financial instruments have seriously undermined our ability
to tax FDAP at source, which frequently means that it is not subject to
tax at all. This is true even if the income ultimately inures to the
benefit of U.S. residents.
The major categories of FDAP are dividends, interest, royalties and
rents. Of these, royalties and rents are typically not subject to
source-based taxation because of our tax treaties. Interest is likewise
rarely subject to tax at source because of the portfolio interest
exemption (IRC 871(h)), which exempts most payments of interest to
nonresidents from withholding tax. Interest payments that do not
qualify for the portfolio interest exemption are frequently exempt by
our tax treaties. Thus, the main category of FDAP that is still subject
to withholding tax is dividends. Generally, even dividends paid to
residents of countries with whom we have a tax treaty are subject to
tax at 15 percent, while dividends paid to residents of countries with
which we do not have a tax treaty are subject to the full tax of 30
percent.\1\
---------------------------------------------------------------------------
\1\ Dividends paid to controlling shareholders are generally
subject to tax under treaties at 5%, but some of our recent treaties
reduce this tax to zero.
---------------------------------------------------------------------------
How can derivatives be used to avoid the withholding tax on
dividends? A simple example involves a derivative called a total return
equity swap (TRES). In a TRES, a foreign investor enters into a
contract with a U.S. investment bank under which the investor pays the
bank an initial amount, say 100. In return, the bank agrees to pay the
investor an amount equal to the dividends paid by a U.S. corporation in
a given period of time (e.g. 5 years). In addition, the bank agrees at
the end of the 5 years to pay the investor any appreciation in the
value of the U.S. corporation's stock over 100, and the investor agrees
to pay the bank if the stock declines under 100. The bank then turns
around and invests the 100 in the stock of the U.S. corporation.
What are the tax consequences of this arrangement? The capital gain
or loss at the end of the 5 years is not subject to U.S. tax even in
the absence of a TRES because we generally do not tax capital gains of
nonresidents. However, the TRES does make a difference to the taxation
of any dividends paid during the 5 years. If the investor had invested
directly in the stock of the U.S. corporation, any dividends would have
been subject to tax at a rate of at least 15 percent. However,
dividends paid by the U.S. corporation to the U.S. investment bank are
not subject to withholding tax because they are not paid to a
nonresident. The investment bank does include them in income, but it
gets an offsetting deduction for paying the dividend equivalent to the
foreign investor. The dividend equivalents in turn are not subject to
withholding tax because under a regulation adopted in the early 1990s,
payments on ``notional principal contracts'' (such as the TRES) are
sourced at the residence of the recipient.\2\ Thus, because the
investor is foreign, the dividend equivalents are not U.S. source and
therefore are not subject to withholding tax.
---------------------------------------------------------------------------
\2\ Treas. Reg. 1.863-7.
---------------------------------------------------------------------------
Recent press stories have suggested that the use of TRES to avoid
withholding tax on portfolio dividends has increased exponentially
since the arrival of hedge funds. Disturbingly, the stories suggested
that some of the TRES held by hedge funds ultimately inure to the
benefit of U.S. residents, but are not reported to the IRS under the
cover of tax haven bank secrecy. Recent reports that U.S. residents
have been discovered to hold secret accounts in Liechtenstein and the
Isle of Man highlight this concern.
Using TRES to avoid the withholding tax on portfolio dividends is
an old technique, although the amounts involved seem to be growing
dramatically in recent years. A newer version involves using
derivatives to convert dividends (subject to withholding tax) to
interest (not subject to tax because of the portfolio interest
exemption). A good example is the recent investment by the sovereign
wealth funds of Abu Dhabi in Citigroup ($7.5 billion) and of China in
Morgan Stanley ($5 billion).
It has been reported that ``under the terms of the Citigroup
transaction, [Abu Dhabi Investment Authority] agreed to purchase $7.5
billion of equity units. The equity units are structured using
Citigroup's patent-pending Upper DECS strategy. Citigroup has agreed to
pay an 11 percent yield on the units, with slightly over 6.5 percent
classified as interest payments. The remaining payment is a contract
payment on the purchase contract. The result to Citigroup is a tax
savings in the neighborhood of $175 million per year for the 3 years
before the conversion to common shares begins. Morgan Stanley sold $5
billion of equity units through its PEPS structure to China Investment
Corp., and will pay a total annual rate of 9 percent on them. Morgan
Stanley classifies 6 percent of the payments as interest on a debt and
will benefit from a tax savings of approximately $100 million per year
during the preconversion period of the deal.'' \3\
---------------------------------------------------------------------------
\3\ David D. Stewart, Sovereign Wealth Fund Deals Take Advantage of
IRS Ruling, 2008 TNT 41-5 (Feb. 29, 2008).
---------------------------------------------------------------------------
Both of these transactions rely on the IRS' feline PRIDES ruling of
2003.\4\ Feline PRIDES is Merrill Lynch's version of the Citigroup
Upper DECS and the Morgan Stanley PEPS. In all three transactions, the
U.S. entity issues ``equity units consisting of a forward contract for
the purchase of equity shares and notes equivalent to the price of the
stock. The amount of stock deliverable under the forward contract is
determined on the settlement date and has a market value equal to the
settlement price. The forward contract and the notes are treated as
separate transactions, and the purchase price is allocated between them
according to their fair market values on the settlement date. The
holder of the investment units may, but is not required to, separate
the obligations of the units. The holder is also obliged to remarket
the notes. The issuer will make regular payments under the terms of the
transaction and treat the lion's share of the payments as interest
payments on the notes.'' \5\
---------------------------------------------------------------------------
\4\ Rev. Rul. 2003-97, 2003-34 IRB 1.
\5\ Stewart, supra.
---------------------------------------------------------------------------
Under the 2003 Revenue Ruling, the IRS treats the forward contract
and the notes as two separate instruments. As a result, the payments on
the notes are treated as interest, and when the notes are held by a
foreign investor, they are entitled to the portfolio interest exemption
and not subject to withholding tax even though they are mandatorily
convertible into stock, and even though the investment is treated as
equity for bank regulatory purposes. Presumably, the foreign investors
intend to sell the units to a U.S. party before conversion to equity.
2. What Can Be Done?
The immediate response to both the TRES and feline PRIDES
structures is to suggest that the IRS should revise its rules to close
the relevant loopholes. In the case of TRES, the IRS could revise the
regulations and treat dividend equivalent amounts under the TRES as
dividends for withholding tax purposes, just like it does in the case
of securities loans from a foreign lender to a U.S. borrower, where
payments of dividend equivalents from the U.S. to the foreign person
are treated as dividends and subject to withholding tax.\6\ In the case
of feline PRIDES, the IRS could revoke its 2003 ruling and treat the
structure as equity, as suggested by Prof. David Weisbach.\7\
---------------------------------------------------------------------------
\6\ For a discussion of the different treatment of TRES and
securities loans see Reuven Avi-Yonah and Linda Z. Swartz, U.S.
International Treatment of Financial Derivatives, 74 Tax Notes 1703
(1997).
\7\ Stewart, supra.
---------------------------------------------------------------------------
However, the problem with adopting such narrow loophole-closing
measures is that they invite taxpayers to find new ways to achieve the
same goals. For example, if dividend equivalent amounts under a TRES
linked to a specific stock are treated as dividends, the investment
banks will issue TRES linked to a basket of stocks that will behave
similarly to the targeted stock. The IRS may then adopt ``substantially
similar or related property'' rules, and the game will go on. Likewise,
if the feline PRIDES ruling were revoked, I have no doubt that other,
more complex instruments could be invented that achieve the same
goal.\8\
---------------------------------------------------------------------------
\8\ For some ideas see Gregory May, Flying on Instruments:
Synthetic Investments and the Avoidance of Withholding Tax, 96 TNT 239-
32 (1996).
---------------------------------------------------------------------------
A more ambitious reform proposal would be to revise the regulations
and treat the source of all payments on notional principal contracts as
the residence of the payor, rather than the residence of the recipient.
This would align the source rule for derivatives with the source rule
for dividends and interest. However, as long as the portfolio interest
exemption is in the Code, derivatives could still be used to convert
dividends into interest, and then the source would not matter because
the payment would be exempt.
In general, it seems strange to insist on levying withholding tax
on dividends, which are not deductible, while not levying it on
interest and royalties, which are. The payment of a dividend does not
reduce our ability to tax the underlying corporate income, but the
payment of deductible interest and royalties does.
Thus, one possible response to the use of derivatives to avoid
withholding tax is to say ``who cares?'' As noted above, most forms of
FDAP are already not subject to withholding, and if derivatives are
used to avoid the withholding tax on portfolio dividends and our
treaties are revised to eliminate withholding on direct dividends,
perhaps the time has come to give up on the withholding tax altogether.
It collects negligible revenue while imposing high transaction costs on
withholding agents, as indicated by the voluminous regulations
governing withholding under IRC 1441-1446.
3. A Possible Solution \9\
Nevertheless, it seems unlikely that Congress will give up on
withholding taxes on foreigners. And there is one compelling argument
in favor of imposing such taxes: They may be our best chance to prevent
U.S. residents from avoiding tax on U.S. source income earned through
foreign intermediaries.
---------------------------------------------------------------------------
\9\ This section is based in part on Avi-Yonah, Memo to Congress:
It's Time to Repeal the U.S. Portfolio Interest Exemption, 17 Tax Notes
Int'l 1817 (Dec. 7, 1998).
---------------------------------------------------------------------------
The basic problem stems from the portfolio interest exemption. In
1984, the United States unilaterally abolished its withholding tax (of
30 percent) on foreign residents earning ``portfolio interest'' income
from sources within the United States. ``Portfolio interest'' was
defined to include interest on U.S. Government bonds, bonds issued by
U.S. corporations (unless the bondholder held a 10 percent or more
stake in the shares of the corporation), and interest on U.S. bank
accounts and certificates of deposit. This ``portfolio interest
exemption'' is available to any nonresident alien (that is, any person
who is not a U.S. resident for tax purposes), without requiring any
certification of identity or proof that the interest income was subject
to tax in the investor's country of residence.
The result of enacting the portfolio interest exemption has been a
classic race to the bottom: One after the other, all the major
economies have abolished their withholding tax on interest for fear of
losing mobile capital flows to the United States. The table below shows
current withholding rates in EU member countries and in the United
States on interest paid on bank accounts, securities (government and
corporate bonds), and dividends paid to foreign residents in the
absence of a treaty.
----------------------------------------------------------------------------------------------------------------
Country Bank Accounts Securities Dividends
----------------------------------------------------------------------------------------------------------------
Belgium 0 10 15
----------------------------------------------------------------------------------------------------------------
Denmark 0 0 15
----------------------------------------------------------------------------------------------------------------
France 0 0 15
----------------------------------------------------------------------------------------------------------------
Germany 0 0 15
----------------------------------------------------------------------------------------------------------------
Greece 10 10 0
----------------------------------------------------------------------------------------------------------------
Ireland 0 0 0
----------------------------------------------------------------------------------------------------------------
Italy 10 10 15
----------------------------------------------------------------------------------------------------------------
Luxembourg 0 0 15
----------------------------------------------------------------------------------------------------------------
Netherlands 0 0 15
----------------------------------------------------------------------------------------------------------------
Portugal 15 15 15
----------------------------------------------------------------------------------------------------------------
Spain 0 0 15
----------------------------------------------------------------------------------------------------------------
United Kingdom 0 0 15
----------------------------------------------------------------------------------------------------------------
United States 0 0 30
----------------------------------------------------------------------------------------------------------------
As the table indicates, most developed countries impose no
withholding tax on interest paid to nonresidents on bank deposits and
government and corporate bonds. Withholding taxes are imposed on
dividends, despite the fact that dividends (unlike interest) are not
deductible and, therefore, the underlying income has already been taxed
once.
The standard economic advice to small, open economies is to avoid
taxing capital income at source, because the tax will be shifted
forward to the borrowers and will result in higher domestic interest
rates. However, the countries in the table include large economies (the
United States, Germany, and the United Kingdom) in which the tax is not
necessarily shifted forward. Rather, the principal reason for the lack
of withholding taxes in most of the countries included in the table
above is the fear that if such taxes were imposed, capital would
swiftly move to other locations that do not impose a withholding tax.
Thus, the Ruding Committee, writing about the European Community,
concluded in 1992 that ``recent experience suggests that any attempt by
the [European Union] to impose withholding taxes on cross-border
interest flows could result in a flight of financial capital to non-EC
countries.'' \10\
---------------------------------------------------------------------------
\10\ Report of the Committee of Independent Experts on Company
Taxation (Commission of the European Communities, 1992), p. 201.
---------------------------------------------------------------------------
The experience of Germany is a case in point: In 1988, Germany
introduced a (relatively low) 10 percent withholding tax on interest on
bank deposits, but had to abolish it within a few months because of the
magnitude of capital flight to Luxembourg. In 1991, the German Federal
Constitutional Court held that withholding taxes on wages, but not on
interest, violated the constitutional right to equality, and the
government therefore was obligated to reintroduce the withholding tax
on interest, but made it inapplicable to nonresidents. Nevertheless,
nonresidents may be German residents investing through Luxembourg bank
accounts and benefiting from the German tradition of bank secrecy vis-
a-vis the government.\11\
---------------------------------------------------------------------------
\11\ As indicated by recent press reports, since Luxembourg is now
subject to exchange of information under the Savings Directive
(discussed below), German capital has shifted to Liechtenstein.
---------------------------------------------------------------------------
The current situation is a multiple-player prisoner's dilemma: All
developed countries would benefit from reintroducing the withholding
tax on interest, because they would then gain revenue without fear that
the capital would be shifted to another developed country. However, no
country is willing to be the first one to cooperate by imposing a
withholding tax unilaterally; thus they all defect (that is, refrain
from imposing the tax) to the detriment of all.
In global terms, this outcome would make no difference if residence
jurisdictions were able to tax their residents on foreign-source
interest (and dividend) income, as required by a global personal income
tax on all income ``from whatever source derived.'' However, as Joel
Slemrod has written, ``although it is not desirable to tax capital on a
source basis, it is not administratively feasible to tax capital on a
residence basis.'' \12\ The problem is that residence country fiscal
authorities in general have no means of knowing about the income that
is earned by their residents abroad. Even in the case of sophisticated
tax administrations like the IRS, tax compliance depends decisively on
the presence of either withholding at source or information reporting.
When neither is available, as in the case of foreign-source income,
compliance rates drop dramatically.
---------------------------------------------------------------------------
\12\ Joel Slemrod, Comment, in Vito Tanzi, Taxation in an
Integrating World (1995), 144.
---------------------------------------------------------------------------
In the case of foreign-source income, withholding taxes are not
imposed for the reasons described above. As for information reporting,
even though tax treaties contain an exchange of information procedure,
it is vitally flawed in two respects: First, the lack of any uniform
worldwide system of tax identification numbers means that most tax
administrations are unable to match the information received from their
treaty partners with domestic taxpayers. Second, there are no tax
treaties with traditional tax havens, and it is sufficient to route the
income through a tax haven to block the exchange of information. For
example, if a Mexican national invests in a U.S. bank through a Cayman
Islands corporation, the exchange of information article in the U.S.-
Mexico tax treaty would not avail the Mexican authorities. The IRS has
no way of knowing (given bank secrecy) that the portfolio interest that
is paid to the Caymans is beneficially owned by a Mexican resident
covered by the treaty.
The resulting state of affairs is that much income from portfolio
investments overseas escapes income taxation by either source or
residence countries. Latin American countries provide a prime example:
It is estimated that following the enactment of the portfolio interest
exemption, about US $300 billion fled from Latin American countries to
bank accounts and other forms of portfolio investment in the United
States. Most of these funds were channeled through tax haven
corporations and therefore were not subject to taxation in the country
of residence. For all developing countries, various estimates of the
magnitude of capital flight in the 1980s average between US $15 billion
and US $60 billion per year. Nor is the problem limited to developing
countries: Much of the German portfolio interest exemption benefits
German residents who maintain bank accounts in Luxembourg, and much of
the U.S. portfolio interest exemption benefits Japanese investors who
hold U.S. treasuries and do not report the income in Japan. Even in the
case of the United States, it is questionable how much tax is actually
collected on portfolio income earned by U.S. residents abroad other
than through mutual funds. One estimate has put capital flight from the
United States in 1980-82 as high as US $250 billion. More recently,
Joseph Guttentag and I have estimated the ``international tax gap''
(the tax owed by U.S. residents on income earned through foreign tax
havens) at $50 billion.\13\
---------------------------------------------------------------------------
\13\ Guttentag and Avi-Yonah, Closing the International Tax Gap, in
Max B. Sawicky (ed.), Bridging the Tax Gap: Addressing the Crisis in
Federal Tax Administration, 99 (2005).
---------------------------------------------------------------------------
Thus, in the absence of withholding taxes or effective information
exchange, income from foreign portfolio investments frequently escapes
being taxed by any jurisdiction. This is particularly significant
because the flows of portfolio capital across international borders
have been growing recently much faster than either world gross domestic
product or foreign direct investment. It is currently estimated that
international capital flows amount to US $1 trillion a day; although
this figure is much larger than income from capital, it gives a sense
of the magnitude at stake.
This situation has led knowledgeable observers like Richard Bird to
write that ``the weakness of international taxation calls into question
the viability of the income tax itself. . . . If something is not done
to rectify these problems soon, the future of the income tax is
bleak.'' \14\ Other authors have written papers like ``Can Capital
Income Taxes Survive in Open Economies?'' and ``Is There a Future for
Capital Income Taxation?'' Unless something is done about this
situation, the answer to those questions is likely to be ``no.''
---------------------------------------------------------------------------
\14\ Richard Bird, Shaping a New International Tax Order, 42
Bulletin for International Fiscal Documentation 292 (1988), 303.
