[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 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            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

                              ----------                              


                        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.''
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Any person(s) and/or organization(s) wishing to submit 
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FORMATTING REQUIREMENTS:

      
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noted above.

                                 

    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.''
---------------------------------------------------------------------------
    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:]

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[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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \2\ See preamble to T.D. 8491, 58 Fed. Reg. 53125, 53126 (Oct. 14, 
1993).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \3\ See Treas. Reg. Sec. 1.446-3(g)(4).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \4\ 2003-1 C.B. 363.
    \5\ See TAM 200604033; Advice Memorandum 2007-004; LMSB Coordinated 
Issue Paper 04-1207-077.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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.''
---------------------------------------------------------------------------
    \7\ The formal name of this index is the ``Dow Jones High Yield 
Select 10 Total Return Index.''
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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.]

                                 
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