WASHINGTON WEEKLY
Keeping the Markets Informed from the Capital
June 20, 2008
In its comment letter filed in response to Notice 2008-2, SIFMA defended the current tax treatment of exchange-traded notes (ETNs) and other prepaid forward contracts. SIFMA said current law appropriately taxes ETNs and prepaid forward contracts according to the realization principle, which means that no tax should be paid on uncertain future returns until investors actually receive the returns or become unconditionally entitled to receive them in the future.
SIFMA joined a number of other financial services trade associations in a letter to members of Congress on the importance of the commodities and energy derivatives markets. The trade associations said liquid and efficient energy and commodities markets are essential to the economy and speculators play a crucial role in these markets. The trade associations warned some of the proposals to revamp the futures market regulation would be counter-productive.
The Senate began consideration of housing legislation this week. The Housing and Economic Recovery Act of 2008 establishes a new program that would allow the Federal Housing Administration (FHA) to insure up to $300 billion worth of refinanced mortgages for borrowers facing foreclosure and would create a new regulator for the housing-related government sponsored enterprises (GSEs) and the Federal Home Loan Banks (FHLBs). The bill would also expand the mortgage revenue bond program and temporarily allow municipal bonds guaranteed by the FHLBs to be treated as tax-exempt, even if the bonds are not related to housing.
For the second time in a week, a procedural motion failed to receive the sixty votes needed to move forward with debate on the House-approved tax extender bill (H.R.6049).
The House Ways and Means Committee approved a one-year alternative minimum tax (AMT) patch by a vote of 22-16.
In testimony before a joint Senate panel this week, Commodity Futures Trading Commission (CFTC) Acting Chairman Walter Lukken said the CFTC has not seen any evidence that either manipulation or excessive speculation was responsible for driving up prices.
Federal Reserve Vice Chairman Donald Kohn and Erik Sirri, Director of the Division of Trading and Markets, Securities and Exchange Commission (SEC), said the Fed and the SEC were nearing completion of a formal memorandum of understanding which would provide an agreed upon scope and mechanism for information sharing related to the Primary Dealers Credit Facility.
In a report on the economic and U.S. income tax issues raised by sovereign wealth fund (SWF) investments, the Joint Committee on Taxation warned imposing new restrictions on SWFs would have little benefit and may cause new problems for U.S. investors looking to do business abroad.
SIFMA Defends the Current Rules Governing Taxation of ETNs and Other Prepaid Forward Contracts
In its comment letter submitted to the Treasury Department and the Internal Revenue Service in response to Notice 2008-2, SIFMA defended the current tax treatment of exchange-traded notes (ETNs) and other prepaid forward contracts. SIFMA said taxpayers invest in prepaid forward contracts because of the investment opportunities they offer. Current law appropriately taxes ETNs and prepaid forward contracts according to the realization principle, which means that no tax should be paid on uncertain future returns until investors actually receive the returns or become unconditionally entitled to receive them in the future. SIFMA said the realization principal is based on fundamental tax policy concerns about taxing income that is impermanent, difficult to value and illiquid. SIFMA said as a tax policy matter, the proposed alternatives for taxing prepaid forward contracts are not better than current law. SIFMA recommended when evaluating any potential new rules for prepaid forward contracts, Treasury and the IRS be guided by the following four basic principles: 1) clarity—any new rules should be as clear and unambiguous as possible; 2) consistency—any new rules should apply a consistent set of principles and implementing rules to different types of financial instruments that have similar economic and financial features; 3) administrability—any new rules should be readily administrable by the IRS and understandable by investors; and 4) balance—new rules should strike an appropriate balance between consistency with the taxation of the assets referenced in derivative contracts and recognition that financial derivatives are complex instruments.
