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58–276 2011

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 

SANDER M. LEVIN, Michigan 

JIM MCDERMOTT, Washington 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

STEPHANIE TUBBS JONES, Ohio 

MIKE THOMPSON, California 

JOHN B. LARSON, Connecticut 

RAHM EMANUEL, Illinois 

EARL BLUMENAUER, Oregon 

RON KIND, Wisconsin 

BILL PASCRELL JR., New Jersey 

SHELLEY BERKLEY, Nevada 

JOSEPH CROWLEY, New York 

CHRIS VAN HOLLEN, Maryland 

KENDRICK MEEK, Florida 

ALLYSON Y. SCHWARTZ, Pennsylvania 

ARTUR DAVIS, Alabama 

JIM MCCRERY, Louisiana 

WALLY HERGER, California 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

SAM JOHNSON, Texas 

PHIL ENGLISH, Pennsylvania 

JERRY WELLER, Illinois 

KENNY HULSHOF, Missouri 

RON LEWIS, Kentucky 

KEVIN BRADY, Texas 

THOMAS M. REYNOLDS, New York 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

JOHN LINDER, Georgia 

DEVIN NUNES, California 

PAT TIBERI, Ohio 

JON PORTER, Nevada 

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 

MIKE THOMPSON, California 

JOHN B. LARSON, Connecticut 

ALLYSON Y. SCHWARTZ, Pennsylvania 

JIM MCDERMOTT, Washington 

RAHM EMANUEL, Illinois 

EARL BLUMENAUER, Oregon 

PHIL ENGLISH, Pennsylvania 

THOMAS M. REYNOLDS, New York 

ERIC CANTOR, Virginia 

JOHN LINDER, Georgia 

PAUL RYAN, Wisconsin 

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. 


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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 


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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:] 


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ADVISORY 

FROM THE COMMITTEE ON WAYS AND MEANS 

SUBCOMMITTEE ON SELECT REVENUE MEASURES 

FOR IMMEDIATE RELEASE CONTACT: (202) 225–5522 

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. 


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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 testimony 

for the hearing record must follow the appropriate link on the hearing page of the 

Committee website and complete the informational forms. From the Committee 

homepage, http://waysandmeans.house.gov, select ‘‘110th Congress’’ from the menu entitled, ‘‘Committee Hearings’’ (http://waysandmeans.house.gov/Hearings.asp?congress 

=18). Select the hearing for which you would like to submit, and click on the link 

entitled, ‘‘Click here to provide a submission for the record.’’ Once you have followed 

the online instructions, completing all informational forms and clicking ‘‘submit’’ on 

the final page, an email will be sent to the address which you supply confirming 

your interest in providing a submission for the record. You MUST REPLY to the 

email and ATTACH your submission as a Word or WordPerfect document, in compliance with the formatting requirements listed below, by close of business Wednesday, March 19, 2008. Finally, please note that due to the change in House mail 

policy, the U.S. Capitol Police will refuse sealed-package deliveries to all House Office Buildings. For questions, or if you encounter technical problems, please call 

(202) 225–1721. 

FORMATTING REQUIREMENTS: 

The Committee relies on electronic submissions for printing the official hearing record. As always, submissions will be included in the record according to the discretion of the Committee. 

The Committee will not alter the content of your submission, but we reserve the right to format 

it according to our guidelines. Any submission provided to the Committee by a witness, any supplementary materials submitted for the printed record, and any written comments in response 

to a request for written comments must conform to the guidelines listed below. Any submission 

or supplementary item not in compliance with these guidelines will not be printed, but will be 

maintained in the Committee files for review and use by the Committee. 

1. All submissions and supplementary materials must be provided in Word or WordPerfect 

format and MUST NOT exceed a total of 10 pages, including attachments. Witnesses and submitters are advised that the Committee relies on electronic submissions for printing the official 

hearing record. 

2. Copies of whole documents submitted as exhibit material will not be accepted for printing. 

Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material 

not meeting these specifications will be maintained in the Committee files for review and use 

by the Committee. 

3. All submissions must include a list of all clients, persons, and/or organizations on whose 

behalf the witness appears. A supplemental sheet must accompany each submission listing the 

name, company, address, telephone and fax numbers of each witness. 

Note: All Committee advisories and news releases are available on the World 

Wide Web at http://waysandmeans.house.gov. 

The Committee seeks to make its facilities accessible to persons with disabilities. 

If you are in need of special accommodations, please call 202–225–1721 or 202–226– 

3411 TTD/TTY in advance of the event (four business days notice is requested). 

Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above. 

f 

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 conVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00007 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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stantly 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. 


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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 AviYonah 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. 


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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. 


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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 

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action 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. 


