[Congressional Record Volume 144, Number 136 (Friday, October 2, 1998)]
[Extensions of Remarks]
[Page E1889]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]


[[Page E1889]]
    DID TAX AVOIDANCE PLAY A ROLE IN THE FALL OF LONG-TERM CAPITAL?

                                 ______
                                 

                          HON. RICHARD E. NEAL

                            of massachusetts

                    in the house of representatives

                        Friday, October 2, 1998

  Mr. NEAL of Massachusetts. Mr. Speaker, in the past week, we all read 
about the gathering of Wall Street's financial giants and their 
agreement to bail out Long Term Capital Management L.P., which ``The 
Wall Street Journal'' has referred to as a ``high flying hedge fund 
that was on the verge of collapse.''
  After a meeting orchestrated by the Federal Reserve, a group of 
investment firms and commercial banks agreed to a $3.5 billion bailout 
of Long-Term Capital. Without this bailout, Long-Term Capital's $80 
billion balance sheet and additional exposure in the form of off-
balance-sheet agreements would have been liquidated. A forced 
liquidation could have had an adverse impact on worldwide markets.
  The financial service industry bears the overwhelming portion of 
blame. Lenders extended enormous amounts of credit without adequate 
supervision or knowledge of the activities of the fund.
  However, Congress also shares a part of the blame for this debacle. 
Derivatives have legitimate uses, but they can be used to create 
excessive levels of leverage by avoiding margin requirements. They have 
the potential of tax avoidance. Congress was aware of this. The 
Commodity Futures Trading Commission (CFTC) raised questions earlier 
this year about the adequacy of supervision of hedge funds. Congress 
not only chose to ignore the warning of the CFTC, but it pushed 
legislation that would prohibit the CFTC from proposing new derivatives 
regulation.
  This tax avoidance potential of derivatives did not cause the fall of 
Long-Term Capital, but it may have added fuel to the fire in the 
failure. In the fall of 1997, management of Long-Term Capital wanted to 
increase its stake in the fund. Rather than invest directly, the 
founder and partners entered into a complex transaction with Union Bank 
of Switzerland (UBS) that gave them $750 million of equity in the fund 
through the use of derivatives. According to Derivatives Strategy 
Special on-line Report, the management of Long-Term Capital 
deliberately chose this complex transaction in order to convert foreign 
interest income from their offshore hedge fund into long-term capital 
gains and defer it for seven years. Their motivation for this 
transaction was pure and simple--tax evasion.
  Congresswoman Kennelly was the only one who had the foresight to 
recognize that the tax avoidance potential of derivatives should have a 
legislative response. On February 5, 1998, Congresswoman Kennelly 
introduced H.R. 3170, legislation which would prevent the use of 
derivatives to convert ordinary income into long-term capital gain 
eligible for the 20% capital gain rate. That legislation was aimed at 
investments in hedge funds through derivatives. The deal that the 
management of Long-Term Capital entered into with UBS is an example of 
a transaction that the Kennelly legislation would have shut down.
  I commend Congresswoman Kennelly on her efforts to prohibit 
transactions that use derivatives for tax avoidance. If this 
legislation had been enacted, the motivation for the transaction 
between the managers of Long-Term Capital and UBS would have not 
existed.
  The rise and fall of Long-Term Capital will be studied by Congress in 
the upcoming months. I plan on following Congresswoman's Kennelly lead 
and to work towards the passage of legislation which addresses the tax 
avoidance potential of derivatives.
  The Kennelly bill affects transactions such as the transaction 
between the founder and partners of Long-Term Capital and UBS that are 
not available to the ordinary investor because of their cost. In an 
economic sense these transactions are equivalent to ownership, but 
their costs are substantially greater than the costs of a simple 
purchase.
  Congresswoman Kennelly believes that there is no tax policy 
justification for giving an investor in a derivative more favorable tax 
treatment than an investor in an identical underlying product. The 
Kennelly bill redefines the concept of when there is ownership for tax 
purposes in order to take into account the economic substance of these 
new transactions.
  I look forward to working on the Kennelly bill and ultimately working 
towards passage of legislation that addresses the potential tax 
avoidance of derivatives. Attached is a technical description of the 
Kennelly legislation.

                    Constructive Ownership Treatment

       The Kennelly bill would apply to taxpayers who hold 
     constructive ownership positions with respect to any 
     financial property. The legislation would treat gain from 
     constructive ownership positions as long-term gain only to 
     the extent the investor would have received long-term gain 
     treatment if he/she held the underlying asset directly.
       The bill would define constructive ownership as any of the 
     following transactions (and any other transaction having 
     substantially the same effect as a transaction described 
     below):
       1) entering into an offsetting notional principal contract 
     with respect to the same or substantially identical property;
       2) entering into a futures or forward contract to acquire 
     the same or substantially identical property;
       3) granting a put and holding a call with respect to the 
     same or substantially identical property and such options 
     have substantially equal strike prices;
       4) entering into 1 or more than other transactions (or 
     acquiring 1 or more positions) that have substantially the 
     same effect as a transaction described in any of the 
     preceding subparagraphs.
       The bill would only apply to financial positions in stock, 
     debt instruments, partnerships and investment trusts held 
     through derivatives. This legislation is not intended to 
     apply to interests held through mutual funds.
       A deferred interest charge would apply to constructive 
     ownership transactions in order to recapture the benefits of 
     deferral. The deferred interest charge would be equal to the 
     underpayment of tax rate in Section 6601.
       The legislation would be effective for gains recognized 
     after date of enactment.

     

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