---------------------------------------------------------------------------
However, the present may present a unique opportunity to remedy
this state of affairs because of the EU's adoption in 2003 of a
``Savings Directive.'' Under the Directive, the EU adopted a
``coexistence'' model based on two options, only one of which can be
chosen by a member state: Either to cooperate in an exchange of
information program, or to levy a 20 percent withholding tax on
interest payments made by paying agents within its territory to
individual residents of another member state. Under the exchange of
information system, the member state agrees to provide automatically,
at least once a year, information on all interest payments made by
paying agents in its territory in the preceding year to individual
beneficial owners residing in every other member state. Under the
withholding tax system, the member state agrees to impose a 20 percent
withholding tax on all interest payments made by paying agents within
its territory to individual beneficial owners residing within the
European Union. However, the withholding tax is not imposed if the
beneficial owner provides a certificate drawn up by his country's tax
authorities attesting that they have been informed of the interest to
be received. The withholding tax must be credited against the tax
liability in the beneficial owner's country of residence.
The EU Savings Directive only applies to payments within the EU.
However, its adoption presents a golden opportunity. As explained
above, the problem of nontaxation of cross-border interest flows stems
to a large extent from the unilateral enactment of the portfolio
interest exemption by the United States in 1984. As observed above, the
nontaxation of cross-border interest flows is a repeated prisoner's
dilemma: Each player (the European Union, the United States, and Japan)
refrains from taxing for fear of driving investment to the others, even
though they would all benefit from imposing the tax. However, it is
well established that such repeat prisoner's dilemmas can be resolved
if parties can signal to each other in a credible fashion their
willingness to cooperate.
The EU Directive represents just such a signal. The European Union
is telling the United States that it is willing to go forward with
taxing cross-border interest flows. Thus, if the United States were to
commit itself to taxing cross-border interest by repealing the
portfolio interest exemption, the prisoner's dilemma could be resolved
and a new, stable equilibrium of taxing--rather than refraining from
tax--would be established.
The prospects for agreement in this area are particularly good
because only a limited number of players need to be involved. The
world's savings may be parked in tax havens, but the cooperation of
such tax havens is not needed. To earn decent returns without incurring
excessive risk, funds have to be invested in an OECD member country
(and more particularly, in the European Union, the United States,
Japan, or Switzerland). Thus, if the OECD member countries could agree
to the principles adopted by the European Union in its Savings
Directive, most of the problem of taxing cross-border portfolio
interest flows could be solved.
My proposal is therefore as follows: The United States should move
within the OECD for a coordinated implementation of the principles
contained in the EU Savings Directive. However, while in the European
Union context, exchange of information could play a large role, because
there are few traditional tax havens in the European Union, in a global
context withholding taxes have to be the primary means of enforcement.
As noted above, tax havens with strong bank secrecy laws render it very
difficult to have effective exchange of information among OECD member
countries. If the investment is made through a tax haven intermediary,
exchange of information is likely to be useless unless the tax
authorities in the payor's country can know the identity of the
beneficial owner of the funds that are paid to the tax haven
intermediary.
I would therefore propose that instead of the ``co-existence''
model of the European Union, the United States, and following it the
OECD, should adopt a uniform withholding tax on cross-border interest
flows, which should also be extended to royalties and other deductible
payments to portfolio investments (for example, all payments on
derivatives). To approximate the tax rate that would be levied if the
payment were taxed on a residence basis, the uniform withholding tax
rate should be high (at least 40 percent). However, unlike the
withholding taxes that were imposed before the current ``race to the
bottom'' started in 1984, the uniform withholding tax should be
completely refundable. To obtain the refund, as in the EU Directive, a
beneficial owner need only show the tax authorities in the host
countries a certificate attesting that the interest payment was
reported to the tax authorities in the home country. No actual proof
that tax was paid on the interest income is required: from an
efficiency, equity, and revenue perspective, it is sufficient that the
home country authority has the opportunity to tax the income from
overseas investments in the same way as it taxes domestic-source
income. Thus, even if the home country has a generally applicable low
tax rate on its residents (or even a zero tax rate, as long as it
applies to all bona fide residents), the resident could obtain a refund
by reporting the income to the tax authorities in his home country.
Both the proposed withholding tax and the refund mechanism would
not require a tax treaty. However, it would be possible for countries
to reduce or eliminate the withholding tax in the treaty context when
payments are made to bona fide residents of the treaty partner. In
those cases, the exchange of information in the treaty should suffice
to ensure residence-based taxation. Because most OECD members have tax
treaties with most other OECD members, the proposed uniform withholding
tax would in general apply only to payments made to non-OECD member
countries (including the tax havens).
Were this type of uniform withholding tax enacted by OECD members,
it would go a very long way toward solving the problem of under-
taxation of cross-border portfolio investments by individuals. Such
under-taxation is unacceptable from an efficiency, equity, or
administrability perspective. Moreover, unlike the under-taxation of
direct investment, this type of under-taxation is illegal (which is why
it is so hard to assess its magnitude). By adopting a uniform
withholding tax, the OECD could thus strike a major blow at tax
evasion, which (as described above) is a major problem for the U.S. as
well.
4. Conclusion
Under current conditions, the U.S. collects remarkably little
revenue from the withholding tax on non-residents. That is because most
forms of FDAP other than dividends are exempt, while the withholding
tax on dividends can be avoided by the use of derivatives, in the ways
described above.
One possible reaction to this state of affairs is to repeal the
withholding tax. However, even if it were acceptable for the U.S. not
to tax foreigners on passive income from U.S. sources, the risk of
doing so is that it will enhance the ability of U.S. residents to
derive income from U.S. sources through foreign intermediaries located
in tax havens.
Narrower fixes to the problem posed by derivatives are possible,
but as long as the portfolio interest exemption remains in the Code,
they are unlikely to address the fundamental problem. Thus, in my
opinion the best course to pursue is to repeal the portfolio interest
exemption in coordination with the OECD, and instead impose a
refundable withholding tax, along the lines set out above.
Chairman NEAL. Thank you.
Mr. Styrcula.
STATEMENT OF KEITH A. STYRCULA, CHAIRMAN, ON BEHALF OF
STRUCTURED PRODUCTS ASSOCIATION
Mr. STYRCULA. Thank you. Good morning, Chairman Neal,
Ranking Member English, Members of the Subcommittee. I am
grateful for the opportunity to testify today on this
exceptionally important matter.
I am the founder and Chairman of the Structured Products
Association, a 6-year-old professional trade group that
includes approximately 3,000 financial services professionals
among its membership. In addition to my responsibilities as
Chairman, I have 15 years of experience as a senior-level
structured products and derivatives professional with firms
such as JPMorgan, UBS, and Credit Suisse.
I am here before you this morning to discuss the rapidly
growing financial derivatives and structured products market
here in the U.S., and to express our concerns over the
potential impact a disadvantageous tax treatment may have on
our industry's ability to remain competitive with foreign
counterparts.
Given the importance of financial derivatives and economic
innovation to the American economy, both here and abroad, as
well as its growing contribution to the revenues of Treasury,
it is absolutely imperative that all parties have an
opportunity to contribute to an open dialogue on this matter.
So, we appreciate the opportunity to be here today.
We fully recognize the challenge of determining the
appropriate tax treatment of new financial instruments. It can
often be daunting. Such is clearly the case with financial
derivatives and structured products. Nevertheless, the positive
impact the industry has had on the American economy over the
last two decades should not be underestimated.
In a 1999 speech, former Federal Reserve Chairman Alan
Greenspan described the extraordinary development and expansion
of financial derivatives as ``by far the most significant event
in finance during the last decade.''
In 2000, U.S. financial institutions has 40 percent of the
global market share of the business that at the time was $33
trillion. As Chairman Neal had indicated, that amount now,
according to the BIS, is $516 trillion as of June 2007.
By all measures financial derivatives are integral to the
health of a global economy, and in particular, the American
economy. So, it is imperative for us to acknowledge, however,
that the U.S. is in jeopardy of losing its standing as the
dominant global force in financial derivatives due to
burdensome regulations in the post-Sarbanes-Oxley world.
I would like to turn now to the progeny of derivatives that
are called structured products, which includes exchange traded
notes. As noted in many of the financial mainstream media
accounts over the last year, structured products represents the
fastest-growing investment class of all financial services. The
structured products market in the U.S. grew from $64 billion in
2006 to $114 billion in 2007, a 78-percent increase in just 1
year. The dramatic increase in popularity is linked to the fact
that structured products, in many but not all cases, offer a
superior value proposition to direct or managed investments,
not simply by tax advantages.
Capital-guaranteed structured products are a perfect
example, and we believe a cautionary tale to where taxation
could have an adverse impact on financial innovation. Capital-
guaranteed structured products are to European investors what
mutual funds are to American investors. They provide the best
of both worlds. They protect investors against a significant
market decline while providing exposure to upside potential.
Capital-guaranteed products would have the potential to be
a dominant investment vehicle for protecting millions of
American investors from market declines if it weren't for a
significant drawback, and that is an exceptionally
disadvantageous tax regime for it.
The SPA believes that the current tax treatment of capital-
guaranteed structures is a cautionary tale for all interested
parties. A capital-guaranteed structured note in the U.S. taxes
on phantom income even though no payment has been received on
the securities until maturity by the investor. As a result of
this unduly burdensome and disadvantageous tax treatment, the
United States is a poor competitor with Europe. In 2006, for
example, Europe captured $193.38 billion in capital-guaranteed
structured products. The U.S. only managed $7 billion.
I submit that Treasury would be far better off with a more
advantageous tax treatment of capital-guaranteed notes and
would raise far more revenues than the current tax regimes, as
investors are often reluctant to purchase capital-guaranteed
notes in taxable accounts.
We appeal to the Subcommittee to recognize the exceptional
challenges the financial derivatives and structured products
industries face against our global competitors. The United
States is just now catching up with Europe in structured
products sales after a decade-long period of lagging behind.
After trailing for those decades, the ascendency of the
U.S. growth has, for the first time, started approaching the
striking range of Europe, which was $316 billion last year
versus the U.S.'s $114 billion. So, it is $3 to every $1,
whereas from 2006 it was $6 to $1.
With regard to exchange traded notes, the equivalent in
Europe and Asia are called certificates and warrants. Almost
without exception, the local jurisdictions treat any profit as
capital gains if held for 1 year or longer. Any attempt to put
ETNs at a tax disadvantage would have devastating consequences
on structured products, which we believe are the greatest
financial innovation since convertible securities and exchange
traded funds.
In conclusion, we wholeheartedly agree with the
Subcommittee that new legislation on the taxation of retail
financial instruments is in order. Such legislation, however,
should analyze all investment vehicles at the ground level to
arrive at a fair and consistent approach to the taxation of
financial instruments.
We respectfully submit that any attempt to single out
financial derivatives in the absence of a full consideration of
all financial instruments is a potentially dangerous precedent
that could have vast, unforeseen consequences in our ability to
compete in the global environment during an exceptionally
competitive paradigm shift as we struggle to compete against
Europe and Asia in a rapidly changing global economy.
I thank you for your time, and I look forward to taking
your questions.
[The prepared statement of Keith A. Styrcula follows:]
Prepared Statement of Keith A. Styrcula, Chairman,
on behalf of Structured Products Association
Good morning. I am grateful to Chairman Neal, Ranking Member
English, and Members of the Subcommittee for providing me with the
opportunity to testify on this exceptionally important matter. I am the
Founder and Chairman of the Structured Products Association (the
``SPA''),\1\ a 6-year-old professional trade organization that includes
approximately 3,000 financial services professionals among its
membership. In addition to my responsibilities as Chairman of the SPA,
I have 15 years of experience as a senior-level structured products and
derivatives professional with firms such as JPMorgan, UBS and Credit
Suisse. I am here before you this morning to discuss the rapidly-
growing U.S. structured products market. We also appreciate the
opportunity to express our concerns over the potential impact a
disadvantageous tax treatment on financial derivatives may have on the
American financial services industry's ability to remain competitive
with foreign counterparts. We are also concerned about the possible
adverse impact such treatment may have on prepaid derivative contracts
on retail investors as well as the American economy.
---------------------------------------------------------------------------
\1\ The Structured Products Association (SPA) is a New York-based
trade group whose mission includes positioning structured products as a
distinct asset class; promoting financial innovation among member
firms; developing model ``best practices'' for members and their firms;
identifying legal, tax, compliance and regulatory challenges to the
business. With more than 2,000 members, the Association has members
from the exchanges, self-regulatory bodies, legal compliance community
financial media, investor networks, family offices, and both buy-side
and sell-side structured product firms. The primary mission of the
Structured Products Association is to position structured products as a
distinct investment class, promote financial innovation among member
firms, develop model ``best practices'' for member organizations,
identify issues related to legal, tax, and compliance. The URL for the
SPA website is www.structuredproducts.org.
---------------------------------------------------------------------------
On behalf of our members and of those in the industry whose view
the SPA represents, I would like to thank Chairman Neal for recognizing
the importance of initiating a comprehensive dialogue on the proper tax
treatment of innovative financial instruments. Given the importance of
financial derivatives, structured products and economic innovation to
the American economy both here and abroad--as well as its growing
contribution to the revenues of Treasury--it is imperative that all
parties have an opportunity to contribute to an open dialogue on the
matter. The SPA appreciates the privilege and opportunity to present a
perspective today that reflects those of its professional members.
We fully recognize that the challenge of determining the
appropriate tax treatment of new financial instruments is frequently
daunting. Such is clearly the case with financial derivatives and
structured products. These often-misunderstood financial instruments
have been mischaracterized as ``risky'' and ``complex.'' Nevertheless,
the positive impact the industry has had on the American economy over
the last two decades should not be underestimated.
In a 1999 speech, former Federal Reserve Chairman Alan Greenspan
described ``the extraordinary development and expansion'' of financial
derivatives as ``[b]y far the most significant event in finance during
the past decade.'' \2\ Chairman Greenspan remarked that the U.S.
commercial banks were the leading players in global derivatives
markets, with outstanding derivatives contracts with a notional value
of $33 trillion, a rate ``that has been growing at a compound annual
rate of around 20 percent since 1990.'' \3\
---------------------------------------------------------------------------
\2\ Chairman Greenspan's remarks on Financial Derivatives were made
before the Futures Industry Association conference in Boca Raton,
Florida on March 19, 1999. The full transcript appears on the Federal
Reserve website at http://www.federalreserve.gov/boarddocs/speeches/
1999/19990319.htm.
\3\ Chairman Greenspan further commented on the leading role played
by U.S. commercial and investment banks in the global OTC derivatives
markets. ``[T]he size of the global OTC market at an aggregate notional
value of $70 trillion, a figure that doubtless is closer to $80
trillion today . . . U.S. commercial banks' share of this global market
was about 25 percent, and U.S. investment banks accounted for another
15 percent. While U.S. firms' 40 percent share exceeded that of dealers
from any other country.''
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The astounding growth of financial derivatives has not only
continued its ascendancy in the new decade--it has accelerated to
exceptionally compelling heights. The Bank of International Settlements
noted that as of June 2007, the notional amounts of positions in
financial derivatives globally was $516 trillion at the end of June
2007--representing an annualized compound rate of growth of 33%.\4\ By
all measures, financial derivatives are integral to the health of the
global economy--and in particular, the American economy.
---------------------------------------------------------------------------
\4\ See http://www.bis.org/press/p071219.htm.
---------------------------------------------------------------------------
It is imperative, however, to acknowledge that the U.S. is in
jeopardy of losing its standing as the dominant global force in
financial derivatives due to burdensome regulation in the post-Enron/
WorldCom environment. In foreign exchange derivatives, for example, the
June 2007 BIS report indicates that ``Among countries with major
financial centres [sic], Singapore, Switzerland and the United Kingdom
gained market share, while the shares of Japan and the United States
dropped.'' \5\ The SPA cannot overemphasize how critical it is for the
U.S. financial derivatives market to remain on a level playing field
with global competitors in Europe, Asia, Australia and Canada. Any
newly-imposed regulatory disadvantages introduced to our industry could
impede our ability to compete on a global scale--during a time in which
most reputable economists agree is a critical paradigm shift in the
world economy.
---------------------------------------------------------------------------
\5\ BIS Triennial Central Bank Survey 2007 (June 2007), http://
www.bis.org/publ/rpfxf07t.pdf? noframes=1.
---------------------------------------------------------------------------
I am not here before you as an expert on the treatment of prepaid
forwards and financial derivatives. Accordingly, I will now speak to
the issues surrounding the potential tax treatment of an emerging
investment class known as ``structured products'' and the SPA's serious
concern that H.R. 4912--in its current form--is likely to impose a
burdensome tax regime that would adversely impact a new American
financial innovation that is only now competing effectively with the
European marketplace.
1. What Is a Structured Product?
Simply put, structured products are the fastest growing investment
class in the United States, and the most exciting financial innovation
since exchange traded funds (``ETFs''). A structured product, generally
speaking, has an embedded financial derivative that changes the
``payoff profile'' of a traditional asset class, such as equities,
fixed income, currencies, commodities or alternative investments (hedge
funds, private equity). Structured products are ``synthetic investment
instruments specially created to meet specific needs that cannot be met
from the standardized financial instruments available in the markets.
Structured products can be used as an alternative to a direct
investment; as part of the asset allocation process to reduce risk
exposure of a portfolio; or to utilize the current market trend.'' \6\
---------------------------------------------------------------------------
\6\ Source: http://en.wikipedia.org/wiki/Structured_products.
---------------------------------------------------------------------------
As noted in the mainstream financial media, the structured products
investment class represents the fastest growing investment class in all
of U.S. financial services. According to SPA statistics, the structured
products market in the U.S. grew from $64 billion in 2006 to $114
billion in 2007. As Investment News noted in its February 4, 2008
issue, ``The structured-products industry has been relatively obscure
among most U.S. investors and financial advisers, but lately, it is
basking in the glow of a record-setting 78% increase in 2007 sales.''
\7\ The dramatic increase in popularity is linked to the fact that
structured products--in many, but not all cases--offer a superior value
proposition to direct or managed investments.
---------------------------------------------------------------------------
\7\ Jeff Benjamin, Investment News, ``Structured products flourish
in today's `choppy market','' February 4, 2008. Source: http://
www.investmentnews.com/apps/pbcs.dll/article?AID=/20080204/REG/
544709651.
---------------------------------------------------------------------------
For example, a popular type of structured product might offer a
``capital guarantee'' function, which offers protection of principal if
held to maturity. If an investor invests $100, the issuer simply
invests in a 5-year bond that today might cost $80--but will grow to
$100 after 5 years. The remaining $20 is invested in a financial
derivative that is linked to a desirable asset class such as equity or
fixed income indexes. Regardless of how markets perform, the investor
is guaranteed to receive at least $100 back upon maturity of the
structured product.
