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Authors

James Blakey

Abstract

Credit default swaps (CDSs) gained notoriety for their role in the global financial crisis. In late 2011, the IRS proposed new regulations that would classify CDSs bought by someone who does not own the credit, known as "naked" CDSs, as "financial instruments" and thereby qualify them for the highly beneficial capital gains tax treatment. This classification is incorrect. Naked CDSs, which constitute about 80% or more of all CDSs, are not financial instruments at all. Rather, this article argues, they are gambling wagers -- the winnings on which are taxable at the ordinary income tax rate. This is not the radical suggestion it may seem. In fact, Congress acknowledged that certain derivatives, including CDSs, might constitute gambling when it exempted them from "any State or local law that prohibits or regulates gaming". While the exemption decriminalized Naked CDSs, it made no change to their tax status. Under existing law, this tax rate would apply to the winnings of hedge funds and hedge fund managers through their so-called carried interests. The 20% difference on perhaps hundreds of billions of dollars of income is highly significant to a financially strapped U.S. Treasury. In addition, as gambling income, Naked CDS winnings of hedge fund managers are subject to the 2.9% Medicare tax, and most Naked CDSs are also subject to a 2% federal excise tax on gambling.

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