Financial Services Trades Send Letter on Importance of Commodities and Energy Derivatives Markets
In a letter to members of Congress, SIFMA, the International Swaps and Derivatives Association (ISDA), the Futures Industry Association (FIA), the Managed Funds Association (MFA), the Investment Company Institute (ICI) and the Financial Services Roundtable said commodities and energy derivatives markets (including both over-the-counter and exchange traded) provide a valuable means by which businesses and individuals can hedge the risk of adverse movements in commodities prices. The markets are made up of “hedgers” who seek to hedge some sort of financial or other risk and “speculators” who are willing to take on the risk in the hope of making a profit. Both hedgers and speculators are needed for a market to serve its price-discovery function. The trade associations said blaming speculation or any specific trading practice for rising or falling commodity and energy prices without real evidence of wrongdoing is misguided. SIFMA and the other financial trades said the futures markets and commodity regulators already have and utilize significant regulatory authority in the form of speculative position limits, large trader reporting requirements, special call authority, as well as market surveillance resources and enforcement powers to prevent, detect and prosecute attempted manipulations. The financial services trade associations warned efforts to limit the ability of institutional investors to access derivatives would substantially harm the ability of Americans to protect themselves against inflation and would wrongly limit their investment options in general. SIFMA and the other financial services trade associations applauded Congress’ efforts to explore abusive market practices and encouraged Congress to ensure that the unintended consequences of any proposed market reforms will not outweigh any potential perceived benefits.
Senate Begins Consideration of Housing Bill
The Senate began debate of housing legislation this week. The Housing and Economic Recovery Act of 2008 establishes a new program that would allow the Federal Housing Administration (FHA) to insure up to $300 billion worth of refinanced mortgages for borrowers facing foreclosure. The government-sponsored enterprises (GSEs) would fund the new FHA insurance program with money diverted from an affordable housing trust fund included in the bill. The bill would also create a new regulator for the GSEs and the Federal Home Loan Banks (FHLBs). The new regulator would be required to issue regulations establishing criteria governing the portfolio holdings of the GSEs to ensure the holdings are backed by sufficient capital and are consistent with the mission and the safety and soundness of the GSEs, and would allow the regulator to temporarily increase the minimum capital levels of the GSEs if the regulator determines it is necessary and consistent with the safety and soundness of the enterprise. The Housing and Economic Recovery Act would set the high cost loan limit for the loans the GSEs can purchase to 150 percent of the conforming loan limit (currently $625,000). The bill also increases the FHA loan limit from 95 percent to 110 percent of area median home price with a cap at 150 percent of the GSE limit (currently, $625,000).
The tax title of the Housing and Economic Recovery Act of 2008 would expand the low-income housing tax credit by increasing the state allocation limits. The bill would create a temporary refundable tax credit for first-time homebuyers equal to 10 percent of the purchase price of the home (up to $7,500). The credit must be paid back to the government over 15 years. The tax title also increases the private-activity bond volume cap for mortgage revenue bonds (MRBs) by $10 billion in 2008 to provide loans to first-time homebuyers and to finance the construction of low-income rental housing and refinance certain subprime loans. The bill permanently exempts interest from tax-exempt housing bonds (including MRBs) from the alternative minimum tax (AMT). Under the bill, states would be allowed a one-time refunding of bonds used to finance low-income housing projects that are reissued within four years of the original issuance. The bill would also update the tax-exempt housing bond rules to conform certain aspects of these rules to the low-income housing tax credit rules. In addition, the tax title temporarily allows municipal bonds guaranteed by FHLBs to be treated as tax-exempt, regardless of their use. The bill would also expand the qualifying uses of single-family mortgage revenue bonds to victims of presidentially-declared disaster areas. The proposal would apply to bonds issued after May 1, 2008 and prior to January 1, 2010. The cost of the bill is offset with: 1) a modified credit card reporting provision, 2) a reduction in the capital gains exclusion for vacation homes, and 3) several penalty provisions relating to the filing of tax returns.
