[Congressional Record Volume 145, Number 64 (Wednesday, May 5, 1999)]
[Extensions of Remarks]
[Page E862]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




                  CONSTRUCTIVE OWNERSHIP TRANSACTIONS

                                 ______
                                 

                          HON. RICHARD E. NEAL

                            of massachusetts

                    in the house of representatives

                         Wednesday, May 5, 1999

  Mr. NEAL of Massachusetts. Mr. Speaker, today I am introducing 
legislation to prevent a transaction the goal of which is tax avoidance 
by means of converting ordinary income or short-term capital gains into 
income eligible for long-term capital gains rates.
  Since Congress enacted legislation to lower the capital gains tax 
below that of ordinary income, the press has written about a number of 
transactions that have been developed to recharacterize income 
primarily for the avoidance of tax. Congress closed one loophole in 
1997 involving constructive sales or so-called ``short-against-the-
box'' transactions. In those transactions investors were effectively 
selling an asset and receiving the benefits of a sale without calling 
it a sale for tax purposes. The Taxpayer Relief Act of 1997 termed 
these transactions constructive sales and restored the appropriate tax 
treatment, determining that if it looks like a sale and acts like a 
sale, it should be treated as a sale for tax purposes.
  Consistent with that approach, our former colleague Barbara Kennelly 
developed additional legislation in 1998 that could be termed 
``constructive ownership'' legislation. In this case, an investor 
effectively purchases an asset and has the benefit of ownership, but 
does not pay taxes on income from the asset in the same way as if the 
investor owned it directly. The solution that was proposed was to treat 
that investment no more favorably than the treatment ownership in the 
underlying asset would have received. In addition, while this treatment 
would assure appropriate capital gains treatment, these transactions 
could still be attractive for deferring the recognition of ordinary 
income--in contrast to direct owners who pay taxes annually on ordinary 
income. To correct this, the bill imposes a deferred interest charge to 
recapture the benefits of deferral.
  As many in the industry will recognize, the legislation I am 
introducing today is based on the Kennelly bill, but makes several 
technical improvements which were suggested last year, primarily by the 
New York State Bar Association. Additional comments, of course, are 
certainly in order.
  Investors in a hedge fund (and other pass through entities) are 
required to pay taxes annually on their share of the income from the 
fund regardless of whether they receive a distribution. In the 
transaction covered by the bill, investors indirectly invest in the 
fund through a derivative that is economically equivalent to a direct 
investment. However, the derivative allows the investor to defer his 
tax liability. Invest in a hedge fund, and you pay taxes every year, 
and those profits are taxed at the higher short-term capital gains 
rate. Place that same money in a derivative wrapped around a hedge 
fund, and you pay taxes only at the end of the contract, and the profit 
is taxed at the lower long-term capital gains rate. The bill I am 
introducing today states that if an investor indirectly owns a 
financial asset like a hedge fund through a derivative, they cannot get 
more long-term capital gain than if they owned the investment directly. 
In addition, there is an interest charge to offset the additional 
benefit of the deferral.
  The effective date for this legislation is for gains realized after 
date of enactment. This is a more generous effective date than that 
contained in the Administration's budget. Still, some would argue that 
this is retroactive, because they signed contracts prior to the date of 
introduction of the Kennelly Bill and therefore were not on notice that 
a change in the law might occur.
  Since I announced my intention to reintroduce the Kennelly bill, it 
is my understanding that a number of contracts have been, and continue 
to be, signed under the theory that the legislation may not pass 
Congress, and if it did the transaction could simply be unwound. This 
may explain the recent comments of Robert Gordon, President of 21st 
Securities, as reported in this month's edition of MAR/Hedge, which 
states: ``Gordon says that the penalty is so low (in my legislation) 
that he would advise clients thinking about synthetic hedges (italics 
are mine) to go ahead. ``There is not a lot of cost if the bill does 
become retroactive, you just unwind the swap.'' The penalty is the 
difference between the two interest rates--the one charged in the swap 
by the dealer and the interest rate earned by money in the investor's 
hands. Because the interest today and the interest rate when the law 
changes, say several months from now, will be relatively small, it is a 
small penalty to pay.''
  It is hard to be sympathetic to an investor who enters into a 
particular so-called ``synthetic'' transaction purely for purposes of 
tax avoidance. It is even harder to be sympathetic when the investor 
signs a contract after he was on notice that there was a legislative 
change under consideration. It is hardest of all to be sympathetic to 
an investor who deliberately signs a contract betting that the 
potential for tax avoidance far outweighs a potential loss attributed 
to unwinding a contract if the law does change, and then claims 
``retroactivity'' in a last attempt to secure the benefits of tax 
avoidance.
  Nonetheless, the fact remains that some contracts were signed prior 
to the date of introduction of the Kennelly bill. I have therefore 
added a grandfather clause to this legislation that exempts all 
contracts from changes in this bill if the contracts were signed prior 
to the date of introduction of her bill on February 5, 1998. The 
grandfather clause would cease to exist if the contract was extended or 
modified.
  Mr. Speaker, all capital gains differentials invite attempts to 
recharacterize ordinary income or short-term capital gains into long-
term capital gains. The transactions I am talking about are, of course, 
not available to the ordinary investor who must pay his fair share of 
taxes, but only to a small number of sophisticated wealthy investors. 
Any perception that being sophisticated and wealthy enough allows some 
to avoid paying their fair share of tax undermines the entire tax 
system, as well as the capital gains differential. I believe it is 
important to shut down tax shelters as we uncover them, and if we in 
Congress do not have the courage to do that, then maybe allowing the 
Department of the Treasury to have broader power to characterize tax 
shelters and shut them down through the regulatory process needs to be 
seriously considered.

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