Capital-guaranteed structured products are to European investors
what mutual funds are to American investors. They often provide the
best of both worlds--protecting investors from a significant market
decline, while providing exposure to the upside potential of a
reference index, basket or asset class. Indeed, it is the position of
the Structured Products Association that capital-guaranteed structured
products would have the potential to be the dominant investment vehicle
for prudent American investors, if it weren't for a significant
drawback--an exceptionally disadvantageous tax treatment.
2. The Disadvantageous Tax Treatment of Capital-Guaranteed Structured
Products
The SPA believes that the current tax treatment of capital-
guaranteed structured products is a highly-illustrative cautionary tale
for all interested parties. A typical prospectus on a capital-
guaranteed structured note might note that the investment will be
``treated as `contingent payment debt instruments' for U.S. Federal
income tax purposes. Accordingly, U.S. taxable investors, regardless of
their method of accounting, will be required to accrue as ordinary
income amounts based on the `comparable yield' of the securities, even
though they will receive no payment on the securities until maturity.
[Emphasis ours]. In addition, any gain recognized upon a sale, exchange
or retirement of the securities will generally be treated as ordinary
interest income for U.S. Federal income tax purposes. [Emphasis
ours.]'' \8\
---------------------------------------------------------------------------
\8\ A typical capital-guaranteed structured product issued by ABN
Amro in the U.S. For more information, the EDGAR link is http://
www.secinfo.com/dRCqp.v4e.htm.
---------------------------------------------------------------------------
As a direct result of the unduly burdensome and disadvantageous tax
treatment of capital-guaranteed structured products, the United States
is a poor competitor with Europe. According to the
structuredretailproducts.com database, the tax disadvantage of capital-
guaranteed structured products not only adversely impacts American
retail investors; it results in a devastating impact on potential tax
revenues to Treasury--an artificial inhibition on a potentially strong
generator of tax dollars to close the gap on AMT reform. If the tax
treatment were simple and reasonable to the investor, the U.S financial
services industry would be able to promote this significant, highly-
advantaged vehicle to the average American retail investor while
generating substantial revenue for the U.S. Treasury. Unfortunately,
this tax-driven impediment has put the U.S. far behind its European
competitors. In 2006, for example, Europe captured $193.38 billion in
capital-guaranteed structured products. The U.S. only managed $7.152
billion in 2006. We attribute this directly to the unfavorable tax
treatment accorded to the capital-guaranteed investment vehicle, which
has been roundly criticized by all market participants who are
understandably reluctant to offer the investment to taxable accounts.
In the final analysis, the Treasury is deprived of revenue it might
otherwise realize if the taxation of these appealing investments were
simplified and comparative to the European equivalents.
3. The U.S. Financial Derivatives and Structured Products Markets Need
Simple and Appropriate Tax Treatment to Compete Globally
We appeal to the Ways and Means Committee to recognize the
exceptional challenges the financial derivatives and structured
products industries face against our global competitors. The United
States is just now catching up with Europe in structured products
sales--after a decade-long headstart--and imposing a singular,
disadvantageous tax scheme on our industry will have vast and
devastating consequences on our ability to compete on a global basis.
We are struggling mightily to maintain our market share against Europe,
Asia, Australia and Canada in the next decade in the financial
derivatives arena.
The structured products industry, in particular, has seen a
significant increase in its ability to compete against Europe in the
global structured products arena. After trailing for most of the last
two decades, the ascendancy of the U.S. growth has--for the first
time--put us within striking range (Europe = $316.17 billion vs. U.S. =
$114 billion, narrowing the gap from 6 : 1 over 2006).
The SPA is concerned that an inopportune tax treatment specifically
targeting structured products could put the U.S. at a significant
disadvantage against the rest of the world, a repeat scenario of what
happened to capital-guaranteed structured products.
With regard to exchange traded notes (``ETNs''), the equivalent in
Europe and Asia are ``certificates'' and ``warrants.'' Almost without
exception, the local jurisdictions treat these instruments as long-term
capital gains, if held for 1 year or longer. Any attempt to put ETNs at
a tax disadvantage would have devastating consequences on structured
products--the greatest financial innovation since convertible
securities and exchange traded notes.
Based on the industry's experience with capital guaranteed
structured products, the SPA strongly believes that any tax-driven
complexities introduced to structured products will have a highly
adverse impact on the impressive growth of the U.S. structured products
and financial derivatives markets over the last decade, especially
given the industry's efforts to compete with the European structured
products market.
4. Conclusion
We agree wholeheartedly with the Subcommittee that new legislation
on the taxation of retail financial instruments is in order. Such
legislation, however, should analyze all investment vehicles at the
ground level--inclusive of ETFs, closed-end funds, mutual funds,
convertible bonds, managed accounts, insurance products, unit
investment trusts (``UITs'') and single-stock positions--to arrive at a
fair and consistent approach to the taxation of financial instruments.
The SPA respectfully submits that any attempt to single out financial
derivatives, prepaid forwards, and structured products in the absence
of a full consideration of all other financial instruments is a
potentially dangerous precedent that could have vast and unforeseen
consequences in the global arena.
We point not only to the previous example of capital-guaranteed
structured products as a cautionary tale, but to the clear and present
impact of the well-intended Sarbanes-Oxley bill. Much like the proposed
Neal bill, it was an exceptionally admirable piece of responsible
legislation. Unfortunately, however, it had unforeseen consequences
that put the U.S. at a disadvantage in the global capital markets--
consequences our Nation's capital markets have yet to recover from.
Sarbanes-Oxley permitted London to surpass New York as ``the world's
most competitive financial center,'' according to a report released
February 28 by the city of London, which analyzed the competitiveness
of business centers around the world. The survey interviewed 1,236
senior business personnel from around the world, who ranked New York
second and Hong Kong third. ``While New York dominated all cities when
measured by the capitalization of its listed companies and the trading
volumes of its stock exchanges, the city . . . was criticized by some
survey participants because of Sarbanes Oxley Act regulatory
requirements.'' The SPA is keen to avoid any similar impediment to the
global competitiveness of the financial services industry, and
respectfully asks the Subcomittee to seriously consider the
consequences of an unprecedented taxation on financial derivatives,
prepaid forwards and structured products.
H.R. 4912's approach to single out financial derivatives and its
progeny has the real and present danger of imposing an unfavorable tax
treatment on U.S. financial instruments. The direct result is a
devastating impact on our industry's competitive efforts against highly
formidable and well-capitalized European counterparts, many of which
enjoy substantial tax advantages over us. We respectfully request that
the Subcommittee fully consider our industry's intensively competitive
position, and not impose any singular tax treatment that would provide
further undue burden upon the American financial services industry's
Herculean efforts to remain competitive against European and Asian in
this rapidly-changing global economy.
Chairman NEAL. Thank you, Mr. Styrcula.
Professor Avi-Yonah, it is hard for me to understand how
something called PRIDES, PEPS, DECS, or TRES could be harmful
to our tax system, but that seems to be part of your testimony
today. Through this derivative, an investor gets something
quite close to equity ownership without actual ownership. A big
plus is that a foreign investor can avoid dividend withholding
tax by calling it interest.
Apparently some sovereign wealth funds have caught wind of
this arrangement. Do you believe that treating this as equity
or as the actual purchase of stock through a nominee would
solve the tax problem?
Mr. AVI-YONAH. Yes. I do think so. I think that these
products are created as equity for non-tax purposes. They are
treated as equity for banking regulatory capital purposes. They
are treated as equity for purposes of the regulation for
investment into the U.S. In other contexts, including the
exchange traded notes and the other types of derivatives that
we are talking about today, it is very rare for these products
to be bifurcated in this way.
I mean, basically in order to get the Federal tax results,
you need to take something that is traded as a single unit and
split it into two, and treat one segment as a pure note with
interest and the other segment as a forward contract.
In other contexts, I think the more normal treatment would
be to aggregate them together, treat them as a unit as they are
sold, and that would mean treating them as equity and providing
dividend treatment for the payments. That would mean collecting
withholding tax, and in particular, when we are talking about
investments that come from countries with which we don't have a
treaty, that means a full 30 percent withholding tax.
Nor is it inconceivable to imagine that these investments
would still be made. I still remember, for example, how a Saudi
Prince invested in almost 10 percent of Citibank in
straightforward stock in the 1990s, without bothering about the
fact it was subject to a 30 percent withholding tax on the
dividend.
So, it is not impossible to imagine that these investments,
to the extent that we need them, would still be made. But
certainly I don't see any particular reason why, just because
of the structure of the derivative, this would be treated
somehow as being interest and simply be exempt from the
withholding tax.
Chairman NEAL. Thank you.
Professor Raskolnikov, you have listed some other
investments that enjoy special tax advantages in the Code--home
sales, pensions, insurance, municipal bonds. This does raise an
interesting question.
If one could invest in a 30-year product with tax deferral
and guaranteed capital gain treatment at the end, what current
products might look less attractive in comparison other than
just mutual funds?
Mr. RASKOLNIKOV. Yes, Mr. Chairman. So, it is a very
advantageous tax treatment. Today, non-dividend-paying common
stock is very tax-advantaged. Realization requirement gives
taxpayers the opportunity to time their gains and losses, and
there is no current income.
Real estate, life insurance have strong tax advantages, but
a lot of them are well established. They have been in the Code
for a long time. The system does give up capital income
revenues by providing these tax advantages. So, the question
is, as new products come in, whether it is worth extending
this.
Chairman NEAL. Mr. Desmond, your testimony cites the SEC
filings both for the issuers of foreign currency ETNs as not
requiring current income inclusion and enjoying capital gains
treatment, and for the other ETNs with filings advising
investors that these products are not debt for tax purposes.
You said that this ``presented a unique question whether
tax deferral is appropriate.'' Might you elaborate for us?
Mr. DESMOND. Yes, Mr. Chairman. I think that highlights the
issue that I spoke about in my oral testimony, which is which
cubbyhole to put these instruments into.
The statements made in the SEC filings with respect to
those instruments do walk through the various cubbyholes of the
traditional categorizations that financial products fall into,
and walk through basically the same analysis that I did in my
testimony, and indicate or conclude that they aren't debt
instruments because there is no guaranteed return of principle,
the value of the underlying indexed asset may go up or down,
and if it goes down significantly, your initial investment of
$100, for example, may not be returned to you and it may
decline significantly.
Those documents also conclude that there is not an agency
relationship, that the issuer is actually issuing its own note
and it is not holding the underlying asset on an agency basis
for the investor. So, therefore, the treatment that you would
have if you actually held the stock--an agent held the stock
for an investor--would also not be appropriate, those documents
conclude.
They also go on then to conclude that the treatment as a
forward contract is appropriate, and the consequences of that
cubbyhole or that category, if you will, are the deferral of
the income on those contracts until such time as it is actually
realized, either through the end of the contract at the end of
its term or upon disposition of the contract before that time.
Chairman NEAL. Mr. Desmond, much has changed since 1993
when Treasury first entertained the thought of guidance on
prepaid forward contracts. But as you point out, the investor
pool has grown dramatically and includes average investors now.
That's part of the consideration and concern of this hearing
this morning.
Does this mean that Treasury is more likely to follow
through with guidance this time?
Mr. DESMOND. We haven't reached any conclusions, Mr.
Chairman, on exactly what the right answer is. I think there is
some additional tension being placed on the tax treatment of
these instruments because, as you indicated, they have moved
more into a retail market.
From our perspective, in terms of the tax issues to address
through guidance, one of the key factors we consider is how
many taxpayers are affected by the uncertainty of treatment.
And 10 or 15 years ago, it was only a small number of
taxpayers, relatively, and the urgency of addressing that
question was not the same as it might be today when you have
thousands or tens of thousands of potential investors.
One other observation on the change in terms of moving this
product toward a retail market. Historically, if you had
sophisticated investors and institutions investing in prepaid
forward contracts, first of all, they often know what they are
getting into and they can assume the tax risk and know what
they are getting into. Also, many of those holders were
institutions, dealers, and electing traders who would be taxed
on those currently because they are subject to mark to market
rules under existing tax regimes.
When those products move into more of a retail market, the
holders are retail investors who likely are not subject to a
mark to market regime as sophisticated traders and dealers
might be, and therefore you have more of an issue with respect
to potential for a deferral.
So, I think there are a number of reasons why that has
become an important issue for us, a more important issue as it
moves into the retail market.
Chairman NEAL. Thank you.
Professor Raskolnikov, your testimony does an excellent job
in describing what our three benchmarks should be in
derivatives taxation. As you have said, our piecemeal system
often cannot meet these goals. One of the criticisms lodged
against the income accrual approach on prepaid forward
contracts is that it would be too complex for these average
investors to do.
Might you comment on whether this admittedly incremental
approach can be administered and complied with?
Mr. RASKOLNIKOV. Thank you, Mr. Chairman, first of all.
Second, yes. I think it could. There are more complex regimes.
The constructive ownership rules resulting from the bill
introduced by you some time ago is much more complex. So, that
is point number one.
Point number two, as I mentioned in my written testimony,
when we talk about retail investors, it is important to keep
things in perspective. So, it is true that there are many more
people who will probably invest and have tax consequences from
these kinds of derivatives like ETNs, exchange traded notes,
today than 10 years ago when only really wealthy people could
do over-the-counter private derivatives with investment banks,
like hedge fund swaps, that constructive ownership rules were
addressing.
At the same time, in general it is believed that we have
over-investment in real estate and under-investment in
financial capital, in stocks, and other publicly traded
securities. So, a lot of people don't have any savings. Middle
class has savings in 401(k)s, IRAs, and tax-deferred accounts.
For them, tax consequences don't matter.
So, fairly sophisticated retail investors--I am not saying
that these are super-rich, but fairly sophisticated retail
investors--are the ones who are going to be likely holders of
these derivatives. For them, it is a somewhat complicated
regime, but I would not say that it is an inordinately
complicated regime. They have accountants. Many of them have
tax lawyers. They would probably be able to figure out,
especially because financial intermediaries with this kind of
regime can provide most or all of the information. That is
really key.
The regime is good when it can be implemented. Financial
intermediaries can send the equivalent of Form 1099 saying,
this is your accrual for the year, and with a copy to the IRS.
Then it is going to work. I think that that is likely to be the
case here.
Chairman NEAL. Let me yield to Mr. English.
Mr. ENGLISH. Thank you, Mr. Chairman.
Professor, you propose in your testimony what amounts to a
substantially higher tax rate on derivatives than on the holder
of the underlying assets. Should we in Congress have any
concern that this could result in the distortion of investment
decisions?
Mr. RASKOLNIKOV. Thank you, Mr. English. Well, yes and no
is the answer. It is not so easy. Distortions are always a
concern, so you are absolutely right. I agree with you 100
percent.
Speaking about the tax burden on these exchange traded
notes or prepaid derivatives being higher than on the
underlying asset, it is a tradeoff. It is higher in one sense
but it is lower in the other sense. It is higher because there
is imputation of interest. That does not happen when you
actually invest in the underlying. But it is lower because the
trading gains and dividend income is all deferred up to 30
years in the future.
So, this is--you can think about it as balancing two
possible tax burdens. One is higher in one context, another one
is higher in another.
Mr. ENGLISH. Understood. Mr. Avi-Yonah, given the current
state of the economy, what is going on right now in credit
markets, my own view is that we should be encouraging and
definitely not discouraging U.S. investment. I am concerned
that your suggestion to expand the reach of our withholding
taxes might have some potential impact on investment in the
U.S.
Barring some major change in the equation, wouldn't your
proposal encourage foreign investors to simply shift their
investments to countries that wouldn't have these sorts of
rules? Isn't that the lesson that we learned from the
experience of Germany, which you noted that had a disastrous
experience with their 10 percent withholding tax two decades
ago? Your thoughts?
Mr. AVI-YONAH. Yes. I mean, this is certainly a valid
concern. You could even say that we have now, because of these
kinds of concerns, whittled down the scope of the withholding
tax so much. I mean, we don't withhold tax on interest, we
generally don't withhold tax on royalties and rents, and we
under treaties also don't withhold tax on some dividends.
So, what is left is these portfolio dividends, and that is
a relatively narrow scope. On this, in order to enforce this,
we have a very elaborate set of withholding regulations that
everyone who is dealing with foreigners needs to enforce.
So, you could certainly make an argument that there is a
problem in having too much law for too little revenue, and that
the best thing would be to give up the withholding tax
altogether.
I have two concerns with that. One is simply that I don't
think it is very likely that Congress will give up on the
withholding tax any time soon. There hasn't been any
indication.
But the other issue really is that I am worried about some
of this lack of withholding tax affecting our ability to tax
U.S. people on U.S.-source income. Because there has been, as
you may have read in the press recently, stories, for example,
about the Lichtenstein banker who turned up with some stolen
documentation. The Germans got it, and then they shared it, and
then lo and behold, it turns out that some Americans are having
bank accounts there, too.
Every time a banker from one of these tax havens gets to
talk, it turns out that there are Americans there. There are
all kinds of estimates running around about how much of this
there is. But where I am concerned is if there was no
withholding tax whatsoever on any kind of investment in the
U.S., and I am doubtful if the IRS has the capacity in the
absence of information or withholding to really enforce our
taxes on our residents adequately and prevent them from doing
exactly what the Germans did, which is going to Luxembourg and
then back into Germany.
So, what can be done about it? Well, I think two issues.
One is, I mean, the particular narrow loopholes that I was
talking about in terms of closing, I don't think they would
affect the overall foreign investment into the U.S. These are
relatively small transactions that are particularized to a
particular situation, and I don't think they have a broader
reach.
What I think might affect the broader issue is if we start
looking at the portfolio interest exemption again. I think that
needs to be done in coordination with the Europeans in
particular. The interesting thing about this is that as a
result of the German experience, the E.U. now has a savings
directive that applies either to information exchange or
withholding tax to all payments to other E.U. residents.
I think they would be perfectly willing to coordinate some
kind of withholding tax with us if we are willing to talk with
them about it because essentially, that is what they want to
do.
Mr. ENGLISH. Would coordination with the E.U. be adequate
in itself? Aren't we also talking about some other very large
markets where capital can flow to?