A motion to waive a budgetary point of order on an amendment offered by Sen. Christopher Bond (R-MO), which would have eliminated the expanded FHA loan program, failed by a vote of 21-69, ultimately defeating the amendment. The Senate also defeated a second amendment offered by Sen. Bond, which would have prohibited the GSEs from funding the bill’s affordable housing fund and the FHA loan program, by a vote of 11-77. An amendment offered by Sen. Jim Bunning (R-KY), which would have sent the bill back to the Senate Banking Committee with instructions to report what financial benefits Countrywide would receive from the bill failed 11-70. In a statement of administration policy released this week, the administration said the president’s senior advisers would recommend the president veto the bill in its current form. The administration supported certain provisions in the bill, including new regulatory oversight of the GSEs. The administration opposed the creation of the affordable housing fund, the bill’s provisions to provide block grants to allow States to purchase foreclosed properties and the bill’s provision that would permit bonds guaranteed by the Federal Home Loan Banks to be exempt from Federal income tax even if those bonds are not related to housing. The administration said it opposed an increase in the conforming loan limits beyond a reasonable level based on median area home prices, as calculated by the Office of Federal Housing Enterprise Oversight. Debate on the Housing and Economic Recovery Act is expected to continue next week.
Procedural Motion on Tax Extenders Fails Again in the Senate
For the second time in a week, a procedural motion on the House-approved tax extender bill (H.R.6049) failed to receive the sixty votes needed to move forward. The Senate voted 52-44 to proceed to the Renewable Energy and Jobs Creation Act of 2008, which would extend a number of expired or expiring tax provisions for one year, including the active financing exception under Subpart F. The bill would also authorize $2 billion in clean renewable energy bonds (CREBs); authorize $3 million in tax-credit Qualified Energy Conservation Bonds; extend the authority for qualified green building and sustainable design project bonds and authorize an additional $400 million in qualified zone academy bonds (QZABs). Under H.R.6049, Davis-Bacon prevailing wage requirements would be imposed on projects financed with CREBs. The Renewable Energy and Jobs Creation Act of 2008 is fully offset with three provisions: a provision that would delay for ten years the effective date of the worldwide interest allocation election that would otherwise take effect next year; a provision that would impose current taxation on deferred compensation plans in countries in which the U.S. does not have a tax treaty; and an extension of coal excise taxes.
If and when the Senate invokes cloture on H.R.6049, Senate Finance Chairman Max Baucus (D-MT) plans to offer his legislation, the Energy Independence and Tax Relief Act (S.3125), as a substitute. S.3125 contains many of the same tax extender provisions as the House bill. However, unlike the House-approved bill, S.3125 includes a one-year alternative minimum tax (AMT) patch. The AMT patch included in S.3125 is not offset. The Energy Independence and Tax Relief Act does not require qualified CREB projects comply with Davis-Bacon prevailing wage requirements. The Baucus substitute is paid for by extending the coal excise tax through 2018; imposing current taxation on deferred compensation plans in countries in which the U.S. does not have a tax treaty; delaying for nine years the effective date of the worldwide interest allocation election that would otherwise take effect next year; and modifying the definition of a dependent with respect to various tax code provisions.
Ways and Means Approves Paid-For AMT Patch
The House Ways and Means Committee approved a one-year alternative minimum tax (AMT) patch by a vote of 22-16. The Alternative Minimum Tax Relief Act of 2008 (H.R.6275) would increase the exemption levels to $46,200 for individuals and $69,950 for married couples filing jointly for 2008 and allows personal credits to be claimed against the AMT for one year. The $62 billion cost of the bill is fully offset by provisions, which would: 1) tax carried interest at ordinary income tax rates rather than at the capital gains rate; 2) limit the 199 manufacturing deduction for oil and gas companies; 3) modify the tax withholding for deductible payments made between parent companies and subsidiaries; 4) require information reporting by banks and other institutions on reimbursements to merchants that accept electronic forms of payment, such as credit and debit cards; 5) allow the federal government to attach a continuous levy to vendors of property if the vendors owe the government taxes and 6) change the corporate estimated tax payment rules. The Ways and Means Committee defeated an amendment offered by Rep. Phil English (R-PA) that would have struck the revenue offsets from the bill by a vote of 16-21. An amendment offered by Rep. Kevin Brady (R-TX), which would have struck the provision limiting the 199 manufacturing deduction for oil and gas companies and would have increased the mileage reimbursement rate to reflect the increase in gas prices was defeated by a vote of 17-20. The Committee also defeated a second amendment offered by Rep. Brady that sought to create a carve-out for real estate partnerships from the carried interest proposal by a vote of 16-21.