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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 


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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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f 

Chairman NEAL. Thank you. 

Mr. Yonah. 


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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. 


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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. 


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1Dividends paid to controlling shareholders are generally subject to tax under treaties at 5%, 

but some of our recent treaties reduce this tax to zero. 2Treas. Reg. 1.863–7. 

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

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. 

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 


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3David D. Stewart, Sovereign Wealth Fund Deals Take Advantage of IRS Ruling, 2008 TNT 

41–5 (Feb. 29, 2008). 4 Rev. Rul. 2003–97, 2003–34 IRB 1. 

5Stewart, supra. 

6For a discussion of the different treatment of TRES and securities loans see Reuven AviYonah and Linda Z. Swartz, U.S. International Treatment of Financial Derivatives, 74 Tax 

Notes 1703 (1997). 7Stewart, supra. 

8For some ideas see Gregory May, Flying on Instruments: Synthetic Investments and the 

Avoidance of Withholding Tax, 96 TNT 239–32 (1996). 

and will benefit from a tax savings of approximately $100 million per year during 

the preconversion period of the deal.’’ 3

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

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

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

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 


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9This 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). 

indicated by the voluminous regulations governing withholding under IRC 1441– 

1446. 

3. A Possible Solution9

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. 

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 


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10 Report of the Committee of Independent Experts on Company Taxation (Commission of the 

European Communities, 1992), p. 201. 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. 12 Joel Slemrod, Comment, in Vito Tanzi, Taxation in an Integrating World (1995), 144. 13Guttentag 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). 

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

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

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. 

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


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14 Richard Bird, Shaping a New International Tax Order, 42 Bulletin for International Fiscal 

Documentation 292 (1988), 303. 

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.’’ 

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 counVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00037 Fmt 6633 Sfmt 6621 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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try 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. 

f 

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. 


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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 


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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:] 


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1The 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. 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.’’ 4See http://www.bis.org/press/p071219.htm. 

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. 

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

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. 

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 


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5 BIS Triennial Central Bank Survey 2007 (June 2007), http://www.bis.org/publ/rpfxf07t.pdf? 

noframes=1. 6Source: http://en.wikipedia.org/wiki/Structuredlproducts. 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. 

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. 

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

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. 

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 ‘comVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00042 Fmt 6633 Sfmt 6621 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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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. 

parable 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

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 taxdriven 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 inVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00043 Fmt 6633 Sfmt 6621 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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struments 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. 

f 

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 inVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00044 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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vestments 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 actuVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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ally 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 


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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 


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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. 


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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—— 


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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 disVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00050 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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appear 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 somewhat 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 


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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 


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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. 


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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 


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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? 


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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 


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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. 


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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. 


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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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f 

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. 


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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 economiVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00063 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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cally 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 shortterm 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, 


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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 


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1For 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 zerocoupon 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. 2See preamble to T.D. 8491, 58 Fed. Reg. 53125, 53126 (Oct. 14, 1993). 

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 overuse (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. 

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. 

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 


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3See Treas. Reg. § 1.446–3(g)(4). 4 2003–1 C.B. 363. 

5See TAM 200604033; Advice Memorandum 2007–004; LMSB Coordinated Issue Paper 04– 

1207–077. 

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. 

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. 

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. 


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6The information provided about existing ETNs reflects my best understanding based on information I have had the opportunity to review and may be incomplete. 7The formal name of this index is the ‘‘Dow Jones High Yield Select 10 Total Return Index.’’ 

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

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.’’ 


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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. 

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

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 


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9While this discussion focuses on ETNs, the ICI is not opposed to the Bill’s application to prepaid forward contracts that are not publicly traded. 

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-tomarket 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 


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10 But see Treas. Reg. 1.446–3(g)(4), supra. 11See Code §§ 1291–1298. 

staff. For the remainder of this testimony, I would like to focus on our ‘‘big picture’’ 

comments. 

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. 

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 


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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. 

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 markto-market treatment. If the holder fails to elect either of these regimes, the default 

rule could be the section 1260 regime. 

f 

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. 


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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 costand 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 


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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 nondividend-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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f 

Chairman NEAL. Thank you, Mr. Samuels. 

Mr. Shulman. 


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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 realizationbased 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 forVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00085 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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ward 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. 


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[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 nonprepaid 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 


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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. 

f 

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, 


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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-thecounter 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. 


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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 nondebt-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 deVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00090 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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ferring 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 


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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.] 


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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 muVerDate Nov 24 2008 09:46 Jan 18, 2011 Jkt 058276 PO 00000 Frm 00093 Fmt 6633 Sfmt 6602 I:\WAYS\OUT\58276.XXX APPS06 PsN: 58276

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tual 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.] 

Æ 


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