Mr. AVI-YONAH. Well, actually, I don't think so because
what is nice about this world, in a way, is that obviously you
can't leave your money in the tax havens because you don't get
a decent rate of return. The other markets that are out there
are mostly developing countries, China, India, and so on, and
those are too risky for the normal portfolio investors. They
don't usually go there.
So, if you look at where the portfolio investors flow, they
are overwhelmingly into obviously the member countries. The
Japanese already withhold. If we get together with the E.U. and
with Japan and we all withhold--even Switzerland, which is a
relatively big country, you can't really leave the money there.
There is not enough investment opportunities.
In order to earn decent returns at relatively low rates,
you have to go into the E.U., the U.S., or Japan. Those are
really the only possibilities. I think it is quite plausible to
have an agreement with the two of them.
Mr. ENGLISH. I will think about your testimony. That is
very challenging.
Thank you so much, Mr. Chairman.
Chairman NEAL. Thank you, Mr. English.
The Chair would now recognize Mr. McDermott.
Mr. MCDERMOTT. Thank you, Mr. Chairman. I want to comment
or praise you for bringing the most arcane issue I have seen in
my 20 years in Congress.
Chairman NEAL. We won't do it again.
Mr. MCDERMOTT. I don't know how you are going to top this.
Mr. Styrcula says if we are going to do this, this is going
to be a danger to the economy. So, Mr. Raskolnikov, I would
like you to explain to me--I read an article today in the Wall
Street Journal which says that the top 400 families, the 400
richest people in this country, pay 18.23 percent income tax.
This is down from 30 percent 10 years ago.
So we are piling up wealth more and more in the hands of
people who could figure out what this derivative business is
all about. Please explain to me why Mr. Styrcula would say it
threatens our competitiveness if we haven't got all these
arcane instruments that basically shelter?
I have an article here from 2006 talking about Goldman
Sachs doing some oil trade return notes that don't pay anything
until 2036. So, there is no income tax whatsoever on that
stuff. So I can explain to the people in my district, put it in
terms that I can understand, why derivatives are so important
for the competitiveness of the United States that is spending
$3 billion in Iraq, and won't tax, and therefore has got deeper
and deeper debt? How are derivatives saving us?
Mr. RASKOLNIKOV. Well, Mr. McDermott, I think that
derivatives definitely play a useful function. So, I don't want
to say that----
Mr. MCDERMOTT. What is that function?
Mr. RASKOLNIKOV. That function for businesses is risk
reduction.
Mr. MCDERMOTT. Risk reduction?
Mr. RASKOLNIKOV. Risk reduction. Hedging. Derivatives allow
businesses to keep the risks that they want and get out of the
risks that they don't want. So, imagine a jeweler who knows a
lot about jewelry but doesn't know a lot about gold prices and
silver prices. So the risk that this person wants to take is
the risk of how fashions will change and what kind of jewelry
to make. But the risk they don't like is they have no idea how
the gold prices are going to move.
So, derivatives would allow them, if you wish, to lock in
the price of their supplies. It can be gold for jewelers, it
can be oil for airlines, and so forth.
Mr. MCDERMOTT. So, the risk is no longer on them. Who is
the risk on?
Mr. RASKOLNIKOV. The risk is on someone who wants to take
that risk, like a speculator.
Mr. MCDERMOTT. Like a hedge fund?
Mr. RASKOLNIKOV. Maybe it is a hedge fund. Maybe it is a
wealthy----
Mr. MCDERMOTT. So, when the hedge fund goes belly up, then
we run in and bail out the hedge fund. Is that what we do?
Mr. RASKOLNIKOV. Well, that is a different issue. Bailing
out hedge funds is well beyond----
Mr. MCDERMOTT. Well, isn't that what we did? We did that
several years ago.
Mr. RASKOLNIKOV. We did do that. That's right, at least
with one of them.
Mr. MCDERMOTT. So, we are shifting off of the jeweler,
putting it on the hedge fund, and saying, we will catch you
when you fall on your rear?
Mr. RASKOLNIKOV. Yes. That last point I am not sure I am
happy with. But if the hedge fund is truly interested in taking
on a risk, and we are not bailing out hedge funds just because
we feel bad about their failures, then derivatives have played
a valuable role. If we do bail out hedge funds, then we are
just transferring the risk from a jeweler to taxpayers at
large. Because it is tax dollars in the end. That doesn't seem
like a good idea.
Mr. MCDERMOTT. It doesn't seem like a good idea at all to
me.
Mr. RASKOLNIKOV. I agree.
Mr. MCDERMOTT. So, why should we do it? I mean, we defend
the taxpayers. This Committee is the one that sets the taxes on
the American people and says, you will pay.
Mr. RASKOLNIKOV. Yes.
Mr. MCDERMOTT. Now, why should I want derivatives to be out
there when I know I am going to have to say to the American
people, we have to bail these guys out because they had this
terrible thing happen to them?
Mr. RASKOLNIKOV. Okay. So, the best answer I can give you
is this. You want to tax something where you can actually
collect revenues. If something you are trying to tax is just
going to disappear the moment you levy the tax, then it is not
worth levying the tax. That is basically Mr. Styrcula's point.
I don't think that they will--now, having said that, I
don't think that derivatives will disappear if you start taxing
them some-
what more. I don't think that the interest imputation regime
that you are considering is a very high tax that will just kill
the products. It is just an opinion. People may differ. But
that is what I think.
If you did think or if you got convinced that imposing a
tax will just kill the product, then you will not have raised
any revenue, and that is just not worth spending time on. That
is the analysis.
Mr. MCDERMOTT. So, our Committee has to deal with the fear
that Mr. Styrcula creates for us, that if we do it, we will
kill the product?
Mr. RASKOLNIKOV. Well, deal, yes. It is definitely
something to consider. It doesn't mean that the answer is,
therefore, don't do anything. I hope that is clear from my
testimony. It just means, be careful.
Mr. MCDERMOTT. Thank you. Thank you, Mr. Chairman.
Chairman NEAL. Thank you, Mr. McDermott.
Mr. Cantor is recognized.
Mr. CANTOR. Thank you, Mr. Chairman. I did want to follow
up on some of the questions from my friend from the State of
Washington, although it certainly whether or not be on the
lines of Iraq. I don't know how we could ever involve the
question of Iraq when we are sitting here talking about
capital-guaranteed products.
Nonetheless, I do want to follow up. I want to find out,
Mr. Styrcula, about the nature of sort of the retail investors
out there. You talked about the size of our market, $114
billion versus three times that in Europe. Dr. Avi-Yonah talked
a little bit about the sovereign wealth funds and the nature or
the source, the timing, and the character of the income.
So, can you just in more layman terms try and talk about
what the nature of that marketplace is? Who is involved and
where is it going?
Mr. STYRCULA. Thank you, Mr. Cantor. I appreciate the
opportunity to do so.
If we go back to the market break in 2000, where all of the
indexes--during the dot com implosion of approximately March
2000, where indexes were losing up to 40 percent of their
value, what wound up happening is for a considerable period of
time, for 2 or 3 years thereafter, indexes were up only single
digits.
Many of the major firms, such as JPMorgan, Merrill Lynch,
and Morgan Stanley, started developing what we call structured
products or investments for higher net worth investors to
actually repair their portfolio with higher income, two times
upside on indexes up to a cap, some relatively sophisticated
financial instruments. Those investors did exceptionally well
from the market break of 2000 until 2003.
So, that led to the growth of an industry in which we said,
well, these are very useful products, some of the more simple
ones, not the super-sophisticated ones, and these are products
that have utility in dialing out volatility and market risk--or
taking on market risk, as the esteemed professor had
mentioned--if they want to do so. Also, for the first time,
average investors were able to get access to markets they
otherwise couldn't get into--commodities, currencies, and what
we call the BRIC countries, Brazil, India, China, and Russia.
So these products have--the reason that the market is
growing is because average investors are having a positive
experience with them. They are perfect hedges in market
volatility; when markets shift and we are in an interest rate-
decreasing environment, structured products provide an
opportunity to increase, based on some equity strategies that
may be a bit too arcane to get into here, but structured
products have proven to be very useful and well-accepted
investments for average American investors.
Mr. CANTOR. Mr. Chairman, if I could ask, do you know the
breakdown of the average sophisticated investor, if you will,
versus the institutional investor versus, again, those using
these products to hedge risks or to speculate versus the more
commonplace investor profile that we think of when people deal
with their 401(k)s or other types of savings or investment
vehicles?
Mr. STYRCULA. Absolutely. Breaking down the $114 billion
figure that we have received from external data providers, the
belief is that $67 billion of that is in the hands of
individual investors, and probably the majority--we don't have
the breakdown, but the majority of that is in the upper high
net worth or accredited investor status. So, we are really
looking at about a 30 to $40 billion market for the retail
investor right now.
There are as many as 40 structured products issuers in the
U.S., including some insurance companies that have gotten into
the business, some mutual fund companies, as well as the
traditional private bank and broker dealer communities as well.
So, we are starting to see, for example, one of the most
prominent structured products of the last year involved being
able to access commodities markets. For regulatory reasons, up
until approximately the year 2000, many investors couldn't have
access to these markets. Now there are forms of capital-
guaranteed access to the markets; as well, exchange traded
notes are providing an exceptional useful function in accessing
difficult markets. It is true that the market is in its
infancy, but we see phenomenal growth potential in it.
Mr. CANTOR. Mr. Chairman, if I could ask Dr. Avi-Yonah very
quickly on the tax theory behind where we are currently, these
vehicles versus the other funds out there where you are having
to pay taxes every year.
I mean, is it ultimately the fact that if you are a mutual
fund investor, let's say that you have a claim to an underlying
asset, that somehow you are then taxed on that interest; and
the fact that in these vehicles here, that you have really--as
you say, the tax treatment is a little bit different than the
other regulatory treatment, that there is a debt instrument
there that ultimately is not realized? Is that really what we
are talking about?
Mr. AVI-YONAH. Well, in the case of those particular
instruments, the theory of the bifurcation is that you really
have a unit that can be broken up, and the investor has the
right to break it up and sell the note part separately.
Therefore, because of that, the IRS is willing to set aside the
forward contract and the note and treat the note as separate
from the forward contract.
But they are marketed as a single unit, and they are
treated as equity for other purposes. So, my view is that there
is no particular reason to bifurcate them in this case. We
don't usually bifurcate financial instruments.
Mr. CANTOR. Thank you, and thank you all very much for
being here.
Chairman NEAL. Thank you, Mr. Cantor.
The Chair will now recognize Mr. Herger.
Mr. HERGER. Thank you very much. I want to thank you, Mr.
Chairman, for allowing me to sit in on this Subcommittee, and
Mr. English. This is certainly a very important issue, one that
is certainly very complex, and I appreciate your holding this
hearing today.
Mr. Desmond, you mentioned that the IRS notice requesting
comment on prepaid derivative contracts listed a variety of
areas of concerns about which the Service hoped to learn more.
Could you perhaps go through some of those issues and highlight
for us what the policy concerns are and which additional
information would be helpful to decisionmaking?
Mr. DESMOND. Yes, Mr. Herger. I think the notice does walk
through a number of issues that we have asked for public
comments on. I think a number of them have been alluded to in
the testimony here this morning.
I think one that was talked about was the concern that we
would have with not interrupting the ordinary business use of
derivative instruments. As was talked about by some of the
other witnesses, there are business reasons why taxpayers enter
into derivative instruments unrelated to taxes, or at least
only tangentially related to taxes. We don't want to be
publishing any rules that would interfere with those business
uses of derivative instruments.
Another sort of fundamental question is whether or not in
this context it is in fact appropriate to require some type of
current accrual of income for tax purposes. I think we have
talked about the various cubbyholes that instruments can fit
into. In many historical contexts, we don't require accrual for
tax purposes until there is actually realization. So, if you
hold stock and it appreciates in value, even though you will be
recognizing income as the value goes up, you are not taxed on
that appreciation until a much later date when you sell the
stock.
So, there is a fundamental question about, in the context
of these instruments, whether accrual should be required.
Assuming you conclude that accrual should be required, there
are a number of different avenues to get there, a number of
different models already in the Tax Code that could be built
upon in a regime that would facilitate current accrual.
We have talked about the mark to market method that is used
in other contexts. There are some other instruments and special
rules that we have published in other contexts that require
current accruals even though there is no actual cash flow on
the instrument. So, that question, again, if you decide that
you should have current accrual, how you should do that. So,
those are issues that we are looking at.
There are also a number of issues that come up in the
international context. If you have either investments being
made by U.S. taxpayers abroad in these instruments or
investments by foreign taxpayers, a number of special
withholding tax issues come up and other issues that are unique
to the cross-border context that we have also asked for
comments on.
Mr. HERGER. I thank you very much.
Just on the capital gains, Dr. Avi-Yonah, could you tell me
what you feel perhaps the proper rate on capital gains should
be? Is it the current law of 15 percent, or should it be raised
or lowered?
Mr. AVI-YONAH. Well, first, I have never been persuaded
that there is any really good reason to tax capital gain at the
lower rate. We of course had equivalence under the 1986 Act.
The basic reason is that most of the arguments in favor of a
lower rate on that capital gains assume that we are going to
treat all of these instruments under a realization requirement.
If we adopt Professor Raskolnikov's suggestion of doing a
mark to market requirement, then you don't have the lock-in
problem and the various other problems, or the inflation
problems, and all the other problems that have traditionally
been given as a reason to tax at least capital gains on these
kind of very liquid instruments where you don't have a
valuation issue and you don't have a liquidity issue. Taxpayers
are able to realize and pay the tax whenever they want to.
Mr. HERGER. So, then you feel the tax rate should be--
should it remain at 15 percent, or should it be raised?
Mr. AVI-YONAH. Well, I think that is basically--rate is a
question for Congress. But what I think is that there should--
--
Mr. HERGER. What is your opinion?
Mr. AVI-YONAH. My opinion is that there should be the same
rate on capital gains as there is for ordinary income. Whatever
the rate is----
Mr. HERGER. So, you feel it should be raised, then?
Mr. AVI-YONAH. Under the current rate structure, it would
be raised, yes.
Mr. HERGER. Mr. Raskolnikov, what is your feeling? Is the
rate where it should be? Should it be raised? I know the
Administration and the Treasury feels it should be permanently
made at the 15 percent--maintained where it is. What is your
thoughts?
Mr. RASKOLNIKOV. I like the 1986 Act. Lower rates on
ordinary income, higher rates on capital gains. Single rate.
Mr. HERGER. So, you would like to see them raised?
Mr. RASKOLNIKOV. Yes. Broader base and lower rates is the
way to go.
Mr. HERGER. Thank you, Mr. Chairman.
Chairman NEAL. We have time for another round of
questioning. So, Mr. Desmond, let me ask you about credit
default swaps, which seem to be in the news a lot recently. It
seems that Treasury has entertained the thought of guidance
here, and I think most of us believe that would be very
helpful.
We have heard that, in its absence, parties to these
unregulated swaps have been free to take whatever position is
most convenient as to the character and tax treatment. Can you
explain if Treasury is working on guidance, and when we might
expect to see some result?
Mr. DESMOND. Yes. Thank you, Mr. Chairman. Credit default
swaps are an instrument. We have been talking mostly or I have
been talking about derivative instruments with an underlying
asset, an index asset, of being an equity of some kind. That is
what we are talking about in the context of most exchange
traded notes.
There are also derivative instruments that can give someone
exposure with respect to a credit risk, and that is what credit
default swaps generally are, although there are all different
categories of them.
It is an issue that we have been looking at. Back in 2004,
we issued a notice requesting comments on the appropriate tax
treatment of credit default swaps, focusing in particular on a
number of international issues that come up with respect to
foreign taxpayers.
There are, I think, a number of reasons why investors enter
into credit default swaps that have nothing to do with taxes.
There are business reasons why you want to seek credit
protection. You may have a loan outstanding to a particular
individual and you may want to protect yourself against the
credit risk with respect to that borrower, and credit default
swaps--or excuse me--yes, credit default swaps do offer some
protection in that context.
So, it is an issue that we have thought about. It is an
issue that we have solicited comments on. But it is really not
one that is driven necessarily by taxes. There are a lot of
reasons for entering into these, a whole number of different
types of credit default swaps that may have different tax
treatment depending on what particular type of credit default
swap you are looking at, and a number of different options for
their characterization depending on the facts.
Chairman NEAL. So, given that explanation, you really don't
have a timetable?
Mr. DESMOND. I don't think we really do have a timetable.
Again, it has been since 2004 that we have been looking at
this. It does come up in discussions of these other issues,
like notional principal contracts, that are on the table when
we talk about derivatives generally.
So, it is something we talk about, again. Again, we see
lots of non-tax reasons for entering into these instruments. It
is not something that we have seen as we have with the exchange
traded notes, sort of a renewed reason for looking at it. I
think the issues that are out there with respect to credit
default swaps are the same issues that have been out there for
some time.
Many of the issues that are coming up recently are not
necessarily tax issues. They are questions about the value of
these instruments and other things that might raise non-tax
issues that I think are putting them into the--sort of bringing
the discussion of them up again. But those are really--many of
those are not tax issues.
Chairman NEAL. Is it possible, then, based upon the answer
that you have given that a tax preparer or tax attorney or
accountant could argue the issue flat around for their client?
Mr. DESMOND. Certainly there are a number of different
types of credit default swaps, and the tax treatment with
respect to those different varieties, there can be--you know,
absent very clear guidance on a specific transaction, there are
certainly arguments as to the particular tax treatment of it.
Chairman NEAL. Mr. English.
Mr. ENGLISH. Thank you, Mr. Chairman.
Mr. Avi-Yonah, I understand that the U.S. tax treatment of
an equity swap with a non-U.S. person is not clear, and that
the existing guidance regarding U.S. withholding rates is
incomplete. My understanding further is that in the absence of
clear rules in this area, banks use a variety of factors to
attempt to identify good equity swaps as distinguished from bad
ones.
In this regard, would it be helpful if there was a clear
set of rules to determine when an equity swap should be
respected and when they should be recharacterized to subject
payments to withholding and/or information reporting such as,
for example, a share lending arrangement or a nominee ownership
arrangement? If so, is this something best addressed by the
IRS, or should Congress intervene legislatively?
