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The Clock Is Ticking for Tax Dodgers

By Robert Hunter

Wealthy individuals adept at using derivatives to take advantage of tax loopholes aren’t the biggest fans of Barbara Kennelly. Last year, the Democratic representative from Connecticut led the charge to close the short-against-the-box loophole, which allowed individuals to sell borrowed shares of a stock they continued to hold, reaping investment gains without having to sell the stock or pay taxes on it. Her proposal, known as “constructive sale,” found its way into the Taxpayer Relief Act of 1997, and for a brief moment, Kennelly rested assured that she had stopped a surging tide of tax avoidance.

But Wall Street doesn’t give up easily, and shortly after the Taxpayer Relief Act passed, tax lawyers went through the new legislation with a fine-tooth comb. Soon deals began popping up that took advantage of an obscure loophole in the ’97 Act. Now Kennelly, continuing her crusade against tax avoidance by the wealthy, is striking back. Investors hoping to take advantage of the strategy should act fast—there’s no telling how long the good times will last.

The ’97 Act reduced long-term capital gains rates to 20 percent, while the rates on short-term trading gains remained the same—up to 39.6 percent. The investment community came up with an inspired strategy to capture the lower tax rate on short-term gains: A dealer buys a share in a hedge fund and sells the individual investor a relatively long-term derivative on the fund—usually a swap but in some cases an option. The individual then has the chance to realize all of the upside of the hedge fund at maturity, while paying the 20 percent long-term capital gain tax rate. The deal works because hedge funds typically don’t make regular distributions, and because dealers are able to mark their positions to market, avoiding taxation. Since the dealer generally hedges the exposure, it is economically indifferent to the underlying, and it collects the premium for the deal up front. The deals are fairly expensive to investors—usually 1 percent or more of the contract’s notional value—but the potential tax benefits are enormous.

“I’d be delighted to work with anyone who has ideas about how this legislation might be improved. But I am hopeful that these tax-avoidance techniques can be curbed.”
Barbara Kennelly
U.S. Representative,
D-Conn.

Some estimate that billions of dollars worth of these deals have been transacted thus far. Bankers Trust is generally recognized as the leader, but Lehman and others have made a bundle as well. Some dealers, such as NationsBanc Montgomery Securities, have even considered setting up full-fledged hedge fund swaps businesses, and hedge funds have been aggressively marketing the deals.

Kennelly hopes to change all that. Her new proposal, known as “constructive ownership,” seeks to tax investors who take part in such deals as if they had owned the underlying hedge fund shares all along. And to turn the knife, interest would be charged on any income that would have been taxed earlier, had the individual owned the underlying. “The goal of this,” says Richard Shapiro, a tax partner in Ernst & Young’s financial services practice, “would be to put holders of these hedge fund shares economically and in character in the same position they would have been in had they not been in the derivative transaction and had simply owned the underlying hedge fund.” And since the deals come at a fairly steep premium, all economic incentive to make them would be removed.

Kennelly, currently a gubernatorial candidate in Connecticut, has been magnanimous since announcing the proposal. “I’d be delighted to work with anyone who has ideas about how this legislation might be improved or more precisely drawn,” she has said. “But I am hopeful that these tax-avoidance techniques can be curbed in the context of tax or budget legislation this year.”

The proposal is currently in legislative purgatory, not attached to any bill but ripe for the plucking by any legislator looking for revenue. The precise economic value of the proposal, however, is unclear. “I don’t believe it’s a huge moneymaker,” says Shapiro, “but no one knows precisely what the actual revenue value could be.” Still, many on Wall Street are nervous. “The proposal has been treated quite seriously by the financial products community,” notes Shapiro, “particularly because of Kennelly’s influence in connection with the constructive sale legislation adopted last year, which, effectively, was her language. This is viewed as an extension of that.”

Business in hedge fund swaps and options has already dropped off, as investors worry that new legislation may not include a “grandfather” clause and thus could affect current deals. Others, meanwhile, worry that vaguely worded legislation could have unintended effects on owners of such standard derivative products as index futures and forwards, which may be construed as earning short-term income each time a stock enters or exits the index.

But the proposal has few opponents in Washington. “It’s the kind of legislation that the tax-reformer types aren’t against,” says Shapiro. “It is sort of a ‘good-government’ proposal.” Even if the legislation is enacted, however, Kennelly may have to go back to the grindstone. In June, a conference in New York entitled “Derivatives Tax Planning for High-Net-Worth Individuals,” sponsored by Frank Fabozzi and the Information Management Network, provided a host of preemptive tax-avoidance strategies to skirt her proposal.

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