Predicting the taxation of prediction markets.
TABLE OF CONTENTS I. INTRODUCTION 954 II. BACKGROUND OF PREDICTION MARKETS 956 III. CURRENT TAXATION OF PREDICTION MARKETS 962 IV. PREDICTIVE DERIVATIVES ARE FINANCIAL INSTRUMENTS UNDER 965 CURRENT TAX LAW A. Taxation as a Financial Instrument: Options 965 B. Taxation as Forward Contracts 967 C. Taxation as a Financial Instrument: Notional Principal 967 D. Taxation as a Financial Instrument: Section 1256 973 Contracts E. The Illegality of Prediction Markets 976 F. Summary: Prediction Derivatives Are Financial 977 V. WHY PREDICTION MARKETS ARE NOT GAMBLING OR CONTRACTS 977 HELD AS PROPERTY A. The Income Tax Concept of Gambling 978 B. Prediction Derivatives Have Social Usefulness 981 C. Summary: Why Trading Prediction Derivatives Is Not Gambling 984 D. Taxation of Prediction Derivatives as Contractual income 984 E. Summary: Why Predictive Derivatives Are Contracts Held as Property 988 VI. CONCLUSION 989
Taxation is to the study of law what derivatives are to the study of finance: a subject matter that is both very complicated and very important. Each field is heavily technical and of little concern to most laymen. Further, the set of rules governing the taxation of derivatives is still largely unsettled. At the intersection of these two complicated fields is a new kind of purported financial instrument, a product of the internet that has been actively marketed to the masses. Generally called "prediction markets," websites host a trading system where members of the public can stake real money on their predictions concerning the occurrence or nonoccurrence of future events. Participants are able to buy and sell contracts, the value of which is directly tied to the probability of the occurrence of an event. The contracts are priced between zero (representing the perceived impossibility of an event's occurrence) and one (indicating that the market considers the event to be an established certainty). In effect, the participants in these prediction markets are betting on the occurrence of a well-defined event, the nature of which is limited only by the human imagination. Some of the most popular contracts seem to be based on political outcomes.
The terminology of this product has become as diverse as the events in which they specialize. For example, the contracts have been called "event derivatives," "nonproperty derivatives," "informational futures," and "electronic futures contracts," to name just a few terms. (1) The label "derivative" is used because these contracts are assets, the value of which depends on (or is derived from) something else. The description "nonproperty" refers to the idea that the value is based on the occurrence of an event or the level of a financial index at a fixed point in the future, instead of the future price of a commodity. Sometimes the label depends on the subject matter. For example, "political futures contracts" are based on political outcomes, like an election result. Alternatively, they have been called "binary options," because upon expiration the contract is an all-or-nothing proposition.
In contrast to the diversity of the terms, there is a unified belief among not only their promoters but also among academics in the utility and legitimacy of prediction markets. (2) The exchanges have been praised as more accurate than political polls, (3) and some exchanges have even been used by some well-known companies as marketing tools. (4) Other prediction markets are used merely for recreational purposes (using fake money). (5) Yet, the legality of real-money prediction markets is in serious question. In the view of some, trading in such contracts constitutes gambling and violates both federal and state laws. (6)
The tax treatment of prediction markets is an equally contentious issue--or, at least, it should be. To date, federal tax law gives little guidance on how to treat gains and losses from these types of contracts. As a result, the actual taxation proceeds at the discretion of the taxpayer reporting the income. In fact, only one exchange, HedgeStreet, puts a tax label on its contracts. Other taxpayers might genuinely consider the activity to be gambling, investing, or some other occupation entirely. The lack of federal guidance on how to characterize proceeds from prediction contracts also enables taxpayers to elect inconsistent tax treatments for gains and losses from year to year in order to achieve the most beneficial tax result. In sum, there is a lack of consensus and awareness about the taxation of this type of income, a type that is growing exponentially.
In response, this note first aims to discuss what is known about the current taxation of prediction markets. This note then attempts to answer how they should be taxed under current tax law and concludes that prediction derivatives based on political and financial events should best be considered forward contracts under current tax law. Part II summarizes the development of prediction markets. Part III discusses the current lack of consensus on their tax treatment. Three specific prediction markets are examined: Intrade, HedgeStreet, and Iowa Electronic Markets. In Part IV, the case is made that prediction derivatives are best understood as forward contracts under current tax law. Part V elaborates on this point by discussing why prediction futures do not represent gambling or mere income producing contracts held by the taxpayer as property. Finally, the conclusion, Part VI, reaffirms the proposition that prediction contracts are forward contracts and thereby creatures of finance.
II. BACKGROUND OF PREDICTION MARKETS
Prediction markets are created for the purpose of making predictions. Contracts are created between two parties, the market value of which is continually dependent on the probability of the eventual occurrence or nonoccurrence of a certain event, such as the election of a candidate. Alternatively, a prediction contract's value could be dependent on the eventual value of an index upon a set date, for example, the median housing price in a given real estate market. The current market price for such a contract can then be interpreted as an expression of the event's probability. Because these contracts may be traded amongst many exchange members, there is said to be a prediction market. There are three prediction markets where the majority of Americans make their predictions with real money: Iowa Electronic Markets, Intrade, and HedgeStreet.
Iowa Electronic Markets (IEM), the oldest of the modern exchanges, dates back to just before the 1988 Presidential election. (7) Organized by the Tippie College of Business at the University of Iowa for classroom purposes, the website has since expanded tremendously. (8) It now allows the general public (including foreign individuals) to trade on a limited assortment of political and economic outcomes, such as presidential nominations and elections and stock price returns. The goals of the IEM are to serve as an educational tool and generate data for research purposes. In contrast, Intrade, incorporated since 2001, operates as a for-profit exchange based out of Dublin, Ireland. (9) Intrade offers markets in domestic and international politics and pieces of legislation, as well as contracts based on the weather, current events, and financial indicators. Intrade states that it has over 70,000 members and takes orders from over 100 countries. (10) In contrast, HedgeStreet allows only U.S. individuals or organizations to trade contracts on its website. (11) HedgeStreet offers only informational futures that have a financial aspect to them (that is, no political futures). Among the most popular contracts are those based on foreign exchange rates, housing prices, the consumer price index, weather indicators, or even the price of gold.