Mr. AVI-YONAH. So, I think that the fundamental issue is
the source rule because our current source rule is that all
payments on notional principal contracts basically are taxed
based on the residence of the recipient, which in the case of a
foreign would mean that they are not U.S. source income and not
subject to withholding tax.
You mentioned our treatment of securities lending
transaction. In that context, we have decided to source the
payments by reference to the underlying. So, a dividend
substitute payment that is paid from a U.S. borrower of a
security to a foreign lender of a security is treated for
withholding tax purposes and other tax purposes as equivalent
to a dividend because it is a dividend equivalent.
I personally think that the same treatment should be
extended to dividend equivalence in other contexts, such as
swaps, equity swaps. If you do that, then I don't think it
matters so much.
I mean, under the current law, basically the question is,
where do you draw the line, and how much can you go in the
direction of hedging your investment and tracking precisely the
dividends and still be under the notional principal contract
source rule?
But my view is that the source rule needs to be changed. As
I mentioned before, I can't think of any other example where
such a major source rule was adopted by regulation without any
congressional input, as far as I can tell. Most of our source
rule, by far the vast majority of our source rules, are in the
Code. I think that this is something for Congress to take a
look at.
Mr. ENGLISH. So, this is something that you would recommend
we consider a legislative solution?
Mr. AVI-YONAH. Yes, I do.
Mr. ENGLISH. Very good.
Mr. Raskolnikov, you went through a variety of pros and
cons of a mark to market regime and concluded, as I understood
it, that on balance, it is a workable system for derivatives.
In particular, you have dismissed the concerns about investor
liquidity to pay
for the taxes since many derivative investors are comparatively
wealthy.
But is that really the case for mutual fund or ETN
investors, and would you make any allowance for them?
Mr. RASKOLNIKOV. Thank you, Mr. English. So, mutual funds
are outside of my proposals because mutual funds are not
derivatives.
Mr. ENGLISH. Well, then, let's focus on----
Mr. RASKOLNIKOV. ETNs. So, thank you for asking the
question. It actually gives me an opportunity to say something
about what Mr. Styrcula said and just clarify one thing. He
said----
Mr. ENGLISH. I would like to stay focused, though, because
I have very limited time.
Mr. RASKOLNIKOV. Oh, sorry.
Mr. ENGLISH. If you could directly answer the question.
Mr. RASKOLNIKOV. Sorry. So, the question--but that goes
exactly to your question. So, apparently $30 billion is
invested in retail prepaid forwards. Thirty billion dollars is
a large number, but we don't know how many people are there.
I suspect--I suspect--that most of these people are fairly
well off; or if they are not well off, they are investing in
401(k)s and IRAs and they won't care about the mark to market
regime. So, will these relatively well-off people have
liquidity? I suggest that it is quite likely that they will to
pay the tax, yes.
Mr. ENGLISH. I wish I had a little more confidence in your
suspicions.
Mr. Desmond, are there any studies that would illuminate on
this point?
Mr. DESMOND. Not that I'm aware of, Mr. English. I think
the numbers that have been thrown out are industry data. They
are not data that the Treasury Department has looked at. So,
nothing that we have done. Nothing that I am otherwise aware
of.
Mr. ENGLISH. Then I will go back to the professor.
If Congress were to opt against the mark to market regime
for derivatives that you have advocated, do you think the time
value of money-based alternative, which is outlined in the
Chairman's bill, would be workable? Why or why not?
Mr. RASKOLNIKOV. I think it may be workable, yes. Why? It
is a fairly simple system, much simpler than other legislation
that has already been passed, like constructive ownership
rules.
Financial intermediaries who are selling these products to
the masses, so to speak, well-off masses, for sure, will be
able to provide taxpayers with information about the accruals
that need to be included in income, and they will be able to
provide this information to the IRS. That is the hallmark of a
workable system.
Mr. ENGLISH. Thank you, Mr. Chairman.
Chairman NEAL. Thank you, Mr. English.
I want to thank the witnesses for their testimony today. We
perhaps will have some followup questions that will be asked of
you, and we hope you will respond promptly. This was most
helpful. So, at this point, I would like to thank you, and
again take the opportunity to call the second panel.
Let me thank the panelists, and we will begin with Mr.
Sauter.
STATEMENT OF GEORGE U. ``GUS'' SAUTER, CHIEF INVESTMENT
OFFICER, THE VANGUARD GROUP; MANAGING DIRECTOR, QUANTITATIVE
ENERGY GROUP
Mr. SAUTER. Chairman Neal, Ranking Member English, and
Members of the Subcommittee, good morning. My name is Gus
Sauter, and I am the Chief Investment Officer of the Vanguard
Group.
Vanguard is one of the world's largest investment
management firms, with nearly $1.3 trillion in U.S. assets
under management in more than 150 mutual funds. I directly
oversee the management of approximately 75 percent of these
fund assets, including both indexed and actively managed equity
and bond and balance funds, as well as money market funds.
I am glad to have the opportunity this morning to share our
views on exchange traded notes or ETNs. My perspective on these
products is that of the Chief Investment Officer of Vanguard,
with professional responsibility for investing in financial
products and capital markets for the benefits of millions of
investors.
Our basic message is that now is the time to address these
products that some in the press are calling derivatives for the
masses. Indeed, all one needs to begin investing in these
derivatives is $50 and a brokerage account.
Unparalleled, and I am told unintended, tax benefits have
in part fueled the explosive recent growth of ETNs. There were
no ETNs at all in May of 2006. The first ETN was offered in
June of 2006. Since then, six issuers have brought some 30
different ETNs to market. At the end of 2007, just 2 months
ago, there were $4 billion in ETNs. Today, just 2 months later,
there are $6 billion worth of assets.
New ETNs are now being announced on a regular basis. In our
view, this explosive growth may have been many magnitudes
greater than it currently is if ETNs' current tax treatment had
been thought to be relatively certain to continue.
ETNs are presented as a way to convert investment returns
into long-term capital gains and to defer tax payment until the
derivative is sold or redeemed, possibly many years in the
future. No comparable financial product is taxed so favorably.
Regulated futures, for example, are marked to market annually,
that is, treated as sold at the end of each year, and taxes may
be owed without an actual sale, though they are also exchange
traded forward contracts like ETNs.
This highly favorable tax treatment is the result of a gap
or loophole and not an express policy decision. ETNs are simply
bringing to a head a question that has been left unresolved for
many years, how prepaid forward contracts should be taxed.
The time has come to answer this question directly. As a
manufacturer, seller, distributor, and consumer of investment
products, Vanguard is keenly interested in knowing how ETNs are
and will be taxed. Their treatment should be the result of
deliberate policy choices rather than legislative or
administrative gaps.
Under current conditions, retail investors can be expected
to continue to buy these offerings, making it increasingly
complicated to reset expectations and adopt a sound
comprehensive tax policy in the future.
In addition, current tax policy has the potential to create
significant collateral damage to many participants in the
capital markets. Consider, for an instance, the case of
municipal bonds. Consider an ETN that is created to provide the
performance of the broad U.S. taxable bond market, the Lehman
aggregate bond market.
That ETN would provide the investor the return of the U.S.
bond market without taxation on a current basis. Taxes would be
deferred until the investment is sold. At that point, they
would be taxed as capital gains.
You can imagine that this is a very appealing investment
for a taxable investor, and that these types of investments
would compete against municipal bonds, which also have a tax-
favored status. As a result, municipal bonds would have to have
substantially higher interest rates than they currently pay,
dramatically increasing the cost of financing municipal
projects.
At the same time, there are other industries that are
greatly impacted by this. Variable annuity providers, for
instance, again allow investors to aggregate or participate in
markets while not being taxed currently and paying tax at the
end of the investment timeframe. At that point, the investment
is taken out and paid current income taxes. You can imagine
that an ETN would be much more favorably viewed than a variable
annuity.
Then finally, the retirement savings industry would be
dramatically impacted. Today there are incentives, from a tax
standpoint, to invest in 401(k) plans. If ETNs were available,
those incentives would be gone.
That is why we are here today, to support H.R. 4912,
introduced by Chairman Neal. It takes a significant step in
what we regard as the right direction to address ETNs and other
prepaid forward contracts. Clarity is essential to enable
financial services firms and investors to plan for the future.
We look forward to working with you to improve the situation
going forward.
I thank you for the opportunity to share our views, and I
will be pleased to answer any questions.
[The prepared statement of George U. ``Gus'' Sauter
follows:]
[GRAPHIC] [TIFF OMITTED] T8276A.017
[GRAPHIC] [TIFF OMITTED] T8276A.018
[GRAPHIC] [TIFF OMITTED] T8276A.019
Chairman NEAL. Thank you, Mr. Sauter. Congresswoman
Schwartz wanted to acknowledge your presence here today. She is
tied up at a Budget Committee markup.
Mr. SAUTER. Thank you.
Chairman NEAL. Mr. Paul.
STATEMENT OF WILLIAM M. PAUL, COVINGTON & BURLING LLP, ON
BEHALF OF INVESTMENT COMPANY INSTITUTE (ICI)
Mr. PAUL. Thank you. Mr. Chairman, Ranking Member English,
and Members of the Committee, my name is William M. Paul. I am
a partner with the law firm of Covington & Burling LLP. I
appear before you today on behalf of the Investment Company
Institute, the National Association of U.S. Investment
Companies, which include mutual funds, closed-end funds,
exchange traded funds, and investment trusts.
In my written statement, I include some challenges on that
innovative financial products pose to the tax system. Because
of time limitations, I will direct my remarks before you this
morning to ETNs.
ETNs pose two challenges to the tax system. One is the
treatment of the time value of money return on the prepayment
by the investor. The other is the fact that the return on the
ETN reflects the results of a series of notional investments
and reinvestments in commodities or securities that would
result in current recognition of gain or loss if an investor
engaged in them directly or through a partnership or mutual
fund. As noted in the technical explanation of H.R. 4912, these
two problems are exacerbated by the 30-year maturities of many
ETNs.
The time value of money concern focuses on the prepaid
forward structure of ETNs, the ``wrapper,'' if you will,
without regard to the nature of the underlying assets and
whether the composition of those assets changes over time. The
holder makes an upfront payment some 30 years before the issuer
is obligated to perform. Even though the total amount the
holder will receive is contingent, a portion of the holder's
return is attributable to the time value of the prepayment.
In contrast, the constructive ownership concern views the
prepaid forward contract as a means of acquiring the full
economics of ownership without the tax consequences of
ownership. This concern focuses on what is going on inside the
contract or inside the wrapper. Approaches motivated by this
concern, notably section 1260, try to ensure that the taxpayer
does not achieve a better tax result from ownership through a
derivative than he would receive through a direct investment.
The ICI supports H.R. 4912 as an important first step in
addressing ETNs. However, we believe that improvements are
needed in order to provide a comprehensive response to ETNs.
The technical explanation of the bill identifies both the time
value of money concern and the constructive ownership concern.
The bill itself addresses only the former. The bill would
require holders to accrue interest income on their investment
in the contract under a modified version of the OID rules. The
bill does not attempt to implement constructive ownership
policies based on notional gains realized inside the contract.
In our view, it is more important for the tax system to
respond to the constructive ownership concerns raised by ETNs
than to the time value of money concerns. The arguments for
taxing the time value of money return to prepaid forward
contracts are economically sound, but the tax policy
considerations involved are subject to legitimate debate.
In contrast, we believe that the constructive ownership
policy is well established in our tax system and much more
compelling. As articulated in the legislative history of
section 1260, that policy mandates that a taxpayer who
replicates economic ownership of a referenced asset through a
derivative should not receive better tax treatment than one who
owns directly. This policy is fundamental to protecting the tax
base tied to returns on capital investment.
In many ways, ETNs can be viewed as the next generation of
constructive ownership transactions that section 1260 is
intended to address. When section 1260 was enacted in 1999,
derivatives were being used to provided economic ownership of
hedge funds and mutual funds without the tax consequences of
direct ownership. With ETNs, the result was that ordinary
income and short-term gains were deferred and converted to
long-term gains.
ETNs use improved technology in the form of dynamic indexes
to fall outside the scope of section 1260. The dynamic index
functions as a synthetic mutual fund or partnership, so much so
that ETNs even impose a notional investor fee each year that
mimics a mutual fund management fee. Notwithstanding the
advances in technology, the results obtained by investing in
ETNs are precisely the results that section 1260 was intended
to stop.
While amending section 1260 to cover ETNs is possible, the
consequences that follow under that provision would effectively
kill most ETNs. Accordingly, we would support the alternative
approach of expanding the concept of notional amounts credited
under the contract in H.R. 4912 to include notional gains
realized inside of the contract.
For example, the commodity ETNs reflect the return from
trading strategies in futures contracts. As those notional
futures contracts are closed out or settled, the resulting
gains are credited under the contract and could appropriately
be included in income of the holders.
Such an approach would require the issuer to provide the
requisite information to holders in a way that is closely
analogous to the requirements for the qualified electing fund,
or QEF, election under the rules that apply to passive foreign
investment companies, or PFICs. The rules addressing
investments in a PFIC can be viewed as a precursor to section
1260.
In the relatively simple days when that legislation was
enacted, U.S. taxpayers were deferring and converting
investment income by investing in offshore funds that do not
make current distribution of income or gains. Congress
responded in 1986 with rules to prevent such deferral and
conversion.
The various approaches adopted to prevent taxpayers from
deferring and converting investment income by investing in
PFICs could provide a model for addressing the deferral and
conversion afforded by ETNs.
First, if the issuer provides the necessary information,
the holder could elect to include in income the notional income
and gains credited for the year. This would be the QEF
analogue. Second, because ETNs are publicly traded, the holder
could elect mark to market treatment, just as the holder of
publicly traded PFICs can. Third, if the holder fails to elect
either of these alternatives, the deferred tax and interest
regime of section 1291 or the existing section 1260 regime
could apply.
Thank you very much. I would be happy to take your
questions.
[The prepared statement of William M. Paul follows:]
Prepared Statement of William M. Paul,
Covington & Burling LLP, on behalf of Investment Company Institute
(ICI)
My name is William M. Paul. I am a partner with the law firm of
Covington & Burling LLP. I appear before you today on behalf of the
Investment Company Institute (``ICI''), the national association of
U.S. investment companies, including mutual funds, closed-end funds,
exchange traded funds, and unit investment trusts. Members of ICI
manage total assets of $12.33 trillion and serve almost 90 million
shareholders.
The topic of derivatives and their taxation is broad, diverse and
exceedingly complex. I will not attempt to cover the topic in anything
approaching a comprehensive way. Rather, I would like to make some
general observations and then turn to a discussion of exchange traded
notes.
I. Derivatives
A derivative is a financial instrument the value of which is
determined by reference to one or more financial assets, such as
stocks, bonds or commodities. Traditional derivatives include options,
forwards and futures contracts. Nontraditional derivatives, that is,
derivatives that have been developed more recently, include interest-
rate swaps, equity swaps, credit default swaps prepaid forward
contracts, and myriad variations on these instruments. The tax rules
governing traditional derivatives are fairly well established. Tax
rules governing interest-rate swaps, equity swaps and most total return
swaps were adopted by Treasury in the early 1990s and have worked
relatively well. Issues still exist, however, with respect to equity
swaps and total return swaps. No guidance has been issued as yet on
credit default swaps or on the treatment of holders of prepaid forward
contracts.
One of the factors contributing to the development of new
derivatives is the desire of participants in the capital and financial
markets to gain more targeted exposure to specific risks. For example,
if an institution wants exposure solely to the credit risk of a
corporate issuer, holding bonds of that issuer is not sufficient
because it entails both interest-rate risk and credit risk. Credit
default swaps were developed to enable market participants to isolate
pure credit risk from interest-rate risk. Other factors driving
innovation in financial products are a desire to avoid regulatory and
other restrictions and to reduce inefficiencies associated with
existing alternatives. Advances in computer and communications
technology have significantly enhanced the ability of Wall Street to
develop new financial products in recent years.
The dramatic increase in the use of nontraditional derivatives has
been greatly facilitated by the development of standardized agreements
to govern transactions in the over-the-counter market. Using
standardized agreements makes the market much more efficient because
participants do not need to separately negotiate the terms of each
transaction. ISDA has been the key player in developing these
standardized contracts, which exist for many types of nontraditional
derivatives, including credit default swaps.
II. Challenges to the Tax System
Most of our tax rules were developed in simpler times when the
economic environment was not nearly as diverse, complex and
sophisticated as it is today. If a corporation issued a security for
cash, it was generally either stock or debt. Now corporations issue a
variety of instruments for cash and the tax question is no longer
merely the historic debt-equity question. Instead the question is how
should the tax system categorize the instrument and how should it be
taxed?
Our annual accounting system for computing income does not deal
well with contingencies that are not resolved by the end of the taxable
year. In earlier, simpler times this inadequacy was tolerable as the
number and scope of transactions raising problems were contained. In
the modern era, with its plethora of contingent payment contracts in
the trillions of dollars, the pressure on our traditional realization
principles is intense. Congress and Treasury have responded in various
ways to prevent the deferral that would result under traditional
realization principles. Examples include the contingent payment debt
rules, which require current accrual at a market rate of interest even
though the amount the holder will ultimately receive is unknown; the
mark-to-market rules of section 1256, which apply to most exchange
traded derivatives and require the parties to the contract to recognize
gain or loss based on the fair market value of the contract on the last
day of the year; and section 475, which requires securities dealers to
mark their positions to market without regard to whether they are
traded on an exchange.
Developing appropriate regimes for taxing new financial products is
a daunting process in many respects. The products are often complex and
difficult to understand economically, and they can be used by market
participants in various ways, some of which may be more threatening
from a tax perspective than others. The fundamental issue that needs to
be ``gotten right'' in developing an appropriate tax response is the
economics of the instruments. If the tax treatment is out of whack with
the economics, the product will be over-utilized or under-utilized.
Moreover, even a relatively small mistake in taxing the economics can
lead to extensive over-use (and associated revenue loss). If the tax
law makes a mistake in the depreciation of restaurants by using a
useful life that is 1 year too short, the number of excess restaurants
built in the U.S. may increase at the margin. But the ``bricks and
mortar'' reality of building restaurants creates significant frictions
on the ability to exploit the resulting undertaxation. In the financial
products world, this is not the case. The availability of leverage
(either direct or indirect) and the ability to add zeros to the end of
numbers with the stroke of a pen--or more aptly, the stroke of a
computer key--make it easy for slight errors to have very significant
ramifications.
