Neal Would 'Update' Derivatives Treatment

According to Neal, his legislation builds on recommendations of the Treasury Department and the New York State Bar Association and would "prohibit corporations from recognizing gain or loss in derivative transactions to the extent the derivative purchased by the corporation involves its own stock." He said the bill "merely updates current law to include in section 1032 current and future forms" of new types of derivative products developed since the 1984 Deficit Reduction Act.

Neal noted that the bill also includes a provision that "recognizes a time value" of money, as recommended by the bar association. He said he hopes the industries affected by this legislation "will provide written comments on technical changes they believe need to be addressed . . . especially on the time value of money section of the bill."

HON. RICHARD E. NEAL OF MASSACHUSETTS IN THE HOUSE OF REPRESENTATIVES

Tuesday, November 9, 1999

Mr. NEAL of Massachusetts. Mr. Speaker, today I am introducing a modest bill which builds on the recommendations of the Department of the Treasury and the New York State Bar Association. This legislation applies section 1032, which was added in 1954 to the Internal Revenue Code, to all derivative contracts. The impact of this change is to prohibit corporations from recognizing gain or loss in derivative transactions to the extent the derivative purchased by the corporation involves its own stock.

Section 1032 states that a corporation generally does not recognize gain or loss on the receipt of money or other property in exchange for its own stock. In addition, a corporation does not recognize gain or loss when it redeems its own stock for cash. Section 1032 as originally enacted simply recognized that there was no true economic gain or loss in these transactions. However, the 1984 Deficit Reduction Act extended this policy to option contracts, recognizing the potential for tax avoidance inherent in these contracts. Since that time the financial industry has developed a number of new types of derivative products. My legislation merely updates current law to include in section 1032 current and future forms of these new types of financial instruments.

On June 16, 1999 the New York State Bar Association issued a report on section 1032 which recommended the changes discussed above. In addition, building on the work of the Treasury Department's budget recommendation, the New York State Bar Association also recommended that Congress require a corporation that retires its stock and "substantially contemporaneously" enters into a contract to sell its stock forward at a fixed price, to recognize as income a time-value element. In effect, these two transactions provide a corporation with income that is economically similar to interest income but is tax- free. This legislation includes a provision that recognizes a time- value element, i.e., the version recommended by the Bar Association. The effective date of this legislation is for transactions entered into after date of enactment.

The problem identified in 1984, and in 1999 by the Department of the Treasury, is best described in the New York State Bar Association Report. The report states:

We are concerned that all the inconsistencies described above (both in the general scope of section 1032 and in its treatment of retirements combined with forward sales) present whipsaw and abuse potential; the government faces the risk that income from some transactions will not be recognized even though those transactions are economically equivalent to taxable transactions. In addition, the government faces the risk that deductions are allowed for losses from transactions that are equivalent in substance to transactions that would produce nontaxable income, or -- because taxpayers may take different positions under current law -- even in the same form as such transactions. To avoid these inconsistencies, we believe it is necessary to amend section 1032. . . .

Mr. Speaker, I consider the legislation I am introducing today to be a normal housekeeping chore, something the Committee on Ways and Means has done many times in the past and hopefully will do so in the future. As such, I hope it will be seen both in Congress and in the industry as relatively noncontroversial, and that it can be added to an appropriate tax bill in the near future. I do hope, however, that the industries affected will provide written comments on technical changes they believe need to be addressed in this legislation as introduced, especially on the time value of money section of the bill.