In some ways, prediction markets, especially those involving contracts based on political events, are not new. During the turn of the last century, newspapers, such as the New York Times would publish daily quotes in the weeks before a presidential election. (12) The 1916 election, for example, witnessed some $165 million (in 2002 dollars) wagered on the organized New York markets. (13) Comparatively, modern online prediction markets are smaller. Nonetheless, Intrade garnered $15 million in trade volume for the Bush reelection contract during a year-and-a-half of trading activity. (14) Modern and antiquated political prediction markets do share a great deal in common. Then, as now, they serve as a reliable substitute for polls. It is generally thought that these markets provide an aggregation of all available information about the probability of an event's occurrence, and they create incentives for people to both seek information and provide truthful information. (15) In contrast to traditional polls, the markets also purportedly capture the strength of people's beliefs. (16) Simply stated, the confident will trade more. Academics consider prediction market numbers superior to polling data for another reason: the information can respond in real time to campaign gaffes and breaking news stories. (17)
The actual aggregators of information, the traders, are not necessarily aware of the grand implications for economic and statistical theory. In fact, the motivation to trade varies from member to member. Political markets at both turns of the century have been motivated by both pride and profit. (18) Prediction markets allow traders to "put their money where their mouth is." Accordingly, there is an emotional element seldom present in traditional futures trading. Studies published by the professors of the University of Iowa who run the oldest electronic political futures markets, IEM, have noted that "[t]raders are biased and mistake-prone. (19) These markets involve more than traders' objective projections about political outcomes. HedgeStreet claims that futures based on financial indicators allow its members to hedge against individual economic risks; for example, traders can hedge against the costs of rising gasoline by betting that the price of oil will go up. (20) Thus, just as there is no one single kind of prediction market, there is no one impetus to trade.
Does the culmination of these disparate motivations have any effect on the accuracy of the markets? Yes, they arguably make the markets more efficient. When the emotionally misguided or the partisan invest in their candidate, they are simply "leav[ing] money on the table" for more astute traders. (21) Thus, the incentive for the market to re-align with reality is strong. Regardless of their recreational motive, speculators and partisans serve a two-fold purpose: they provide liquidity and thereby prompt even more liquidity. As a result, the markets' popularity does not undermine their effectiveness.
These amateur investors can learn the basics of trading in minutes. In their current incarnation, prediction markets generally work as follows. First, the website establishes a contract. The contract pays an amount of money (usually $10 or $100) upon the occurrence of a well-defined event. Participants set up accounts and fund them with money by credit card or bank wire. Consequently, they are able to "buy" and "sell" the contracts. A member buys the contract if he or she believes the event will occur. A member sells the contract if he or she believes the event will not occur. Buyers put forth "bid" offers and sellers maintain "ask" prices. The exchange matches offers from buyers and sellers. The buyer pays the price of the contract and the seller puts forth the difference between the defined payout (usually $10 or $100) and the price. All contracts settle in cash.
Example 1: Zhanna, a self-described news junkie living in New York, is convinced that Newt Gingrich will seek and win the 2008 Republican nomination. On June 1, 2007 she signs onto an online exchange and makes a bid offer of 1000 contracts priced at $0.80 each. The contract pays out $10 upon Gingrich's nomination (as defined by the contract's terms). $0.80 was the price at which the last contract was traded. It means the market thinks there is an 8% chance Gingrich will secure the nomination. The next day, Pauline, sitting in an internet cafe in Paris, observes the outstanding bid. Feeling that Gingrich has no chance, she makes an offer to sell 1000 contracts at Zhanna's bid price of $0.80. The contracts are immediately executed. Pauline and Zhanna do not know each other and do not know the other one is on the other side of the contract. Pauline has accordingly put up $9200 for a perceived 92% chance to win $10,000. Zhanna has put up $800 for an 8% chance to win $10,000. On July 1, 2007, Gingrich announces his candidacy and the trading price of the contract increases, reflecting a perception that Gingrich's chances at the nomination are better. The following year, Gingrich is declared the winner and the contract settles. Zhanna collects the $10,000 and has made a net profit of $9200. Pauline has correspondingly lost $9200.
Participants need not hold the contract until settlement in order to make a profit. The price of a purchased contract may rise. The price of a sold contract may fall. In order to capture that profit, the buyer or seller must execute another trade. The trade must be the opposite of the original trade. Although participants are entering into another contract, the exchanges generally do not require them to have adequate capital in their accounts because entering into the second, contrary position automatically closes out both positions. The participant's account is immediately credited with both the original capital plus any gain or less any loss.
Example 2: On June 1, 2007, Oleg, an energy consultant in Kiev, Ukraine, has read internal corporate reports suggesting that the price of oil will soon drop as the result of rumored political developments in Iran. At 9 a.m. EST, the price of oil is $55 per barrel. At his job, he signs onto the online exchange, and makes an offer to sell 1000 contracts at $2.00 each, which pay out $10 each if the price of oil at the close of trading is higher than the opening price of $55. The price reflects the perception that an increase in the price of oil is 20% likely and 80% unlikely. Immediately, 300 contracts of his order are traded with Jon, who has an outstanding bid of 300 contracts at $2. Jon is a retired executive of a major oil company living in Arizona. He charts the price of oil daily and feels he can earn a better return trading informational futures than with a traditional stock portfolio which affords him no sense of control. Both the bid price and quantity were known to Oleg. Thus, after the trade, Oleg has risked $2400 and Jon has risked $600. The contract's last traded price stands at $2.00. Hours later, Oleg is becoming nervous about the price of oil and believes it might rise after all. Now he wants to get out of the market altogether. The contract price, as indicated by the last traded price, is $1.10. Therefore, he cancels his remaining still unfulfilled orders and wants to capture the gain inherent in his position. The gain can be measured by the difference between the price he paid for the contract and the current market price. To capture this gain, Oleg must make a bid offer at a price which is below $2, the price Oleg paid per contract. Unfortunately, the market is very illiquid, but he manages to buy 200 contracts at $1.20. The online exchange immediately credits him with a $160 gain ($0.80 gain on each of the 200 contracts). In addition there is a return of capital of $1600. With respect to those 200 contracts, Oleg is considered to have closed his position. Observe that he is still short 100 contracts. In contrast, Jon maintains his position and is determined to wait until settlement of the contract. At 5 p.m. EST, the contract expires and the price of oil stands at $54. Thus, the 100 contracts pay $10 each to Oleg. In sum, Oleg has made $1160 on a "wager" of $2400. Jon, however, receives nothing and loses the $600 "wagered."