This is not to say that the development or use of new financial
products is primarily tax driven. To the contrary, they are primarily
driven by business, investment and economic considerations. Taxes are,
however, often an important factor.
One way in which tax is often a factor is in choosing the specific
financial product or products that a taxpayer will use to achieve its
business or investment objectives. It is widely understood that the
same cash flows can be generated by different combinations of financial
products that are taxed in different ways.\1\ Understandably, taxpayers
will tend to use the financial product or combination of products that
result in the most favorable--or least onerous--tax treatment.
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\1\ For example, the cash flows of a zero coupon bond can be
created by buying a stock and entering into a forward contract to sell
the stock. Similarly, the cash flows from buying a zero-coupon bond and
a call option on a stock are the same as the cash flows from buying the
stock and a put option to sell the stock.
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Yet another challenge is the flexibility of financial products. In
developing appropriate rules, Treasury and IRS are very cautious in
``drawing lines'' that define whether a product is subject to a
particular regime or not. If they draw a bright line, financial
products can morph so that they fall either just inside that line or
just outside that line, with significant differences in tax treatment
as a consequence. One recent example of this phenomenon is so-called
``call-spread converts.''
The need to ``get it right'' in determining the correct treatment
for a new financial product means that Treasury and IRS are often slow
to respond. In the last 20 years or so, Treasury has struggled mightily
and with mixed success to issue much needed guidance in this area. The
contingent debt regulations were issued in proposed form and modified
and withdrawn several times over a 10-year period before the ultimate
approach was finally adopted. Treasury has been thinking about the
taxation of prepaid forward contracts since at least 1993 \2\ and had a
guidance project on its business plan for several years, but has never
issued guidance. After an 11-year hiatus following the issuance of the
notional principal contract regulations in 1993, Treasury finally
addressed swaps with contingent nonperiodic payments in 2004 by issuing
proposed regulations that have proved to be highly controversial.
Treasury has been studying credit default swaps now for several years.
Treasury's ability to respond to new financial products is also often
hampered by questions regarding the scope of Treasury's authority.
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\2\ See preamble to T.D. 8491, 58 Fed. Reg. 53125, 53126 (Oct. 14,
1993).
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These observations are not intended as a criticism of Treasury.
Their caution is understandable. However, the market does not stand
still while Treasury reflects. If there is market demand for a product,
the market for the product will grow and the tax treatment will be
determined by what is known as ``market practice.'' Even though there
is not a hard and fast ``Wall Street rule,'' it is undeniably the case
that it becomes more difficult over time for Treasury, the IRS or even
Congress to put the genie back in the bottle.
III. Approaches to Taxing New Financial Products
In evaluating how a new financial product should be taxed,
practitioners and Treasury tend to follow the same approach. The first
step is typically to identify other products for which tax rules exist
and that are similar to the new product in question. Thus, for example,
discussions about how credit default swaps should be taxed tend to
focus on comparing them to options and notional principle contracts,
both of which are closely comparable but not exactly the same. In the
case of credit default swaps, comparisons are also made to financial
guarantees and insurance.
In conducting this evaluation, the ``norm'' is to view the product
as a single instrument. A convertible bond is often cited as an
illustration of this approach. Although a convertible bond is
economically equivalent to straight debt and an option to acquire the
issuer's stock, it is treated as a single instrument for tax purposes.
While a new product is typically analyzed as a single instrument,
this is not always the case. On occasion, products are ``bifurcated''
into two or more instruments to determine the appropriate tax
treatment. A good example is the treatment of swaps with significant
nonperiodic payments, which the regulations bifurcate into a loan and
an ``on market'' swap.\3\ There are also examples of the tax law
integrating two separate but related instruments and taxing them on a
combined basis. The straddle rules are an example of partial
integration.
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\3\ See Treas. Reg. Sec. 1.446-3(g)(4).
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The current controversy regarding variable prepaid forward
monetization transactions can be viewed as a dispute over whether two
separate but related transactions should be integrated in determining
the appropriate tax treatment. (This controversy is often confused with
the separate, but also current, controversy regarding the treatment of
holders of prepaid forward contracts generally and of exchange traded
notes more specifically, which I will turn to in a moment.) The
variable prepaid forward contract monetization transaction controversy
relates to whether a taxpayer holding appreciated stock should
recognize gain when he enters into a forward contract requiring him to
deliver a variable number of shares on a specified future date and
receives in return an upfront payment equal to 80 to 85% of the current
market value of the stock. In Revenue Ruling 2003-7,\4\ the IRS ruled
that if properly structured, this transaction does not result in gain
recognition at the time the taxpayer enters the contract and receives
the upfront payment. More recently, the Service has learned of
variations of the transaction that include a separate but related share
lending agreement pursuant to which the taxpayer lends the stock to the
same counterparty and authorizes the counterparty to sell the stock
subject to an obligation to return identical stock at a later time. The
Service has issued a technical advice memorandum, an advice memorandum,
and a coordinated issue paper, all taking the position that the share
lending agreement is effectively part of the variable delivery forward
transaction and that the two in combination result in a current
sale.\5\ The securities industry strongly disagrees with this view and
a case presenting the issue has been docketed in the Tax Court.
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\4\ 2003-1 C.B. 363.
\5\ See TAM 200604033; Advice Memorandum 2007-004; LMSB Coordinated
Issue Paper 04-1207-077.
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IV. Exchange-Traded Notes
I would now like to turn to a discussion of a new financial product
known as an exchange traded note (``ETN''). After providing a summary
description of ETNs, I will describe the challenges that ETNs present
for the tax system. I will then turn to the consideration of possible
legislative responses, focusing primarily on the approach reflected in
H.R. 4912.
A. Description of ETNs
1. Common Features of ETNs
While there are some variations, ETNs typically have the following
features:
a. They are long-term notes (often 30 years) issued by a bank (the
``Issuer'').
b. There are typically no interest or other payments on the notes
prior to maturity.
c. The notes are issued in denominations of $50 and do not
guarantee return of principal.
d. The amount due at maturity is determined by reference to a
specified index that (i) takes into account the performance of a
specified investment or trading strategy, and (ii) is reduced by an
``investor fee'' that accrues at a stated rate (ranging from 40 to 125
basis points).
e. ETNs may be redeemed prior to maturity in lots of 50,000 notes
or more. The redemption price is the index value of the notes at that
time (in some instances reduced by a redemption fee). This redemption
feature is designed to ensure that the market price of an ETN
corresponds to the value of the index it tracks.
f. Holders of ETNs are subject to the Issuer's credit risk, i.e.,
the risk that the Issuer will not be able to pay the notes at maturity
or that the market price of the notes may be adversely affected by a
decline in the Issuer's creditworthiness. The redemption feature
described above may mitigate this risk.
g. The tax disclosures for ETNs generally indicate that they should
be treated as prepaid forward contracts for tax purposes, and the terms
of the ETNs require holders and the Issuer to treat the notes that way.
The disclosures generally state that holders should not recognize gain
or loss prior to the sale, redemption or maturity of the notes and
should receive long-term capital gain treatment if they hold an ETN for
more than 1 year.
2. Different Types of ETNs
There are currently at least 34 ETNs. I understand that at least 8
more have either just launched or are about to launch, with many more
in the pipeline. The 34 ETNs that I have had the opportunity to review
can be broken down into six categories based on the nature of the index
they reference (the ``reference index''): (i) commodities, (ii) foreign
currencies, (iii) equities, (iv) option strategies, (v) master limited
partnerships, and (vi) closed-end funds. ETNs in each of these
categories are described below.\6\
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\6\ The information provided about existing ETNs reflects my best
understanding based on information I have had the opportunity to review
and may be incomplete.
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a. Commodity ETNs
There are currently 20 commodity ETNs, the returns on which are
tied to various ``total return'' commodity indexes. Examples include
the S&P GSCI Total Return Index, the Dow Jones-AIG Industrial Metals
Total Return Sub-Index, and the Rogers International Commodity Index.
Each of these indexes tracks the return a taxpayer would receive if he
or she entered into a series of commodities futures contracts and also
invested in Treasury bills or some other interest-bearing obligations.
For example, the S&P GSCI Total Return Index ETN reflects the return a
taxpayer would receive by holding Treasury bills and entering into a
basket of 24 futures contracts on physical commodities. The relative
weightings of the commodities in the index are adjusted over time. The
index value is determined by ``rolling over'' the referenced futures
contracts, i.e., as a futures contract approaches its settlement date,
it is replaced by a new futures contract on the same commodity.
b. Foreign Currency ETNs
There are six foreign currency ETNs. Three of these ETNs track the
exchange rate between the U.S. dollar and, respectively, the Euro, the
British Pound and the Japanese Yen. The terms of these ETNs appear to
be identical except for the referenced foreign currency. An investor in
these ETNs is entitled to receive at maturity an amount equal to the
stated principal amount multiplied by the increase (or decrease) in the
specified index, minus the accrued investor fee. The specified index
has two components. The ``currency component'' is equal to the increase
or decrease in the specified exchange rate (e.g., Euro/USD) since the
notes were originally issued. The ``accumulation component'' is an
interest return tied to an overnight deposit rate in the referenced
foreign currency. In Rev. Rul. 2008-1, the IRS ruled that these ETNs
are to be taxed as foreign currency-denominated debt instruments.
In recent weeks three additional foreign currency ETNs have been
introduced. Two of these ETNs track baskets of currencies and pay a
cash yield to holders. The third ETN tracks an index tied to the
``carry trade,'' which refers to the strategy of borrowing in
currencies with low interest rates and lending in currencies with
higher interest rates. Currently, the index reflects ``borrowings'' in
five specified currencies and corresponding ``loans'' in five other
specified currencies.
c. Equity ETNs
There are currently five equity ETNs, each of which tracks an index
reflecting a segment of the public equities markets. These include the
Spectrum Large Cap U.S. Sector Momentum Index, the Morningstar Wide
Moat Focus Total Return Index, the Opta S&P Listed Private Equity
Index, and an index that tracks the ``Dogs of the Dow.'' \7\ By way of
example, the ``Dogs of the Dow'' ETN reflects the return an investor
would receive if he or she invested an equal amount in each of the ten
stocks included in the Dow Jones Industrial Average that have the
highest dividend yield. The index is adjusted each December to add or
subtract stocks and to rebalance the weighting of any stocks that
remain within the ten ``dogs.''
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\7\ The formal name of this index is the ``Dow Jones High Yield
Select 10 Total Return Index.''
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d. Option Strategy ETN
There is one option strategy ETN that reflects the performance of
the CBOE S&P 500 BuyWrite Index. This index is designed to measure the
total return a taxpayer would receive from owning all of the stocks in
the S&P 500 Index and writing a succession of 1-month call options on
the S&P 500 Index that are either ``at the money'' or slightly ``out of
the money.'' \8\
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\8\ An at-the-money call option has an exercise price equal to the
current value of the underlying stock. An out-of-the-money call option
has an exercise price above the current value of the underlying stock.
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e. Master Limited Partnership ETN
One ETN tracks the return an investor would receive from investing
in a number of energy-oriented master limited partnerships (``MLPs'').
This ETN tracks the BearLinx Alerian MLP Select Index. Unlike most
ETNs, this ETN makes periodic payments, which are tied to the amounts
investors would receive as distributions if they invested in the
underlying MLPs directly.
f. Closed-End Fund ETN
There is one ETN that tracks an index of 75 closed-end funds. This
ETN tracks the Claymore CEF Index, which consists of closed-end funds
that are selected based on distribution yield and ``discount'' to net
asset value (i.e., the excess of net asset value over the price at
which the fund's shares trade in the market). This ETN also makes
distributions that correspond to the distributions a direct investor in
the underlying funds would receive.
B. Problems That ETNs Present for the Tax System
As the Technical Explanation of H.R. 4912 recognizes, ETNs pose two
challenges to the system: (i) the treatment of the ``time value of
money'' return on the prepayment and (ii) the fact that the index
``represents a series of notional investments and reinvestments'' in
commodities or securities that would result in the current recognition
of gain or loss if an investor engaged in them directly or through a
partnership or mutual fund. As further noted in the Technical
Explanation:
These two fundamental problems in turn are exacerbated by the very
long-term maturities of many ETNs, often 30 years. If the tax analysis
proposed by issuers of ETNs and similar instruments were to prevail,
investors in such instruments would thus be able to defer tax from the
current returns with which they are credited, and from the sales and
purchases with which they are credited, for up to 30 years.
The ICI very much agrees with this statement regarding the
challenges posed to the tax system by ETNs. Before turning to a
discussion of H.R. 4912, I would like to make a few observations about
both the ``time value of money'' and ``constructive ownership'' aspects
of ETNs.
The ``time value of money'' concern focuses on the prepaid forward
structure of ETNs--the ``wrapper'' if you will--without regard to the
nature of the underlying assets and whether the composition of those
assets changes over time. The holder makes an upfront payment some 30
years before the issuer is obligated to perform under the contract and
is compensated for doing so by the fact that his return under the
contract is tied to prices in the cash market (i.e., the current market
price) instead of the forward price. (Alternatively, the holder is
compensated by an explicit interest factor as part of the ETN index
formula.) Even though the total amount the holder will ultimately
receive is contingent, a portion of the holder's ultimate return is
attributable to the time value of the prepayment. Generally speaking,
the holder's ultimate return will be greater as a result of the
prepayment by an amount equal to the future value of the prepayment at
maturity, with such future value computed using an appropriate interest
rate.
In contrast, the constructive ownership concern views the prepaid
forward contract merely as a means to accomplishing the full economics
of ownership without the tax consequences of ownership. This concern
focuses on what is going on inside the contract--inside the wrapper.
Approaches motivated by this concern, notably section 1260, try to
ensure that the taxpayer does not achieve better tax results from
ownership through a derivative than he or she would receive through a
direct investment. Under this view, the appropriate treatment from a
time-value-of-money perspective is tied to how time value associated
with a direct investment in the underlying would be treated. For
example, if the underlying is simply 100 shares of some nondividend-
paying stock, a constructive ownership approach would not attempt to
tax any time value of money return. It would simply attempt to tax the
prepaid forward consistently with (or at least no better than) taxation
of direct ownership of the underlying stock.
I think of these alternative approaches to ETNs as analogous to the
approach to partnership taxation under subchapter K. In certain
respects, subchapter K views the partnership as an entity (an ``entity
approach'') and in others it looks through the partnership to the
underlying assets and activities of the partnership (the ``aggregate
approach''). In much the same way, a time-value-of-money approach looks
at the wrapper and a constructive ownership approach looks at what is
going on inside the wrapper.
C. H.R. 4912
On December 19, 2007, Congressman Neal introduced H.R. 4912 (the
``Bill'') addressing the tax treatment of ETNs and other prepaid
forward contracts. The Bill would require holders of ``prepaid
derivative contracts'' to include an amount equal to the ``interest
accrual amount'' in taxable income each year. Such amount would be
treated as interest income. The Bill would not affect the tax treatment
of the issuer of a prepaid derivative contract.
The interest accrual amount for any taxable year is generally equal
to the product of the holder's adjusted basis in the contract at the
beginning of the year multiplied by the monthly short-term applicable
Federal rate (``AFR'') for the first month of such taxable year.
However, if ``notional amounts are credited'' under the contract at a
higher rate, then the income accrual amount is computed by multiplying
the holder's adjusted basis in the contract by such higher rate. If a
holder acquires or disposes of a contract during the taxable year, the
interest accrual amount for the year is prorated based on the relative
portion of the year that the holder held the contract. The holder's
basis in the contract would be increased by the interest accrual
amounts included in the holder's gross income.
Distributions with respect to a contract would not be includable in
income. Distributions would first reduce the holder's basis in the
contract and distributions in excess of basis would be treated as gain
from a sale of the contract. Any loss on the disposition of a contract
would be an ordinary loss to the extent of basis increases attributable
to the interest accrual amounts included in the holder's income.
Special rules apply in the case of contracts that are publicly
traded. First, the interest accrual amount for a taxable year is capped
at the mark-to-market gain for the year. Second, if this cap is
triggered for a taxable year, the excess interest accrual amount not
taken into income is carried forward to the next taxable year and
increases the interest accrual amount for such year. Third, although
the holder's basis in the contract for gain and loss purposes will be
increased by the interest accrual amount includable in income for the
year (after application of the mark-to-market cap), the holder's
adjusted basis for purposes of computing the interest accrual amount in
the following year is increased by the full income inclusion amount
determined without regard to the mark-to-market cap. A contract is
treated as publicly traded if (i) it is traded on a qualified board or
exchange, or (ii) the issuer (or a person acting on the issuer's
behalf) regularly provides firm bid and ask quotes to the public with
respect to the contract.
The Bill would not apply to any contract held for less than 1 year
that is disposed of before the due date for filing the tax return for
the tax year in which the contract was acquired. The Bill also would
not apply to any contract that is marked to market with respect to the
taxpayer.
The Bill defines a ``prepaid derivative contract'' as any ``prepaid
contract'' with a term greater than 1 year that is a derivative
instrument with respect to (i) one or more securities, (ii) one or more
commodities, or (iii) any financial index. Excluded from the definition
are instruments that are treated for tax purposes as: (i) stock, (ii)
debt, (iii) a partnership interest, (iv) part of a constructive
ownership transaction to which section 1260 applies, (v) a hedging
transaction within the meaning of section 1256(e)(2), (vi) a notional
principal contract, or (vii) an option. The Treasury Department is
given authority to apply the Bill's provisions to options that are
``economically similar'' to a prepaid derivative contract. The term
``prepaid contract'' is defined to mean any contract under which there
is no substantial likelihood that the taxpayer will be required to pay
any additional amount under the contract.
The Bill would apply to contracts acquired after the date of
enactment.
DISCUSSION
The ICI supports the Bill as an important first step in addressing
ETNs.\9\ We have a number of technical suggestions and comments, which
we will provide to the staff. For the remainder of this testimony, I
would like to focus on our ``big picture'' comments.