Joint Senate Hearing Examines CFTC Oversight
Commodity Futures Trading Commission (CFTC) Acting Chairman Walter Lukken told members of the Senate Agriculture Committee and the Senate Appropriations Subcommittee on Financial Services and General Government during a joint hearing this week, the CFTC has undertaken several initiatives to enhance oversight of the energy and agriculture markets in the last nine to twelve months and the CFTC has not seen any evidence that either manipulation or excessive speculation was responsible for driving up prices. Lukken said the CFTC has taken steps to increase information and transparency; ensure proper market controls; continue aggressive enforcement efforts; and improve oversight coordination. He also told the committees about modifications to the CFTC’s no-action letter for foreign boards of trade (FBOT) that would require other foreign exchanges to provide the CFTC with comparable trader reports and to impose comparable position and accountability limits for any products linked to U.S. regulated futures contracts. He said international recognition between regulatory authorities and exchanges will improve the transparency of the markets and facilitate greater oversight. Lukken warned raising margin requirements may drive investment to other foreign markets and requiring higher margins on long and short positions would be a dangerous precedent. Acting Chairman Lukken also told the committees the CFTC would provide to Congress by September 15 its analysis of data obtained as a result of its call for detailed trading data from swaps dealers and index traders.
Senate Appropriations Subcommittee on Financial Services and General Government Chairman Richard Durbin (D-IL) said the recent volatility in prices indicates something beyond supply and demand fundamentals. Senate Agriculture Chairman Tom Harkin (D-IA) said the Committee has all of the necessary information and will move forward on the CFTC nominees as quickly as possible. Senate Agriculture Ranking Member Saxby Chambliss (R-GA) discouraged any additional regulatory legislation until the CFTC is able to collect more data and implement the new authorities granted under the farm bill. Senate Appropriations Subcommittee on Financial Services and General Government Ranking Member Sam Brownback (R-KS) said strengthening CFTC oversight is one aspect of addressing the recent rise in commodities prices. He said he worries speculation and commodity index funds are playing a significant role in increased oil prices.
SEC and Fed Close to Finalizing MOU
During the Senate Banking Subcommittee on Securities, Insurance, and Investment hearing on risk management, Federal Reserve Vice Chairman Donald Kohn and Erik Sirri, Director of the Division of Trading and Markets, Securities and Exchange Commission (SEC), said the Fed and the SEC are nearing completion of a formal memorandum of understanding which would provide an agreed upon scope and mechanism for information sharing related to the Primary Dealers Credit Facility and other overlapping supervisory areas. Kohn said the shared information would be used to monitor primary dealers which have financial holding companies and those that do not. Kohn also said the Fed is reviewing the temporary lending facility and considering alternatives for the future. Sirri said the SEC is directing investment banks supervised under the voluntary Consolidated Supervised Entities (CSE) program to undertake additional stress testing at the holding company level. Kohn noted the Fed is not supervising investment firms comprehensively to assess risk management, but is present to assess the adequacy of liquidity and capital. He said the Fed is redoubling its efforts to ensure the senior management of firms properly defines overall risk preferences and creates incentives for employees to comply by employing firm-wide limits and controls.
Kohn also said the Fed is encouraging firms to properly manage counterparty risk through a variety of techniques to measure potential exposure on over-the-counter (OTC) derivatives. Kohn said he supports recent industry efforts to address counterparty credit risk, and the idea of a central counterparty clearinghouse for credit derivatives and other instruments. The clearinghouse through its concentration and risk management would simplify previously complex instruments. Sirri agreed the risk management of complex instruments, such as collateralized debt obligations and derivatives, would be improved by the establishment of a central counterparty clearinghouse.