With the exception of IEM, exchanges make money by charging fees. (22)
Similar to the situation at the turn of the century, the legal status of prediction markets is not entirely clear. For example, Illinois has banned betting on political outcomes. (23) This kind of action is sanctioned by the constitutional police power of the states. (24) Because most gambling, especially that which occurs over the internet, involves interstate commerce, the federal government may also exercise regulatory power. To that end, in 2006, the U.S. Congress passed and President Bush signed the Unlawful Internet Gambling Enforcement Act (UIGE) (25) . Previously, the federal government attempted to regulate internet gambling under the Wire Act. There is a debate as to what exactly is prohibited under the acts. (27)
Because prediction markets peddle in so-called futures contracts, the legality of their operation possibly becomes even more complicated. Futures contracts, traditionally based on commodity prices, generally fall under the regulatory oversight of the Commodity Futures Trading Commission (CFTC). (28) A purported futures market not regulated by the CFTC or exempt from CFTC regulation might be illegal. (29) IEM, for example, operates under a 1992 No-Action Letter issued by the CFTC. (30) HedgeStreet is a CFTC designated market." This right of oversight became very real when the CFTC fined Intrade $150,000 for soliciting U.S. citizens to trade on commodity options contracts that were not regulated by the CFTC nor exempt from their oversight. (32) Intrade agreed to pay the fine and stop trading contracts based on the value of foreign currencies. (33)
III. CURRENT TAXATION OF PREDICTION MARKETS
What is known about the current federal taxation of prediction markets? Not much. When the online exchanges have been asked about taxation issues, Iowa Electronic Markets has been the most forthcoming. (34) IEM neither reports nor withholds on the income of its participants. Early on, the IEM consulted an attorney's opinion about tax issues. The attorney believed that because the IEM operates as an exchange and does not operate as a broker, there was no obligation to report to the Internal Revenue Service (Service).
Intrade, in stark contrast, did not reply to e-mails asking for their views on how political futures should be taxed. Its website states that a concerned member should seek professional tax advice in the appropriate jurisdiction. (36) Intrade apparently neither reports nor withholds income for the Service, or for any other tax agencies in the over 120 jurisdictions in which it claims to do business. (37)
HedgeStreet representatives explained the firm's approach to taxation. (38) The exchange reports income to the Service and issues members a Form 1099B showing gains and losses on positions held during the tax year. HedgeStreet considers its traded contracts to be "regulated futures contracts" within the definition of section 1256. (39) Taxpayers are instructed to file a Form 6781 and claim section 1256 treatment of the resulting net gain or net loss. Although explained below in greater detail, section 1256 essentially recharacterizes the outcome as 60% long term and 40% short term capital gain or loss. (40)
As mentioned above, none of the three exchanges withhold on income. Withholding is usually thought of in the context of wages. However, under section 3406(a), back-up withholding of 28% on reportable payments is mandated if the payee does not provide a social security number. (41) Reportable payments include payments made by brokers to their customers. (42) Included in the definition of "broker" are "dealers" and "barter exchanges," which are defined as "any organization[s] of members providing property or services who jointly contract to trade or barter such property or services." (43) None of the three exchanges seem to withhold under the back-up withholding rules. HedgeStreet would not be subject to back-up withholding rules because it does collect a social security number from its participants. Intrade, as a foreign payor, does not have to file a return with respect to the payments at issue and is thus not subject to the back-up withholding rules. (44) IEM, as stated above, believes it is not a broker within the definition of the statute requiring withholding. (45)
The importance of reporting and withholding cannot be understated. Taxpayers' interest in prediction markets is emerging amidst lawmakers' interest in closing the so-called "tax gap." (47) Broadly speaking, the tax gap is the difference between the money which taxpayers owe and that which they voluntarily pay. (48) According to the Treasury Department's Office of Tax Policy, the tax gap is estimated to stand at $345 billion for the 2001 tax year. (49) The biggest cause of a widening tax gap is the underreporting of income by individuals in activities where no reporting requirements exist. (50) Prediction markets therefore present excellent candidates for tax gap reform.
The current taxation of prediction markets is not well understood. It is certain, however, that there is a need for reassessing the taxation of prediction markets under current federal tax law. Implicit in this certainty is another proposition: that gain from prediction markets is includible in gross income under the U.S. tax code.
In order for an item of income to be taxed, it must be included in a taxpayer's gross income under the Internal Revenue Code (Code). The Code defines "gross income" for federal tax purposes as "all income from whatever source derived." (51) The definition extends broadly to all accessions to wealth or economic gains not otherwise exempted elsewhere in the Code. (52) Under section 61(a)(3), gains from property are specifically includible in gross income. (53) Awards and prizes are includible under section 74(a). (54) Income from prediction markets, whether considered property or prize, is thus includible under either Code provision. If neither provision seems to specifically provide for this type of income, it is undeniably an accession to wealth. Taxpayers are economically better off having won the money associated with the settling of a binary option. Therefore, prediction markets give rise to gross income under section 61. It is simply a question of how this income is or ought to be taxed.