---------------------------------------------------------------------------
\9\ While this discussion focuses on ETNs, the ICI is not opposed
to the Bill's application to prepaid forward contracts that are not
publicly traded.
---------------------------------------------------------------------------
As noted above, the Technical Explanation of the Bill identifies
both the ``time value of money'' concern and the ``constructive
ownership'' concern. However, the Bill itself addresses only the former
concern. The Bill would require holders to accrue interest income on
their investment in the contract under a modified version of the OID
rules. The Bill generally does not attempt to implement ``constructive
ownership'' policies based on notional gains recognized inside the
contract.
We believe that a comprehensive approach to ETNs is needed. We are
concerned that an approach that accrues interest at the short-term AFR
(currently 3.2%) may be insufficient to achieve appropriate taxation of
ETNs consistent with applicable tax policies. We are just at the
beginning of creativity in the ETN world, and without a comprehensive
and robust response, we suspect that Congress will need to revisit this
area in the near term to respond to continued developments. We believe
that the Bill could be enhanced by expanding on the concept of
``notional amounts credited under the contract'' (``NACUC''). The
Technical Explanation makes clear that the Bill limits NACUC to
explicit interest or dividend yields inside the contract. The concept
of notional amounts credited under the contract could be expanded to
include notional gains realized inside the contract. For example, the
commodity ETNs reflect the return from trading strategies in futures
contracts. As those notional futures contracts are closed out or
settled, the resulting gains are, in some sense, credited under the
contract and could appropriately be included in income of the holders.
In our view, it is more important for the tax system to respond to
the constructive ownership concerns raised by ETNs than to the time-
value-of-money concerns. The arguments for taxing the time-value-of-
money return to prepaid forward contracts are economically sound, but
our tax system has to date generally refrained from imputing an
interest-like return when the return on the instrument is totally
contingent.\10\ In contrast, we believe that the constructive ownership
policy is well established in our tax system and much more compelling.
---------------------------------------------------------------------------
\10\ But see Treas. Reg. 1.446-3(g)(4), supra.
---------------------------------------------------------------------------
As articulated in the legislative history of section 1260, that
policy mandates that a taxpayer who replicates economic ownership of a
referenced asset through a derivative should not receive better tax
treatment than one who owns directly. This policy is fundamental to
protecting the tax base tied to returns on capital investment.
In many ways, ETNs can be viewed as the next generation of
constructive ownership transactions that section 1260 is designed to
address. When section 1260 was enacted in 1999, derivatives were being
used to provide economic ownership of hedge funds and mutual funds
without the tax consequences of direct ownership. A taxpayer and an
investment bank would enter into a forward contract or other ``total
return'' derivative with, say, a 3-year term. After 3 years, the
taxpayer would receive an amount measured by the value of the hedge
fund plus distributions he would have received had he held the interest
in the hedge fund directly over the 3 years. As with ETNs, the result
was that ordinary income and short-term gains were deferred and
converted to long-term gains. ETNs use improved technology--in the form
of dynamic indexes--to fall outside the scope of section 1260. The
dynamic index functions as a synthetic mutual fund or partnership, so
much so that ETNs even impose a notional ``investor fee'' (e.g., 125
basis points) per year that mimics a mutual fund management fee or the
fee an investor would pay a financial advisor to manage a portfolio of
directly owned securities. Section 1260 does not apply because instead
of referencing the return on a partnership or mutual fund, ETNs
reference the return on a dynamic index. Notwithstanding the advances
in technology, the results obtained by investing in ETNs are precisely
the results that section 1260 was intended to stop.
The rules addressing investments in passive foreign investment
companies (``PFICs'') can be viewed as a precursor to section 1260. In
the relatively simple days when that legislation was enacted, U.S.
taxpayers were deferring and converting investment income by investing
in off-shore funds that do not make current distributions of income or
gains. Congress responded in 1986 with rules to prevent such deferral
and conversion.\11\ In their current form, the PFIC rules provide three
alternative regimes. The ``default'' regime is very much like the
section 1260 regime. Long-term gain treatment is denied and the
taxpayer is generally required to treat any gain as arising ratably
over his holding period and pay interest on the implicit deferral of
tax. Recognizing the harshness of this regime, Congress provided the
``qualifying electing fund'' (``QEF'') regime, which affords the
taxpayer the option of including in income currently his share of the
PFIC's income and long-term capital gain. In order for this election to
be available, the PFIC must agree to provide the taxpayer with the
requisite information each year. More recently, Congress has added a
mark-to-market election with respect to PFIC stock that is publicly
traded. If this election is made, all mark-to-market gain is treated as
ordinary income and mark-to-market losses are treated as ordinary to
the extent of prior mark-to-market gains.
---------------------------------------------------------------------------
\11\ See Code Sec. Sec. 1291-1298.
---------------------------------------------------------------------------
While amending section 1260 to cover ETNs is possible, the
consequences that follow under that provision would effectively kill
most ETNs. Accordingly, we would support an alternative approach along
the lines of expanding the concept of notional amounts credited under
the contract under H.R. 4912, as described above.
Note that such an approach would require the issuer to provide the
requisite information to holders in a way that is closely analogous to
the requirements for the QEF election under the PFIC rules. Indeed, the
three approaches contained in the PFIC rules could provide a model for
addressing the deferral and conversion afforded by ETNs. If the issuer
provides the necessary information, the holder would include in income
the notional income and gains credited for the year (the QEF analogue).
Alternatively, because ETNs are publicly traded, the holder could elect
mark-to-market treatment. If the holder fails to elect either of these
regimes, the default rule could be the section 1260 regime.
Chairman NEAL. Thank you, Mr. Paul.
I welcome back an individual who has spent a career sitting
at that dais, Mr. Samuels.
STATEMENT OF LESLIE B. SAMUELS, PARTNER, CLEARY GOTTLIEB STEEN
& HAMILTON LLP, ON BEHALF OF SECURITIES INDUSTRY AND FINANCIAL
MARKETS ASSOCIATION (SIFMA)
Mr. SAMUELS. Chairman Neal, Ranking Member English, and
Members of the Subcommittee, thank you for inviting me to
testify. I am a lawyer now in private practice with the firm of
Cleary Gottlieb Steen & Hamilton. I am testifying today on
behalf of the Securities Industry and Financial Markets
Association, SIFMA.
I am here today to discuss the tax treatment of prepaid
derivative contracts. On behalf of SIFMA, I would like to thank
Chairman Neal for having this hearing to facilitate a dialogue
on the appropriate tax treatment of prepaid derivatives and
comparable financial instruments.
We welcome the opportunity to provide our views on the
development of a comprehensive set of rules for taxation of
prepaid derivatives that are consistent, administrable, fair,
and certain. The Treasury Department and the IRS have commenced
a similar review of this complex area, and we are actively
working with them.
For the reasons discussed below, SIFMA has serious concerns
with H.R. 4912. In particular, we are concerned that the bill
would impose an overly complex tax regime that would single out
prepaid derivative contracts for unfavorable treatment by
requiring that investors include amounts in income that they
have no right to receive and may never receive. In some cases,
investors will be taxed on phantom income even when the value
of the prepaid derivative is falling.
During the last 15 years, the capital markets have seen a
growth in the volume and variety of prepaid derivatives. These
instruments have grown in popularity because they give
investors convenient and cost-efficient access to sophisticated
financial strategies and enable them to take financial
positions with respect to a vast selection of referenced
financial assets and cash flows.
Many prepared derivatives provide risks and returns that
are different from a hypothetical direct investment in the
underlying assets. These prepaid derivatives provide returns
that do not mimic direct ownership of the referenced assets.
Prepaid derivatives are utilized by a broad base of
investors, including individuals, retirement plans, tax
exempts, mutual funds who are buyers, and other institutional
investors.
Recent media attention has focused on a relatively new type
of prepaid derivative, an exchange traded note or ETN. ETNs,
which represent a small subset of the market, are actively
traded on an exchange. The idea behind the ETNs is to give
retail investors access to sophisticated financial strategies
and liquidity on a cost- and tax-efficient basis.
Some members of the mutual fund industry have expressed
concern that the availability of ETNs to retail investors
reduces the relative attractiveness of mutual funds and puts
them at a competitive disadvantage. SIFMA believes that ICI's
assertions that ETNs are substantially similar to mutual funds
and that they benefit from far superior tax treatment are
oversimplified and not helpful to moving forward the debate.
There are important differences in the economic terms of
ETNs and mutual funds. These differences explain why ETNs and
mutual funds are treated differently for tax purposes. Most
notably, mutual fund investors have the current right to
receive cash. Holders of ETNs do not.
The difference between the tax treatment of ETNs and mutual
funds is based on a fundamental rule of tax law that an
investor who has the full right to take cash income but elects
not to is subject to taxation on the cash as if it were
received. This is why investors in mutual funds are taxed
currently on distributions even when they choose to reinvest
the cash. Similarly, when holders of ETNs have the right to
receive cash, they are taxed on that cash.
Another important difference between mutual funds and the
prepaid derivatives is that investors in mutual funds
effectively own the underlying securities held by the funds. In
contrast, a prepaid derivative is an unsecured contract between
the investor and the issuing company. Investors in these
derivatives are fully exposed to the credit risk of the issuer
until maturity of the contract. By contrast, investors in
mutual funds are not subject to this type of credit risk.
Although many prepaid derivatives are issued in the nominal
form of corporate notes, they are not debt instruments in the
tax sense of the word. Unlike traditional debt, these notes do
not entitle an investor to an unconditional return of the
principal at maturity plus some amount of interest. Investors
in prepaid derivatives may receive no returns, and can have a
significant risk of losing some or all of the original
investment.
Under tax principles of income realization, investors
should generally not be taxed on phantom income and unrealized
gains which can evaporate at any time along with the investor's
original investment.
H.R. 4912 would fundamentally change the way all prepaid
derivative contracts are treated. The bill will require accrual
of income despite the fact that the investor does not receive
any amounts currently and is not assured of repayment of the
original investment. In short, H.R. 4912 moves the line on when
phantom income should be accrued from debt to include prepaid
derivatives that are not debt-like.
In considering whether the phantom income line should be
moved, it is important to keep in mind other investments where
phantom income is not required. For example, an investor in
non-dividend-paying common stock is not taxed until the stock
is sold.
One of the reasons that the tax rules for derivatives give
rise to so many different views about what is the right answer
is that there are many piecemeal rules addressing a range of
financial instruments in the marketplace.
We appreciate that this hearing has been called to start
the legislative review of the current tax rules as they apply
to complex financial products. Since the Treasury has also
called for comments on the taxation of prepaid derivatives, we
respectfully suggest that the legislative review be coordinated
with Treasury's consideration of these same issues.
We look forward to participating in this important
dialogue. Thank you.
[The prepared statement of Leslie B. Samuels follows:]
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Chairman NEAL. Thank you, Mr. Samuels.
Mr. Shulman.
STATEMENT OF MICHAEL B. SHULMAN,
PARTNER, SHEARMAN & STERLING LLP
Mr. SHULMAN. Chairman Neal, Ranking Member English, and
Members of the Subcommittee, thank you for inviting me to
testify. I am a lawyer in private practice with Shearman &
Sterling in Washington, D.C. My practice focuses on the
taxation of financial instruments, including prepaid forward
contracts.
In this regard, I have advised a number of clients on tax
issues associated with exchange traded notes. However, I am
appearing here today on my own behalf and not on behalf of any
client or organization. The views I express here are solely my
own.
I would like to speak to you today about several important
tax policy issues raised in connection with prepaid forward
contracts, including those associated with H.R. 4912. With
certain limited exceptions, taxpayers recognize gain or loss
from investment activities only when a realization event
occurs.
The current treatment of prepaid forward contracts is
consistent with this realization-based approach. That is, an
investor that acquires a prepaid forward contract is not
taxable on its investment until it sells the contract or
receives cash with respect to the contract.
To be sure, there are certain exceptions from the tax
system's realization-based approach. For example, a holder of a
debt instrument may be required to accrue interest on the
instrument prior to the receipt of cash. But this is because
the holder of a typical debt instrument is entitled to a return
of, as well as a return on, its investment. As the Joint
Committee report correctly points out, there is simply a
dividing line between debt and non-debt instruments.
It is understandable that prepaid forward contracts, and
exchange traded notes in particular, would provoke a lively tax
policy debate regarding these important issues. But I would ask
the Committee to consider whether it is wise to abandon the
realization-based approach the tax system has traditionally
employed.
I recognize that the tax consequences associated with
owning a prepaid forward contract are different and in many
cases more favorable than those associated with ownership of
the underlying asset or assets. In particular, under current
law, the holder of a prepaid forward contract does not
recognize dividends and interest on a current basis and is
unaffected by the shifting of assets underlying the contract.
It is important to recognize, however, that ownership of a
prepaid forward contract differs in several important respects
from direct ownership of the underlying assets, including that
the investor bears the credit risk of the counterparty under
the prepaid forward contract; the investor does not exercise
any voting rights that may be associated with the underlying
assets; it has no dominion and control over any cash flow
generated by the underlying assets; and it has no control over
the acquisition or disposition of the underlying assets.
There have been assertions that the current tax treatment
of prepaid forward contracts is inappropriate because such
contracts are economically equivalent to a non-prepaid forward
contract to buy the underlying assets and a deposit of funds to
secure the forward price, in which case the holder would be
required to accrue interest income on a deposit.
To the extent that legislative changes are advanced under
the principle that prepaid forward contracts are economically
similar or even identical to other investment strategies, I
would respectfully suggest that innumerable examples exist of
financially equivalent transactions that have different tax
treatment.
The Joint Committee report does an excellent job of framing
the tax policy debate over prepaid forward contracts. Here we
do not have a situation where the tax results to holders of
prepaid forward contracts necessitate a change in law. Instead,
Congress is presented with two competing tax policy concerns.
On the one hand is the fundamental principle that investors are
not taxed with respect to investment until they receive cash.
On the other hand, there is the fact that holders of a prepaid
forward contract may derive more beneficial tax treatment than
the owner of investments with similar economic profiles.
Historically, Congress has abandoned the realization-based
approach to taxation only when it needed to do so in order to
prevent a tax result that was viewed as untoward. I
respectfully suggest that prepaid forward contracts do not
present such a situation.
Turning to H.R. 4912, I would assert that the proposed bill
would reverse settled law by requiring the imputation of
interest on prepaid forward contracts even though the amount
required to be included in income by investors would bear
little or even no relationship to the investor's economic
income.
Thus, if the bill is intended to address the disparate tax
treatment under current law between prepaid forward contracts
and direct ownership of the underlying assets, it fails to do
so and instead provides a regime that in most cases would be
substantially more adverse than the treatment that would apply
to direct ownership of the underlying assets.
Moreover, the tax regime proposed by the bill is novel and
more punitive relative to prior legislation, including
provisions targeted to more debt-like transactions. For
example, Congress's enactment of provisions addressing market
discount bonds in 1984 and conversion transactions in 1993
avoided requiring the imputation of interest even though both
provisions were targeted to transactions that provide investors
with debt-like returns, unlike prepaid forward contracts.
No interest imputation was required in such cases,
presumably because of the administrative complexity of an
interest imputation system. As I mentioned earlier, prepaid
forward contracts do not provide holders with debt-like returns
and thus present a less likely candidate for an interest
imputation system than those prior regimes that rejected such a
system.
Finally, the tax issues associated with prepaid forward
contracts are not unique and instead exist across a broad range
of financial instruments. I would suggest that any legislative
approach to the treatment of prepaid forward contracts should
be undertaken in connection with the broader consideration of
the tax treatment of all financial products.
Thank you for your attention, and I look forward to taking
any questions you may have.
[The prepared statement of Michael B. Shulman follows:]
Prepared Statement of Michael B. Shulman,
Partner, Shearman & Sterling LLP
Chairman Neal, Ranking Member English, and Members of the
Committee, thank you for inviting me to testify. I am a lawyer with the
firm of Shearman & Sterling LLP. My practice focuses on the taxation of
financial instruments, including the tax treatment of prepaid forward
contracts. However, I am appearing here today on my own behalf, and not
on behalf of any client or organization. The views I express here are
solely my own.
I would like to speak to you today about several important tax
policy issues raised in connection with prepaid forward contracts,
including those associated with H.R. 4912.
With certain limited exceptions, taxpayers recognize gain or loss
from investment activities only when a realization event occurs. For
example, a taxpayer who invests in corporate stock generally recognizes
no gain or loss with respect to its investment for tax purposes (other
than dividend income) until its disposition of such stock, regardless
of price fluctuations.
The current treatment of prepaid forward contracts is consistent
with this realization-based approach. That is, an investor that
acquires a prepaid forward contract is not taxable on its investment
until it sells the contract or receives cash with respect to the
contract.
To be sure, there are certain exceptions from the tax system's
realization-based approach. For example, a holder of a debt instrument
may be required to accrue interest on the instrument prior to the
receipt of cash, but this is because the holder of a typical debt
instrument is entitled to a return of (as well as a return on) its
investment. Another example is the constructive sale rules, which
require the recognition of gain where a taxpayer has effectively
``locked in'' gain with respect to an appreciated financial position.
The policy rationale for the existing exceptions to the realization-
based approach have no application to prepaid forward contracts.
Specifically, in contrast to a debt instrument, a holder of a prepaid
forward contract has no right to a return on (or even a return of) its
investment. And, unlike the constructive sale context, the holder of a
prepaid forward contract has not ``locked in'' any amount of gain.
It is understandable that prepaid forward contracts (and exchange
traded notes in particular) would provoke a lively tax policy debate
regarding these important issues. But I would ask the Committee to
consider whether it is wise to abandon the realization-based approach
the tax system has traditionally employed.
I recognize that the tax consequences associated with owning a
prepaid forward contract are different (and in many cases, more
favorable) than those associated with ownership of the underlying asset
or assets. In particular, under current law, the holder of a prepaid
forward contract does not recognize dividends and interest on a current
basis that it would recognize if it were the tax owner of the
underlying assets and is unaffected by the shifting of assets
underlying the contract. It is important to recognize, however, that
ownership of a prepaid forward contract differs in several important
respects from direct ownership of the underlying assets. First, the
investor bears the credit risk of the counterparty under the prepaid
forward contract, and thus might not receive the economic results of
the underlying assets if the counterparty defaults on its obligations.
