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Chairman Neal introduces prepaid derivatives bill

December 19, 2007
Press Release

(WASHINGTON) Congressman Richard E. Neal, Chairman of the Subcommittee on Select Revenue Measures, made the following statement on the floor of the US House of Representatives today in support of legislation he has filed that will address the taxation of prepaid derivative contracts. According to Neal’s remarks, “the appropriate tax treatment of financial products is ever-evolving, just as the market for these products is. Occasionally, Congress or Treasury must step in and clarify how these new offerings should be treated under the tax code. And my bill today will do that.” For Congressman Neal’s full statement, please see below…

Introduction of Prepaid Derivatives Bill

Remarks by Rep. Richard Neal

December 19, 2007


Madame Speaker, I rise today to introduce legislation addressing the taxation of prepaid derivative contracts. The appropriate tax treatment of financial products is ever-evolving, just as the market for these products is. Occasionally, Congress or Treasury must step in and clarify how these new offerings should be treated under the tax code. And my bill today will do that.

Recently, a new product called Exchange Traded Notes, has caught the attention of regulators and investors. The main benefit of these notes is their tax treatment. Issuers have advised buyers that these interests receive almost unlimited tax deferral on any gain earned. And, they advise that even when the gain is recognized at the point that the note is sold or redeemed, it is taxed as long-term capital gain and not ordinary income. These notes can run as long as 30 years and track an exchange rate, index, or commodity.

So, with almost unlimited tax deferral, it seems that many other investments would pale in comparison. Already, many investors have caught on. These exchange-traded notes have garnered $4 billion of investment in a very short period of time. Some argue that this tax treatment is justified, as holders of these notes have some credit risk. If the issuer goes under, the holder may not get paid.

But this favorable tax treatment has not gone without notice. In a Tax Notes magazine article aptly titled, “Too Good to Be True?” one practitioner called this tax treatment, “The Wild West of the tax law.” And one columnist in The Washington Post likened this new tax sheltering opportunity as opening “Pandora’s Tax Box.” It is important to note that this favorable tax treatment is premised on the opinion of one law firm.

More recently, Treasury has stepped in to clarify that Exchange Traded Notes tied to foreign currencies are debt and do generate taxable income to investors. In a companion notice, Treasury asked for comments on whether holders of other prepaid forward contracts should be required to accrue income during the term of the contract. It is possible that Treasury will produce guidance providing appropriate clarity in this market, but in the interim, I believe legislative action is warranted.

The legislation that I am filing today provides rules for the tax treatment of prepaid derivative contracts, which includes Exchange Traded Notes. Holders of such instruments will be required to include as interest income each year an amount determined by reference to a short-term interest rate. The basis in such contract would be adjusted by any income inclusion so that at disposition, any gain or loss would be properly accounted for just as it would be with any other investment receiving annual payments.

In past Congresses, I have pursued legislation to curb vehicles providing unlimited tax deferral to investors, such as swap funds. I believe it is important that our tax laws reach instances where interest is earned or gain recognized, especially where the products are complex or lack transparency. The legislation that I am filing today takes another step in that direction. But I welcome constructive comments from practitioners on both sides of this issue. Above all, if we amend the tax code, we want to get it right the first time.

I look forward to discussing this complex issue with my colleagues in the New Year and seeking their support for this bill.

CLICK HERE for Background on Neal Prepaid Derivatives Bill (PDF)