This note takes the view that this debate turns on where information futures fall on a spectrum between gambling and financial instruments. The analysis does not necessarily end once a choice is made. For example, different financial instruments are taxed differently. Tax law, like most areas of the law, concerns itself with categories and corresponding consequences. In other words, first we decide what certain proceeds are, and then we will usually know how they should be taxed. This note discusses three possible regimes of taxation that could apply to prediction market proceeds: taxation of financial instruments, gambling wins and losses, and income producing contracts held as capital assets. Because this note concludes that prediction contracts should be taxed as financial instruments, specifically as forward contracts, this proposition is addressed first.
IV. PREDICTIVE DERIVATIVES ARE FINANCIAL INSTRUMENTS UNDER CURRENT TAX LAW
Prediction markets are designed to look and sound like instruments of finance. Individuals often enter into these transactions for similar purposes: to hedge, profit, or to speculate. Moreover, prediction markets allow individuals access to products which mimic financial tools not generally used by the general populace. But are they financial instruments and, if so, what kind? And if they are illegal in one or more jurisdictions, can they still be considered financial instruments?
A concise treatise about the taxation of financial instruments is beyond the scope of this article. The way the Code deals with novel financial instruments has often been described as fitting square pegs into round holes. Ten years ago, in an article entitled Gambling on Uncertainty--The Federal Income Tax Treatment of Weather Swaps, Cat Options and Some Other New Derivatives, Thomas Humphreys evaluated the tax consequences of so-called weather derivatives and other new derivatives under the various rules for different financial instruments. (55) Humphreys describes weather derivatives as "based upon the temperature for a given region during a given time period. The contract parties speculate on the temperature with one party being paid if the weather is colder or warmer than normal depending on the direction of the bet." (56) In his analysis of these new derivatives, Humphreys posits there are five general kinds of financial instruments for federal income tax purposes: stock (equity), debt, options, forwards (including futures), and notional principal contracts. (57)
This paper extends this analysis to prediction markets. First, it should be clear that prediction derivatives are clearly not some species of equity or debt. Their participants have no ownership interest in a going concern or business. In other words, no equity is exchanged. Likewise, prediction markets should not represent a debt obligation. Market participants do not advance funds to one another, nor are there payments of interest that in any sense reflect the time value of money.
Rather, if a prediction futures contract is a financial instrument, the most general label that would appropriately describe such a contract would be a derivative. Broadly speaking, a derivative is a contract between two parties representing the right to and obligation of one or more payments, whose value is derived from the value of an underlying asset or underlying reference rate or index. (58) However, the issue is not resolved once a determination is made whether informational futures are a veritable derivative. The next question is: what kind of derivative is it? Federal tax law essentially recognizes three types: options, forwards, and notional principal contracts. (59) In addition, certain forward and option contracts qualify as "regulated futures contracts" under section 1256. (60)
A. Taxation as a Financial Instrument: Options
Although not defined in the Code, an option is generally thought to be an instrument comprised of the right to buy or sell some underlying property at a set price. (61) Options can further be divided into puts and calls. Puts represent an option to sell certain property at a specified price at or before a certain time in the future. (62) Calls allow the holder to purchase certain property at a specified price at or before a certain time in the future. (63) The tax consequences are not clear until one of three events occur: (i) expiration of the option, (ii) exercise of the option, or (iii) transfer of the option to a third party. (64) Under section 1234, the resulting gain or loss for the holder of the option from any of these outcomes is of "the same character as the property to which the option relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him)." (65) Because capital treatment is generally predicated on a sale or exchange, courts struggled with the character of gain and loss when holders cancelled or otherwise terminated their options. (66) After a 1997 amendment to the Code, section 1234A extends capital treatment to these situations. (67) It should be clear, incidentally, that prediction derivatives are not options under the Code. Prediction market traders are not paying for the right to subsequently buy property at a pre-established price.
B. Taxation as Forward Contracts
A forward contract is a privately-negotiated agreement between two parties for the purchase and sale of a commodity or other property on a fixed date for a specified cash price. (68) Forward contracts are generally given the same "wait and see" treatment accorded to option contracts. (69) This is the case "despite the lack of cases or rulings that specifically address the basic federal income taxation of forward contracts." (70) Code provisions also do not establish the general tax regime of forward contracts. Section 1234A does, however, extend capital treatment to situations where financial contracts (including forwards) are cancelled or otherwise terminated. (71)
At first glance, prediction derivatives appear to be futures and not forward contracts. Unlike forward contracts, which are traded over the counter, futures contracts are exchange-traded agreements for the purchase or sale for a specified price on a regular future delivery date of a standard quantity and quality of a commodity or other property. In the United States, however, where something is traded can determine its tax treatment. For example, the only "futures contracts" mentioned under the Code are "regulated futures contracts," which are traded on a qualified board or exchange that maintains a system of margin requirements. (72) Section 1256 generally imposes mark-to-market taxation on regulated futures contracts in exchange for gains and losses deemed 60% long-term and 40% short-term capital gain or loss. However, for reasons explained below, this section is inapplicable to prediction derivatives, as currently traded.
Assuming these prediction contracts fall outside the scope of section 1256, they do clearly resemble forward contracts. As stated above, the general treatment of forward contracts is not covered by a comprehensive provision in the Code. Instead, they are generally thought to be taxed under the wait and see approach generally applicable to options. (73) Like option contracts, the character of the gain or loss depends on the nature of the underlying property.
The taxation of forward contracts is straightforward, but are prediction derivatives forward contracts for tax purposes? Two questions quickly become apparent when attempting to fit informational futures under the rubric of forwards: (1) Does there exist underlying property such that the character of the income and losses from a forward contract may be determined? (2) If so, is that property a capital asset in the hands of a taxpayer?
