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Equity Tax Strategies Under Fire

Rep. Barbara Kennelly wants to stop some popular derivatives techniques used to reduce capital gains taxes.

By John Thackray

Tax lawyers in derivatives have developed hunched-over shoulders waiting for the Treasury cannons to blast off with fresh legislation inhibiting the use of tax-advantaged instruments. In February they got the salvo they'd been expecting, not from Treasury itself but a stalking horse of theirs named Barbara Kennelly (D-Conn.), who introduced a bill that would close down several derivatives niches made possible by the Taxpayer Relief Act of 1997. This bill, it will be remembered, lowered the maximum capital gains rate from 28 percent to 20 percent for assets held 18 months or longer, and considerably widened the gap between capital gains and ordinary income. Outfits such as hedge funds, which have predominantly short-term capital gains, were thereby "incentivized” to enter into various transactions (swaps, European-style options or forward options settling in cash) where synthetically they shaved off the differential between the maximum federal tax rate of 39.6 percent and the 20 percent capital gains rate.

This heaven-sent opportunity for banks' derivatives departments to act as counterparties in the exchange of maturities also gives hedge funds an advantage not available to John Q. Citizen. Kennelly said at the time that "A preferential capital gains rate can only survive if it is available to all Americans, not something that is available for purchase by a small number of wealthy, sophisticated taxpayers.” And "There is no tax policy justification giving an investor in a derivative more favorable tax treatment than an investor in an identical underlying product.” Her bill, she affirmed, would unmask the derivatives and "redefine the concept of where there is ownership for tax purposes in order to take into account the economic substance of these transactions.”

The effect on Wall Street has been to put a total freeze on this segment of the derivatives market. What's more, many hedge funds that had entered into those deals now regret them, because the Kennelly proposal would be effective for gains recognized after the date of the bill's enactment. And many of these deals, sources say, have been created with three-, five- and even seven-year maturities. Although the proposal will be modified in discussions within the House Ways Means Committee, and its ultimate passage isn't a sure thing, it has caused "tremendous uncertainty among investors,” says Roger Lorence of Goldstein, Golub, Kessler & Co. "Investors would be ill-advised to enter these types of transactions with this sword of Damocles hanging over their heads.”

Basically the Kennelly bill applies to cases of derivatives standing in for "constructive ownership” whose profits will be treated as short-term, as if the maturity swap had never existed. Kennelly has four measures of constructive ownership: offsetting notional principal contracts on the same or identical property; futures or forward contracts to deliver the same property; granting a put and holding a call with the same strike prices on the same property; and transactions that mimic the latter.

Thus is Barbara's barb raised at hedge fund equity swaps, at synthetic long positions in hedge funds and hedge fund forward contracts. It might also have attacked the use of derivatives for converting ordinary dividends and interest into short-term capital gains (clearly something that upsets the U.S. Treasury Department) but chose not to for the time being. She also may have left room for a hedge fund to make these deals for less than "substantially all” of an investment's increase or decline.

Who is Barbara Kennelly anyway? She is the fourth-ranking Democrat on the House Ways and Means Committee and the sponsor of the equity short-against-the-box reform that was part of the Taxpayer Relief Act of 1997, enacted last August (See Derivatives Strategy, October 1997), where she first introduced the "constructive” term to describe underlying economic realities. "Anything she does in the area of financial products has to be taken very seriously,” says Lorence. Kennelly observed that "this legislation would build on legislation enacted last year involving constructive sales. In effect, if it looks like a sale and acts like a sale, it's a sale. Consistent with that approach, this legislation could be termed constructive purchase legislation.”

Some securities lawyers fear that the attack on constructive ownership is but the thin end of a wedge being shaped at Treasury to target a wider array of tax-based derivatives. Worries one hump-backed lawyer: "I think that in the hearings they will draw a larger net than is expressed in the Kennelly proposal.”