Second, the investor does not exercise any voting rights that may be
associated with the underlying assets. Third, the investor has no
dominion and control over any cash flow generated by the underlying
assets. And fourth, the investor has no control over the acquisition or
disposition of the underlying assets.
There have been assertions that the current tax treatment of
prepaid forward contracts is inappropriate because such contracts are
economically equivalent to a non-prepaid forward contract to buy the
underlying assets and the deposit of funds to secure the forward price
(in which case the holder would accrue interest income on the deposit).
To the extent that legislative changes are advanced under the principle
that prepaid forward contracts are economically similar or even
identical to other investment strategies, I would respectfully suggest
that innumerable examples exist of financially equivalent transactions
that have different tax treatment. If one were to attempt to change the
tax system to provide identical tax treatment for financially
equivalent transactions, such a change (even if possible) would result
in a tax system entirely different from the one we have today.
Turning to H.R. 4912, I would assert that the proposed bill would
reverse settled law by requiring the imputation of interest on prepaid
forward contracts, even though the amount required to be included in
income by investors would bear little or no relation to the investor's
economic income. Thus, if the Bill is intended to address the disparate
tax treatment under current law between prepaid forward contracts and
direct ownership of the underlying assets, it fails to do so and
instead provides a regime that in most cases would be substantially
more adverse than the treatment that would apply to direct ownership of
the underlying assets.
Moreover, the tax regime proposed by the Bill is novel and more
punitive relative to prior legislation, including provisions targeted
to more debt-like transactions. For example, Congress' enactment of
provisions addressing market discount bonds in 1984 and conversion
transactions in 1993 avoided requiring the imputation of interest, even
though both provisions were targeted to transactions that provided
investors with debt-like returns. No interest imputation was required
in such cases presumably because of the administrative complexity of an
interest imputation system. As I mentioned earlier, prepaid forward
contracts do not provide holders with a debt-like return, and thus
present a less likely candidate for an interest imputation system than
those prior regimes that rejected such a system.
Finally, the tax issues associated with prepaid forward contracts
are not unique, and instead exist across a broad range of financial
instruments. I would suggest that any legislative approach to the
treatment of prepaid forward contracts should be undertaken in
connection with a broader consideration of the tax treatment of all
financial products.
Thank you for your attention and I look forward to taking any
questions you may have.
Chairman NEAL. Thank you, Mr. Shulman.
Mr. Sauter, we have heard a lot about the credit risk
inherit in ETNs. Why don't you comment on the credit risk of
issuer banks, and is this something the average retail investor
is worried about? I think that is consistent, and you might
have an opportunity to clarify the differences in your
testimony and Mr. Samuels' testimony about the differences
between a mutual fund and an ETN.
Mr. SAUTER. Yes. Thank you. I think most individual
investors really think of ETNs as a cousin to ETFs, ETFs being
a type of mutual fund with certain exemptive relief. But they
don't really fully understand the implications of an ETN. They
don't really understand that they have credit exposure at the
end of the day. They have just heard that ETFs are tax-
efficient and ETNs are even more tax-efficient.
With respect to an investment in a prepaid forward
contract, if you really break it down and see what is going on
behind the scenes, there is an issuer who is taking exposure to
a referenced asset, and the investor who wants the return of
that referenced asset. One would hope that the issuer is
investing in that referenced asset and not just taking risk on.
So, the investor in the prepaid forward contract has
essentially loaned money to the issuer in order to make that
investment in the underlying referenced asset. I think that is
what supports the accrued interest principal.
If you look at a futures contract, an exchange traded
forward contract, in that case again you are looking to get the
return of the referenced asset. The one difference here versus
an ETN or other prepaid forward contract is you are not putting
the money upfront. In this case, the investor holds on to cash,
but there is a daily mark to market so that there is cash
movement that reflects the return on the investment on a daily
basis.
So, the investor has far less risk in a futures contract
than they do in an ETN or prepaid forward contract. They have
given their money to the issuer, in the case of the prepaid
forward contract, and they are at risk at the end of the
prepaid forward contract whether or not the issuer actually has
the ability to repay their principal plus the return on the
referenced asset.
There is, of course, settled tax policy as to how futures
contracts should be taxed. In their case, they are taxed quite
onerously, in fact. They are marked to market on an annual
basis and taxed 60 percent long-term, 40 percent short-term
capital gains.
At the same time, in order to get the full rate of return,
the investor has to take the cash that they would have
invested, or that they would have advanced in the case of a
prepaid forward contract--they take that cash and they put it
in an interest-bearing asset, and they pay current tax on the
interest they are earning. That is how they get the same total
rate of return before tax as the prepaid forward contracts. So,
they are paying tax on an accrual basis annually, and they are
also paying mark to market at the end of the year.
In a mutual fund, you have a different situation. There,
the investor actually owns a pool of assets. They know that
they don't have credit risk whether or not those assets will be
available at the end of the day. They have a good deal of
assurance that at the end of their ownership time period that
they will receive payment for their investment.
Of course, mutual funds are taxed currently. When income is
received currently, they pay the tax or they pass it on to the
investor who pays tax, whether it is in the form of interest,
whether it is in the form of dividends, whether it is in the
form of capital gains.
Contrasting that to the prepaid forward contract, it
doesn't pay any return currently. At the end of the investment,
everything is taxed at a capital gains rate. So, you have
converted the character of the income into capital gains tax
rates and you have deferred it significantly in time.
I would argue that from an investor's standpoint, they
don't understand the risk they have, the counterparty risk they
have in the prepaid forward contract. I would say that in the
case of an exchange traded futures contract, forward contract,
that there is far less risk to the investor that they are going
to get their true investment return, but yet there is onerous
taxation. In the case of a mutual fund, there is far less risk
if any risk that they will get the rate of return of the
referenced asset. Again, there is much higher taxation.
Chairman NEAL. Mr. Samuels, I want to give you an
opportunity to respond.
Mr. SAMUELS. I would like to make a couple of observations
about the prepaid derivative market. First, it is a complicated
situation to talk about. I think Mr. McDermott had it right at
the beginning. It is quite arcane.
In talking about prepaid derivatives, there is a whole
range of prepaid derivatives. We are talking about so-called
ETNs. That is one kind. It is a subset. But there is a whole
range of over-the-counter derivatives. That is just two parties
getting together and entering into a prepaid. Those have
returns that are paid--some of them have returns that are paid
currently. Actually, I think some ETNs may have returns that
are paying currently.
When you have returns that are being paid currently on a
prepaid derivative, if you compare it to a mutual fund, the
prepaid derivative holder could actually be in a worse position
because you don't pass through qualified dividends. You don't
pass through capital gains.
So, it is a very complicated topic to deal with. I don't
think there are any easy answers. I admire and support the
Committee's review of the topic because it is something that
has been talked about for a long time and needs further review.
I think this is a very good time to be talking about it.
With respect to ETNs and credit risk, our information from
some of our members is that in light of the recent large write-
downs in the market that some of the financial institutions
have had to take, that that has affected their ability with
respect to entering into prepaid forwards and the pricing of
prepaid forwards so that the credit quality is important to
those participants in the market.
The other thing I would say about the ETN market is that it
is, as we have all said, a relatively new instrument. But an
example in terms of the investor base, and this is what makes
it complicated, is that our information, for example, on the
largest issuer--which is Barclays Bank has issued about 5 or $6
billion of ETNs; they are the largest issuer--in the 18 months
that their ETNs have been outstanding, the market turnover has
been $22 billion. That is the number that they have supplied
us.
So, they had issued $5 billion over 18 months, and it is
ramping up. The turnover is $22 billion. So, that shows that
people aren't holding these and putting them under their beds,
you know. There is a significant turnover, and that is because
the investor base that is buying these are not just
individuals, but they are institutions, including mutual funds,
buying ETNs.
Chairman NEAL. I want to give Mr. English a chance to ask a
question. We are going to be on the floor for about a half
hour, so I would like to--if we could go forward on this. Mr.
English.
Mr. ENGLISH. Thank you.
Mr. Samuels, it is good to see you back. The Neal bill
would require investors in ETNs and prepaid derivative
contracts to accrue income every year and pay tax on that
income every year even if they don't actually receive the
income. Are there other products that, under current law,
benefit from deferral?
Mr. SAMUELS. Mr. English, the tax law has a dividing line
generally speaking between debt and debt-like instruments on
which there may be accrual, like original issue discount, and
the non-debt-like instruments, financial instruments, like
stock and options, which do not require accrual. The question
is--and it was referred to before--what cubbyholes should
prepaid forwards be put in?
But there is a dividing line and a long history of not
imputing risk-free rates of return on stock or options, for
example.
Mr. ENGLISH. Thank you.
Mr. Paul, you are testifying today on behalf of ICI, which
I know is, as I am, a strong supporter of Representative Ryan's
GROWTH Act. That would provide tax relief for millions of
Americans investing in mutual funds for long-term goals such as
retirement by deferring taxation on automatically reinvested
capital gains until fund shares are sold.
I believe this is good tax policy, and I believe mutual
funds provide a diversified, well-regulated investment vehicle
for allowing individuals to meet their financial goals.
As we consider the tax deferral of other instruments and
the appropriate taxation of prepaid derivative contracts, which
include exchange traded notes, I would wonder, Mr. Paul,
basically why do you believe the deferral treatment of these
derivatives should be different?
Mr. PAUL. Thank you, Mr. English. The ICI very much
appreciates your support of the GROWTH Act. Let me make clear
the ICI continues to very strongly support that legislation.
In supporting the GROWTH Act, the ICI is asking Congress to
evaluate the policy arguments for allowing a mutual fund
investor to reinvest capital gain dividends without current
tax. There are a number of similar rollover provisions in the
Code that reflect similar policy judgments.
For example, you can roll over the gain from the sale of
small business stock if you reinvest it in other small business
stock. You can roll over the gain from publicly traded
securities if you reinvest them in a small business investment
company. We used to have a provision that allowed you to roll
over the gain on the sale of your principal residence. We now
just have an exclusion.
In the case of mutual funds, the policy argument is tied to
encouraging long-term savings in a diversified and highly
regulated investment vehicle, namely a mutual fund, which is
subject to all the investor protection safeguards of the 1940
Act.
Congress, as we know, has not enacted the GROWTH Act, so we
are in a world in which mutual fund investors pay tax on
reinvested capital gain dividends. In that world, we are asking
Congress to consider the policy and revenue implications of
allowing the deferral and conversion permitted by ETNs.
That deferral and conversion is not the result of a
deliberate policy choice by Congress. I think this hearing is
very commendable because I think this is something that needs
attention, and if Congress decides that this conversion and
deferral is appropriate, then so be it. But we don't think that
is the right answer.
Unless Congress acts, investors will have a strong tax
incentive to invest in an unregulated ETN with issuer credit
risk over a highly regulated mutual fund. This seems to us to
turn tax policy on its head.
Mr. ENGLISH. On that point, Mr. Paul, I noticed last week
ICI submitted a paper to the Senate Republican Task Force on
Competitiveness, and in that paper you discussed the tremendous
growth of UCITS, which are the European version of ETNs. ICI in
that paper recommends on page 12 and 13 that Congress allow
mutual funds to offer similar products with a tax rollup
feature, meaning that investors would not be taxed until they
redeem their shares.
As I understand it, you are recommending that mutual funds
be allowed to offer an ETN-style mutual fund with unlimited
deferral, the same concept as the GROWTH Act. Today you are
testifying that such products should be taxed under the Neal
bill or under your proposed solution.
If Congress enacted your recommendation, would you propose
that these new products would benefit from tax deferral, as
described in last week's paper, or under the regime that you
propose in today's testimony?
Mr. PAUL. I am sorry. I am not sure I followed the last
part of that question. Could you----
Mr. ENGLISH. If I could just----
Mr. PAUL. If the proposal were adopted, then what was the
question?
Mr. ENGLISH. Do you propose that these new products----
Mr. PAUL. I'm sorry. The new products being----
Mr. ENGLISH [continuing]. Benefit from tax deferral, as
described in last week's paper, or under the regime you
proposed for today's testimony?
Mr. PAUL. When you say these new products, do you mean the
newly proposed UCIT-style mutual fund or ETNs?
Mr. ENGLISH. That is correct. That utilizes the tax rollup
feature.
Mr. PAUL. Well, I think, sir, the way I think about that
proposal you just described is it is an expanded version of the
GROWTH Act proposal. It wouldn't be limited to long-term gains.
But the policy issue again is the same. Does Congress want to
adopt a policy of encouraging long-term savings and diversified
vehicles that are subject to the protections of the 1940 Act? I
think that is part of what is going on in that proposal.
That obviously has not been enacted, and given revenue
limitations, it seems to me it is not likely to be enacted any
time soon. So we continue to be operating in a world in which
mutual fund investors do pay current tax. In that world, the
juxtaposition of an ETN against a mutual fund, with no taxation
on the ETN, again I think creates a perverse result from a tax
policy perspective, that you are creating a tax incentive for
somebody to invest in an unregulated product with credit risk
as opposed to a diversified regulated product with no credit
risk.
Mr. ENGLISH. I agree with you that tax policy should take
into account competitive differences imposed by the Tax Code.
But I am also looking for an exposition of tax theory here that
should guide us more broadly, which I guess brings me back to
the point I made, Mr. Chairman, in my initial testimony, that
maybe this is an issue that is best approached with more than
simply a tax solution.
But I thank you, Mr. Paul, and I appreciate the nuances of
your testimony.
Chairman NEAL. Thank you, Mr. English.
Mr. Samuels, considering that Treasury has said today
specifically that these other ETNs ``present unique questions
as to whether the deferral of tax is appropriate,'' will you be
advising your SIFMA or your issuer clients that retail
investors should be aware that the previous tax advice could be
reversed?
Mr. SAMUELS. Chairman Neal, first let me say that----
Chairman NEAL. You will be here for a long time. You know
you aren't leaving easily today.
[Laughter.]
Mr. SAMUELS. I know that. First let me say this, that SIFMA
is working with Treasury actively in responding to their
request for comments, and will continue to do that.
I believe that the disclosure in the ETNs' prospectuses say
that the law can be changed, and that while there is a
consensus of what the law is now, it certainly could be changed
in a variety of ways. I think that that is an issue that
investors need to take into account when they make their
decision to buy an ETN.
Chairman NEAL. Thank you. We might have time for Mr.
Reynolds, if you would like, to get in a question.
Mr. REYNOLDS. Thank you, Chairman. I just listened to both
the hearing and comments by you, Chairman, and the Ranking
Member. As we look at the complexity of this issue, one, I
think it is important that we also see what Treasury comes back
and lays out to us on this.
But what I haven't heard from anybody, as I understand both
industries looking very closely at that, is if anyone has taken
a look at what the bottom line is on what is best for the
investor while we watch industries have viewpoints of some
solutions here, particularly while we are at a tenderness of
our economy on making moves much, I guess, as Mr. English has
outlined on the aspect of which derivatives, if all or some or
a few.
So, anybody have a comment as they look at what is best for
the investor on this?
Mr. SHULMAN. Well, I certainly have comments on that. I
guess from my perspective, the tax system has always avoided
imposing taxes on phantom income except in situations where it
was really important to do so, such as in the case of debt
instruments. This is not a debt instrument.
Here the income will be phantom income in the sense that
investors do not receive cash. Under the Chairman's bill, the
investors would be subject to tax without receiving any cash.
As importantly, investors may never receive the amount that
they would be taxed on. So, they could be taxed on imputed
interest yet never ultimately realize an economic gain from the
instrument.
So, certainly from an investor perspective, I think the
current system is certainly more favorable and I think more in
line with the historic realization-based approach we have
always had.
Mr. SAUTER. If I might, I would like to say if we strip
away the tax consequences for a minute and ask what is best for
the investor representing the mutual fund industry, obviously I
believe that mutual funds offer the best benefit to investors.
The reason I believe that is because they are highly regulated
and they do have a pool of assets that assures the return that
you are expecting to get.
If you look at an ETN, the investor is ultimately taking on
credit risk for which they are not compensated. The economic
similarity between an ETN would be investing in a mutual fund
that provides the same exposure to the referenced asset plus
writing a CDS contract. Writing a CDS contract would be taking
exposure to the credit quality of the issuer of the ETN.
It turns out that writing a CDS contract, taking credit
exposure to, let's say, Barclays Bank, would cost you about 1
percent--or you would receive 1 percent per year. So, if you
were to invest in a mutual fund and also get the credit
exposure, you would be getting the referenced asset plus 1
percent a year.
The investor is not getting that, but that is the risk they
are taking with an ETN. So, I would say before taxes, I think
the mutual fund is a better product than an ETN for the
investor, the difference being after tax, the ETN has
tremendously favorable tax treatment. We believe that there
should be parity.
Chairman NEAL. I am trying very hard. We have about 2
minutes left. Mr. Herger, would you like to squeeze in a
question?
Mr. HERGER. Very quickly, yes.
Chairman NEAL. Obviously, a general one.
Mr. HERGER. Mr. Samuels, the rationale for the lower taxes
for capital gains and dividends is to encourage investment in
those assets. In the case of an ETN, however, the investor
clearly is not buying these assets, and the insurer may but is
not required to invest in them to hedge its exposure.
As such, should the traditional arguments in favor of
justifying a lower tax rate on capital gains apply to the
derivative product like an ETN?
Chairman NEAL. Very short answer, Mr. Samuels.
Mr. SAMUELS. I would say yes. I believe that the investor
is taking risk with respect to a capital instrument, and that
therefore they should be entitled to capital gains.
I would also say, just to quickly recap, we are saying
different industries. We are all part of the same financial
services industry. We are trying to provide products to
investors to encourage them to invest and to save. I think we
can have some differences, but I think that--just I think it is
important for people to keep that in mind.
Mr. HERGER. Thank you, Mr. Chairman.
Chairman NEAL. Thank you. I want to thank the witnesses for
the testimony today. Again, it was very helpful, and we will
have some perhaps written followup questions. We hope you will
respond.
But thank you. This does help to clarify issues for Members
of the Committee in what I assume is going to be a continued
and ongoing debate.
This hearing stands adjourned.
[Whereupon, at 12:00 p.m., the hearing was adjourned.]