As explained above, the taxation of forwards is generally not provided for in the Code. Instead, there is section 1234A, which simply operates to eliminate the sale or exchange requirement otherwise applicable to forward (and other) contracts. (74) Section 1234A contains no specific definition for property in the context of "underlying property" of forward contracts. Indeed, property has more than one definition in the Code. Under section 1234, property is, however, specifically defined for the treatment of options as meaning "stocks and securities (including stocks and securities dealt with on a 'when issued' basis), commodities, and commodity futures." (75) Because forward contracts are taxed similar to options, this specific definition of property could be of particular importance. For example, the underlying property of prediction derivatives, if any, clearly does not fit within the definition under section 1234. Does this narrow definition rule out the possibility that predictive derivatives have some sort of underlying property?
Humphreys considers this narrow definition of property when evaluating whether catastrophe indices are options for federal tax purposes. (76) He points out the widespread practice of cash settled options, where according to the terms of the option, settlement will be or could be in cash instead of delivery of the underlying property. (77) In essence, Humphreys posits the question: does the ubiquitous acceptance of cash settlement options mean that options that inherently cannot settle in property should also be options for federal tax purposes? (78)
Further, Humphreys argues that the indices are a sort of stand-in for concrete property. (79) The index symbolically represents real damages to concrete property. (80) Humphreys' stand-in property analysis is persuasive, especially with regard to information futures based on traditional financial indicators like the price of commodities. The binary options are a stand-in for dealing in the commodities. This is a vicarious form of investing which indirectly allows new groups of investors to access investments previously unavailable to them. This analysis also comports with HedgeStreet's view that their contracts allow consumers to hedge against products they use on a daily basis, like gasoline.
Applying this analysis to political futures becomes even more difficult because perception of a political campaign is not a stand-in for any sort of commodity. However, the right to be paid a certain amount based on the continually evolving perception and eventual reality of an event's occurrence or nonoccurrence is not entirely unlike a property interest. The definition of property and a property interest have always been limited only to the human imagination. Information and, in particular, political futures are very similar to intangible property.
An intangible asset is a right or privilege that is of some value to an individual or business, but one that has no physical substance (81). Information futures certainly have value (indeed they arise from a market dedicated to their valuation), are usually alienable, and cannot be said to have a physical embodiment. The idea of information as a useful commodity is gradually gaining support in the business and legal worlds. (82) In his book Infotopia: How Many Minds Produce Knowledge, Cass Sunstein explains their role in disseminating valuable information:
A central advantage of prediction markets is that they give people the right incentive to disclose the information they hold. People stand to win money if they get it right and to lose money if they get it wrong. Recall that in a deliberating group, members may have little incentive to say what they know. By speaking out, they provide benefits to others, while possibly facing high private costs. Prediction markets realign incentives in a way that is precisely designed to overcome these problems. People can capture, rather than give to others, the benefits of disclosure. Because investments in such markets are generally not revealed to the public, investors need not fear that their reputation will be at risk if, for example, they have predicted that a company's sales will below or that a certain candidate will be elected president. (83)
Legal, business, and academic circles appear to embrace investing in an instrument which aggregates and reveals privately held information. Indeed, they arguably regard privately held information (and not the events wagered on) as the ultimate intangible property interest behind prediction derivatives. Tax law also recognizes the existence and validity of intangible property in more than one section of the Code.
For example, intangible property has been held in numerous circumstances to be within the definition of property for purposes of its transfer to a newly formed corporation in exchange for a nonrecognition receipt of an equity interest in the corporation under section 351. (84) Certainly the contribution of political futures, which are by their nature easily capable of valuation, might be of use to capitalize a new corporation. This is especially the case if they somehow relate to the hedging needs of the new business. Thus it is not far-fetched that privately-held information qualifies as intangible property for purposes of the Code.
Of course, under intellectual property law, possession of and right to disclose privately held information may not always be a property interest. The mechanism of prediction markets demonstrates that for tax purposes, however, this ability or right resembles a kind of intangible property interest.
Moreover, a determination of whether prediction derivatives have underlying property sufficient to qualify as forward contracts is a different analysis from Humphrey's analysis of catastrophe indices under the narrow definition of property for option contracts. There is no clear reason why the definition of property under section 1234 for option contracts should control for purposes of forward contracts. Forward contracts are admittedly taxed in a similar manner as options but they are a separate, distinguishable financial instrument from options. Thus, what is property for option contracts is not necessarily the same as property for forward contracts.
For example, section 1234 applies solely to option contracts. In contrast, forward contracts are subject to 1234A (and only when forward contracts are terminated or cancelled). As stated above, this section contains no definition of the term property. Interestingly, section 1234A was introduced to ensure capital gain and loss treatment where a contract pertaining to property was cancelled or terminated. (85) This provision was designed to stop taxpayers from claiming ordinary losses when a financial derivative or other contract pertaining to property (like a forward contract) was cancelled or terminated. (86) Thus, section 1234A can be said to generally extend capital treatment to gains and losses generated from forward contracts pertaining to property.
There is also strong evidence that the definition of property in section 1234 should not be used to construe the term property in 1234A. This is because, when section 1234A was introduced, the statute referred to "personal property" as defined in section 1092. In 1997, Congress replaced the term personal property, as defined by section 1092, with the more general term "property." Nowhere in the legislative history accompanying the 1997 Amendment does Congress hint or state that the definition in section 1234 is being referenced. (87) Instead, the legislative history makes clear that the amendment does not affect what constitutes property." (88) Further, it cites an example of an interest in real property as being property under section 1234A. (89) This interest would certainly not qualify under the definition of property under section 1234. (90) The latter should therefore not be controlling in ascertaining what may constitute underlying property under a forward contract.
Thus, there is a strong argument that prediction derivatives do have underlying property to qualify as what they otherwise appear to be: a very novel kind of forward contract. The argument unfolds in two steps. First, (privately held) information serves as an underlying property because of its similarities to other kinds of intangible property interests currently given legal recognition. Second, this underlying intangible qualifies as property under the generally accepted understanding of federal tax treatment of forwards, including the purposively broad definition of property under section 1234A. This argument only becomes stronger because of the awkward fit of other tax regimes to prediction derivatives, as demonstrated below.
