Congress Examines Tax Treatment Of Derivatives

by Mike Godfrey, Tax-News.com, Washington

07 March 2008

A House of Representatives tax subcommittee has held a hearing to examine whether legislative changes are required to bring about more uniform tax treatment of financial derivatives.

"The expanding derivatives market is already a $516 trillion global enterprise, only some of which is subject to regulation and transparency," observed Richard Neal, Chairman of the House Ways and Means Select Revenue Measures Subcommittee, in announcing the hearing.

"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," he added.

Neal also noted that the hearing is timely given the recent market turmoil after one insurer posted heavy losses, in part due to one type of derivative, credit default swaps.

“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 Buffet has referred to derivatives as ‘financial weapons of mass destruction,'" Neal stated in his opening statement at Wednesday's hearing.

“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," he added.

In December 2007, Neal introduced the Prepaid Derivatives Bill into Congress, which sought to address the taxation of prepaid derivative contracts, including Exchange Traded Notes (ETNs), a relatively new addition to the portfolios of retail investors, but one which mutual fund managers complain is given much more favorable tax treatment.

The Treasury recently stepped in to clarify that ETNs tied to foreign currencies are debt, and generate taxable income to investors. It also asked for comments on whether holders of other prepaid forward contracts should be required to accrue income during the term of the contract, and is likely to produce further guidance providing appropriate clarity in derivatives market. However, in the interim, Neal believes that legislative action is warranted.

"In past Congresses, I have pursued legislation to curb vehicles providing unlimited tax deferral to investors, such as swap funds," he stated upon introducing his legislation, adding that:

"I believe it is important that our tax laws reach instances where interest is earned or gain recognized, especially where the products are complex or lack transparency."

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