Daily Tax Update - March 5, 2008

SUBCOMMITTEE HOLDS HEARING ON TAX TREATMENT OF DERIVATIVES:  Today, the House Ways and Means Subcommittee on Select Revenue Measures heard testimony on the tax treatment of derivatives. In his opening statement, Subcommittee Chairman Richard Neal (D-MA) said, “Complexity is the name of the game in the derivatives market. But I believe it is important for Congress to understand how this market operates and for this Committee to understand how these products are taxed. It would be easy for us to assume the regulators are taking care of this. And it would be easy for us to dismiss these products as ones 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. Today, we plan to keep on driving.” Neal added, “As we will hear in testimony today, investors and regulators deserve some certainty and clarity with respect to derivatives. I believe we set up inherent conflicts when derivatives enjoy a better tax treatment than the underlying asset.”

• Treasury Tax Legislative Counsel Michael Desmond said, “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 Internal Revenue Service (IRS) to administer the nation’s tax laws, and we appreciate this Subcommittee’s focus on these issues. The tax treatment of prepaid forward contracts is of continuing interest to the Treasury Department. . .Although it is premature to offer any conclusions or positions with respect to how we might move forward with respect to the issues raised by the Notice, we look forward to continuing to work with this Subcommittee as you consider proposals that would affect the tax treatment of derivatives and, in particular, proposals to change the tax law with respect to prepaid forward contracts.”
• Desmond added, “Because of the large number of taxpayers potentially affected and their relative level of sophistication, the migration of prepaid forward contracts into the portfolios of retail investors served as an occasion for us to revisit the core issue related to prepaid forward contracts—whether or not a current accrual of income should be required. We issued the Notice to inform the public that we are continuing to examine this issue and to solicit comments. As the popularity of prepaid forward contracts grows, more taxpayers are affected by the current lack of clarity and need guidance regarding how to compute their tax liability. We were also mindful of the fact that the market segment into which these transactions is expanding is one that is, perhaps, less capable of appreciating the risks associated with this uncertainty. Although it would be very desirable for us to clarify this area, we have reached no conclusion about how to proceed, about what result should be reached, or about whether we are able to reach that result with administrative guidance.”
• Non-governmental witnesses offered divergent views. Alex Raskolnikov, Associate Professor of Law at Columbia Law School asserted that “All derivatives should be subject to a mark-to-market regime, and gains and losses from derivatives should be taxed at the top individual or corporate ordinary income rate.”
• Reuven Avi-Yonah, Irwin I. Cohn Professor of Law, University of Michigan Law School, writing about the reported use of derivatives to avoid withholding taxes, argued that “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).”
• Other witnesses cautioned against an incremental approach or particularized response to individual products and suggested that any changes needed to be undertaken in the context of considering the taxation of financial products generally. In so doing, some criticized H.R. 4912 as both overbroad with respect to prepaid contracts and too narrow in treating one type of financial product differently than its equivalent.
• For additional information, contact Matthew D. Lerner - mlerner@steptoe.com or Philip R. West -

TAX BILL INTRODUCED MARCH 4^TH:
H.R.5523: To amend the Internal Revenue Code of 1986 to regulate and tax Internet gambling.
Sponsor: Rep McDermott, Jim [WA-7] (introduced 3/4/2008)      Cosponsors (None)

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

STEPTOE & JOHNSON LLP - TAX PRACTICE
Steptoe & Johnson LLP has one of the largest and most diverse law firm tax practices in the country. The practice covers the entire spectrum of federal taxation, including representation of businesses before the Congress, Treasury and the national office of the IRS; transactional planning for domestic and multinational corporations; complex audit and controversy work for corporations and other business interests contesting IRS adjustments; litigation before the Tax Court, Court of Federal Claims, district courts, courts of appeals and the Supreme Court. The firm's tax practice also encompasses all aspects of employee benefits (ERISA), executive compensation, tax-exempt organizations and charitable giving. Steptoe has an extensive state and local tax practice, representing an array of business clients on complex sales and use tax, corporate income tax and property tax matters, both advising those clients and handling audits, administrative appeals, and litigation for them. Read more information on Steptoe's tax practice.

• Learn more about the members of the tax practice group.