Finally, assuming prediction derivatives can be said to have underlying property, there remains the question of whether this property is a capital asset in the hands of the taxpayer. However, it is a fairly straightforward inquiry. Property held by a taxpayer is a capital asset unless it falls within one of the exceptions under section 1221. These exceptions do not apply in the case of most individuals trading prediction derivatives. Thus, the underlying property for individual traders on prediction markets would be considered a capital asset.
If the contracts are forward contracts, the taxation of prediction markets would be remarkably different than, for example, that of gambling proceeds. The gains or losses would be capital in character. Therefore, if the contract was held for more than a year, any gain would be taxed at the preferential long-term capital gains rate. Section 1211 limits deductions of capital losses in excess of capital gains against other items of ordinary income to $3000 per taxable year. (91) However, these losses may be carried indefinitely forward, subject to the same limitation each year. Further, a taxpayer could conceivably deduct expenses due to the production of income under section 212 without having to be in the trade or business of trading prediction futures. (92)
Example 3: In the last tax calendar year, Hawley speculated on various political futures, recording gains of $10,000 and losses of $15,000. All the contracts are held for less than a week. The service determines these contracts are options. Hawley has $5000 in short-term capital loss. Thus, she can deduct $3000 of the loss against other items of ordinary income. The remaining $2000 in losses are not currently deductible but may be carried over to subsequent taxable years, subject to the same limitations.
C. Taxation as a Financial Instrument: Notional Principal Contracts
Treasury regulation section 1.446-3 defines the term "notional principal contract" (NPC) as any "financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." (93) "Specified index," in turn, is defined as "[a]n index that is based on objective financial information." (94) That the definition of notional principal contracts is located in the regulations pursuant to a Code section detailing timing rules is an example of the make-shift character of tax rules concerning financial instruments. As currently structured, informational futures do not represent notional principal contracts. Prediction markets feature contracts which pay out only once. The payout is not based on a notional amount; rather it comes from the other party. Indeed, prediction markets also do not enable the timing abuses, which would necessitate the need for a regime like the one for NPCs. Also, it is not certain that all event based contracts, especially those based on political outcomes, would qualify as objective financial information. Therefore, prediction derivatives are clearly not NPCs.
D. Taxation as a Financial Instrument: Section 1256 Contracts
As discussed above, HedgeStreet is the only exchange to take a position on the taxation of its contracts, and it advises its customers to claim the traded contracts are regulated futures contracts under section 1256. Under section 1256, if a taxpayer holds a regulated futures contract as a capital asset, gain or loss on the contract generally will be capital or loss. Section 1256 treats 60% of the gain or loss as long term and 40% as short term. (95) This 60/40 rule replaces the one-year holding period normally required to obtain long-term gain treatment. (96) Thus, a profit from a contract that is held for less than a day may be partially afforded the reduced rates of taxation of long-term capital gain. To qualify as a regulated futures contract, it must be a contract (1) "with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market" and (2) "which is traded on or subject to the rules of a qualified board or exchange." (97) The second requirement is clearly met. Section 1256 specifically states that this requirement is satisfied if the contract is traded on "a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission." (98) HedgeStreet is such a designed contract market.
The first requirement is not as easily satisfied. Legislative history explains the first requirement as a reference to "a daily cash flow system of the type used by United States futures exchanges to determine the amount which must be deposited, in case of losses, or the amount which may be withdrawn, in the case of gains, as a result of price changes with respect to the contract during the day." (99) This daily cash flow system is usually known as the maintenance of margin accounts.
Margin accounts are usually considered essential because they represent security that a party will perform on a futures contract. A client deposits funds into an account known as the initial margin. As the market value of the member's positions increases or decreases, money is deposited into or withdrawn from the margin account. HedgeStreet has no margin accounts. The CFTC Designation Memorandum states "[t]here is no margining in the HedgeStreet system, that is, any member who purchases a contract bundle must pay the full $10.00 for that contract bundle, and any person who purchases component option in the secondary market must pay the full price for that option." (100) In other words, HedgeStreet's contracts depart from the statutory language. Instead, HedgeStreet, as explained above, requires each party to deposit their fraction of $100, the exact amount representing both the price of the contract and the perceived probability of the event occurring. The system could be described as fully collaterized.
Therefore, while HedgeStreet might offer purported futures contracts that are in fact regulated by the CFTC, these contracts arguably do not qualify as "regulated futures contracts." The financing of the contracts might be functionally equivalent to a mark to market margin system but it is not faithful to the explicit demands of the statute. Further, there seems to be little reason to expand the statutory language to encompass HedgeStreet-styled contracts. HedgeStreet contracts depart not only from the language of the statute but also its purpose. Congress enacted section 1256 to capture the profit of taxpayers whose accounts at an exchange had been credited with gains due to the appreciation of a financial position. (101) The constitutionality and rationale of the section have been upheld by the Ninth Circuit as an application of the doctrine of constructive receipt. (102) The statute was essentially enacted to fight timing abuses. HedgeStreet contracts, most of which are closed out daily, do not present such abuse of timing problems.
HedgeSteet's usurpation of a beneficial tax regime is set against a broader policy debate about section 1256 contracts. Taxpayers have long benefited from the partial preferential rate on traditional regulated futures contracts expiring well within a year's time. It has been noted that section 1256 "accords preferential long-term capital gain rates to taxpayers who have not made the long-term investment in capital assets that the rate differential is intended to encourage." (103) This results in "a complete distortion of the Code's character rules." (104) Because electronic futures contracts, as presently traded, flout both the language and spirit of section 1256, they should not be considered regulated futures contracts.
