Proposed Derivatives Bill Fails to Address Tax Treatment of Some Investments, Tax Attorney Says

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 form 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 investors' 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.