JCT Releases Report on SWFs
In a report on the economic and U.S. income tax issues raised by sovereign wealth fund (SWFs) investments in the United States, the Joint Committee on Taxation (JCT) said investment in the United States by foreign sovereigns, like that of investment by foreign private investors, is a necessary and desirable consequence of the long-term trade deficit position of the U.S. The JCT report said investments by SWFs or foreign governments more generally raise nontax policy concerns. The JCT warned imposing new restrictions on SWFs through taxes or other measures would have little benefit and may cause new problems for U.S. investors looking to do business abroad. JCT warned any new restrictions on foreign investors may be interpreted by other potential investors as an indication the United States is inhospitable to foreign investors, making foreign investment funds more expensive and ultimately reducing aggregate investment.
Bills Introduced This Week
House Financial Services Chairman Barney Frank (D-MA) introduced the Municipal Bond Fairness Act (H.R.6308), which requires Nationally Recognized Statistical Rating Organizations (NRSROs) to apply rating symbols consistently for all securities to which they are applied and states the Act does not prohibit NRSROs from issuing complimentary ratings—such as those intended to measure a security’s volatility. The bill requires the Securities and Exchange Commission (SEC) to create a system to measure NRSRO accuracy and directs the Treasury Department to collect information on the municipal bond insurance industry.
Chairman Frank also announced the details of municipal tax legislation, which would: 1) increase the annual issuance limit for bank qualified bonds from $10 million to no more than $30 million; 2) allow banks to hold such bonds without disallowing a proportional amount of interest expense deduction; 3) repeal issuer aggregation limits; and 4) index annual issuance amount for inflation. The bill would also provide a safe harbor for financial firms to hold up to 2 percent of total assets in tax-exempt municipal bonds without being required to disallow a portion of their interest expense.
Rep. James Matheson (D-UT) and Rep. Charlie Melancon (D-LA) introduced the Close the London Loophole Act (H.R.6284), which would provide the CFTC with the authority to obtain trading data from foreign exchanges operating in the U.S. through direct trading terminals. The bill would also require the CFTC to obtain an agreement from a foreign exchange that it will impose speculation limits and reporting requirements on traders of U.S. energy commodities comparable to the requirements imposed by the CFTC on U.S. exchanges prior to allowing the foreign exchange to establish direct trading terminals in the U.S. The bill is a companion to S.3129, introduced last week by Sen. Carl Levin (D-MI).
Rep. Steve Chabot (R-OH) introduced the Oil Speculation Reduction Act (H.R.6279), which would require the CFTC to obtain an agreement from a foreign exchange that it will impose speculation limits and reporting requirements on traders of crude oil contracts comparable to the requirements imposed by the CFTC on U.S. exchanges prior to allowing the foreign exchange to establish direct trading terminals in the U.S.
The Week Ahead
- On Monday, June 23, the House Energy and Commerce Subcommittee on Oversight and Investigations will examine energy speculation and price manipulation.
- The Senate Finance Committee will hold an oversight hearing on the trade agencies on Tuesday, June 24.
- Also on Tuesday, June 24, the House Ways and Means Subcommittee on Social Security will hold a hearing on ways to protect Social Security beneficiaries from predatory lending.
- The House Budget Committee will examine long-term fiscal challenges and the SAFE Commission Act (H.R.3654) on Tuesday, June 24.
- The Senate Homeland Security and Governmental Affairs Committee will examine legislative options to end excessive speculation in the commodity markets on Tuesday, June 24.
- Also on Tuesday, June 24, the House Judiciary Subcommittee on Commercial and Administrative Law will hold a legislative hearing on the Business Activity Tax Simplification Act of 2008 (H.R.5267).
- The Securities and Exchange Commission (SEC) will consider whether to propose rules related to NRSROs and whether to propose amendments to Exchange Act Rule 15a-6 during an open meeting on Wednesday, June 25
- The Joint Economic Committee will hold a hearing on oil prices and the U.S. economy on Wednesday, June 25.
- On Thursday, June 26, the House Ways and Means Subcommittee on Select Revenue Measures will hold a hearing on the role of Individual Retirement Accounts (IRAs) in our retirement system.
- Also on Thursday, June 26, the Senate Finance Committee will hold a hearing to examine international tax reform.