E. The Illegality of Prediction Markets
The exact legal status of prediction derivatives based on financial and political events might also affect their taxation. Assuming the futures contract in question is illegal in the taxpayer's jurisdiction, does it follow that the activity is per se gambling or at least not eligible for capital asset treatment? In other words, there is the distinct possibility that prediction markets might constitute gambling under federal or state law but, for income tax purposes, might still represent nongambling contractual payments dependent on the value of an underlying asset. Thus, the income from the contract would be illegal income. That one must report illegal income is a well-established proposition. (105) Moreover, the tax law does not distinguish between illegal or legal income, in that it is still a specific type of income (e.g., derived from a business, gambling activity, etc.). (106) Therefore, it is important to point out that this illegal income might retain its character as capital gain. If held for the requisite holding period, individual taxpayers would essentially receive preferential rates on this illegal income.
F. Summary: Prediction Derivatives Are Financial Instruments, Specifically, Forwards
In summary, it has become clear that prediction derivatives are a kind of financial instrument, and because of the particularities of the Code, they are best understood as forward contracts. As demonstrated, prediction contracts, like other financial instruments, work like derivatives and have no specific home in the highly specialized field of the taxation of financial instruments. Instead, they appear very much like a particular kind of forward contract.. The only difference is that forward contracts to date usually deal with underlying tangible property. There seems to be no reason why federal tax law should treat forward contracts with underlying intangible property differently. In fact, prediction derivatives deal in perhaps the most important commodity of the twenty-first century: information. Indeed, intangible property has come within other usages of the word "property" in the Code. This financial innovation should not obscure what would otherwise be a natural concept: taxation of prediction derivatives as forward contracts. What is new is not therefore always different. That prediction derivatives are best described as forward contracts becomes more apparent when considering the possibility that they represent gambling or contracts held as property.
V. Why Prediction Markets Are Not Gambling or Contracts Held as Property
Prediction markets might strike many tax professionals as gambling. It is difficult, however, to initiate an examination of whether political and financial futures are gambling, because there exists no real discussion of what constitutes gambling for federal income tax purposes. In tax cases concerning gambling, for example, the taxpayer either concedes the activity is gambling or the fact-finding court elaborates little on its determination. (107) Traditionally an activity is considered gambling if there is "payment of a price for a chance to win a prize." (108) Whether prediction markets are legally gambling will depend on the jurisdiction and on the interpretation of the recently passed federal anti-gambling legislation. (109) Such an interpretation is not forthcoming because governments shy away from prosecuting the bettors themselves. It would mean an inquisition, since approximately eight million Americans wager $6 billion annually on the internet. (110) Although gambling is not explicitly defined in the Code, federal tax law singles out gambling for special treatment. The different regime has been attributed to outdated morality and the view that "gambling is sometimes seen as a 'zero-sum' activity, with no redeeming social or economic value. (111)
A. The Income Tax Concept of Gambling
The income tax concept of gambling is generally oriented around creating a less favorable regime of taxation compared to other kinds of ordinary income. Professor Stephen Zorn sets forth the principal differences in his article entitled The Federal Income Tax Treatment of Gambling: Fairness or Obsolete Moralism? (112) Most notably, gambling losses are deductible only to the extent of gains from gambling transactions. (113) They are not deductible at all unless the taxpayer chooses to itemize deductions. (114) Further, gambling losses cannot be carried forward. (115) Accordingly, if some or all prediction markets are a form of gambling, then there are relatively severe tax consequences.
Example 4: In the last tax calendar year, Zhanna speculated on various political futures, recording gains of $10,000 and losses of $12,000. The service determines this trading is gambling. Zhanna is only able to deduct the losses to the extent of the winnings. Thus, she can only deduct $10,000 against the income of $10,000. The remaining $2000 in losses is not deductible and cannot be carried forward or backwards.
Since Commissioner v. Groetzinger, (116) in which the Supreme Court held a taxpayer could carry on the trade or business of gambling, there has been some relief from the harsh regime of gambling taxation. Unlike recreational gamblers, professional gamblers are entitled to section 162 deductions for ordinary and necessary business expenses. Professional gamblers, however, are still subject to the limitation on losses imposed by section 165(d). As a result, business and other deductions are first subtracted from gross winnings. Thereafter, gambling losses may be subtracted to the extent of the reduced winnings. Any loss in excess of the reduced winnings may not be deducted from other taxable income and may not be carried forwards or backwards. Further, attaining the status of being a professional gambler (that is, being in the trade or business of gambling) involves a difficult facts and circumstances test. (117)
In addition, gambling operations are expected to withhold on certain payments under section 3402(q). The section generally requires withholding on wagering transactions if the payout exceeds $5000 and the amount of the winnings is at least 300 times the amount wagered. (118) It is important to note that none of the three exchanges consider their contracts to be gambling and that they do not withhold under section 3402(q). Further, the payouts are simply not large enough to trigger withholding under section 3402(q). For example, the IEM deals in relatively small amounts and limits initial account balances to $500. HedgeStreet's contracts have maximum payouts of $100. On the other hand, any HedgeStreet contracts purchased for more than a third of a dollar will be mathematically excluded from withholding. In effect, the payouts from prediction markets simply do not often give rise to the kind of jackpot profits at casinos and the racetrack. In this sense, the payouts are more like returns on investments. This in turn makes the very nature of the activity more like an investment than gambling.
In addition to the withholding imposed by section 3204(q), there is a 2% excise tax on wagering under section 4401. The excise tax is particularly interesting because it is a convenient point to start answering the question: are prediction contracts simply a form of gambling? Unlike the income tax provision, the statute imposing the excise tax gives meaning to both the term "wager" and "contest. (119) Included in these concepts is a payout based on a political outcome. Of course, this definition under the excise tax might not be equivalent to a definition of wagering for federal income purposes. Thomas Humphreys, for instance, points out that wagering under section 165(d) "clearly has a broader meaning, including for example, card games, such as twenty-one (blackjack), poker, baccarat, as well as table games such as craps and roulette" but then declares both sections were inapplicable to the weather derivatives at issue in his paper. (120) If Humphreys is correct, a broader meaning of wagering might possibly include betting on political outcomes.
It is hard to imagine classifying prediction derivatives as gambling for income tax purposes merely because gambling for purposes of an excise tax written in 1954 includes wagering pools based on election outcomes. The income tax concept of gambling is not necessarily broader than the enumerated activities of the excise tax; rather it simply underscores different policies. The excise tax is meant to raise revenue. Section 165(d), in the most general terms, seeks to enforce a vague societal concept of morality by attaching less favorable tax consequences to certain activities. What a society deems worthy of a stigma is, in turn, always evolving. It is not something that can be enumerated. This excise statute is simply not likely to be controlling for the purposes of our inquiry. To a certain extent, it seems the Service might agree. In a 2004 Technical Advice Memorandum, the Service deliberated on what constituted a wagering transaction under section 165(d). (121) The memorandum did state that it saw no reason why the income tax meaning of a wager should differ from the explanation put forth in the Regulations under the excise tax. (122) However, it ultimately based its analysis on the traditional common law notion of a wager. (123) As mentioned earlier, the elements of wager traditionally include (1) a prize, (2) a chance, and (3) consideration. (124) This conflicted approach is not very helpful but it does show that the definition of a "wager" under section 165(d) is an open inquiry.
Case law is also not very helpful. For example, in Jasinski v. Commissioner, the tax court dismissed, with little elaboration, the taxpayer's claim of a gambling loss for an investment in high-yield debentures that ultimately defaulted. (125) The court declared that "interest income is not wagering income and investing in capital assets is not a wagering transaction" as contemplated by section 165(d). (126) In effect, there is a gap between what is gambling and what is an investment. In other words, behind the determination of the type of income prediction derivatives represents, is the question: what distinguishes gambling from an investment?
B. Prediction Derivatives Have Social Usefulness
In discussing whether weather derivatives are gambling, Thomas Humphreys builds on Zorn's observation that gambling, unlike other streams of income, is viewed to have no redeeming social value. (127) Humphreys labels this distinction the "social usefulness test." (128) This is the better approach to understanding whether prediction derivatives are just a form of gambling for income tax purposes. Unfortunately, Humphreys declines to do an analysis under the test, correctly noting that such a test becomes an investigation into the motivations that a party has in entering a transaction. (129) In the context of prediction markets these motivations are very diverse.
Financial futures contracts have definite social usefulness. They make it possible for small investors to invest in traditional subject matter like oil and gold. It is a vicarious kind of investing which eliminates complicated intermediaries and brings the financial markets into the home of any individual. Betting on financial indices is arguably the equivalent of investing in a spider index fund.
The arguments that political futures contracts are socially useful are less obvious. It is true that political prediction markets represent a new tool in managing political risk. Particularly in the developing world, political events have a major impact on economic growth, including private foreign investment. Currently, there is at least $113 billion invested in political risk insurance policies outstanding worldwide. (130) Similar to how weather derivatives compete with weather risk insurance, political futures can be considered a creditable alternative to political risk insurance. Further, political futures might become a legitimate tool of the lobbying industry.
But the real value of political futures might be their uniqueness. Similar to weather derivatives, they present a real opportunity for portfolio diversification. The value of political futures is arguably independent of almost all other investments. In other words, the entire stock market may crash but upcoming elections will still be held. Further, even speculators serve an integral part in political prediction markets because they provide liquidity and the incentive to take advantage of the positions held by the misinformed. The social usefulness is not solely a function of the markets' worth to individuals. The markets arguably confer benefits on the public as a whole. By aggregating huge amounts of information, the markets have the valuable effect of making the political process more transparent. Transparency is a valuable commodity in a democracy. Categorizing the trading as gambling is penalizing people who front the capital needed to make the markets effective.
The trading seems especially benign and useful when compared to the massive speculation on Wall Street. Calling it "Wall Street gambling," Zorn notes that some instruments bear little resemblance "to the basic economic functions of the financial markets. (131) In his famous remarks on derivatives, Warren Buffet elaborated on the problem posed by the novel exotic instruments:
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands. (132)
Prediction markets, no matter how large they become, do not pose these kinds of problems. For instance, they are fully collaterized and usually traded between individuals. In fact, the social usefulness of event derivatives has even found some level of recognition from the U.S. government.
In July 2003, the U.S. Department of Defense announced its intention to launch a Policy Analysis Market, including contracts based on acts of terrorism. (133) The plans were subsequently canceled amidst public outcry about the prospect of people making money on acts of terrorism. (134) If such plans were to ever proceed in the future, surely traders would not be labeled gamblers. It would be an odd result for one branch of government to be innovative and another to fall back on antiquated notions of morality. In fact, tacit approval of political prediction markets actually predates the Bush administration. At one point during the 1996 presidential campaign one of the most frequent visitors to the IEM website registered an IP address from the Clinton White House. (135)
The force of these arguments is to discredit a label of gambling. And yet, these arguments still appear unusual. This is possibly because they are being advanced in the context of the taxation of individual income. Indeed, Humphreys generally approaches new nonproperty derivatives focuses on their taxation from the point of view of a business. (186) In contrast, prediction markets allow individuals, from the privacy of their own homes, to indirectly participate in financial markets. This difference is not without importance. Individuals benefit from the categorization of nonproperty derivatives as capital assets because it means the prospect of long-term capital gain rates, which are significantly less than the rates for ordinary income. By contrast, all gains of corporations will be taxed at ordinary rates, whether capital gain or not. (137) At any rate, there is no immediately apparent reason for the Code to draw a distinction between the investment activities of individuals and those of corporations. Individuals have as much of a right to hedge against risk as businesses do. In other words, it would be arbitrary to allow businesses to use event derivatives to hedge but characterize individual usage as gambling.
C. Summary: Why Trading Prediction Derivatives Is Not Gambling
In sum, prediction contracts do not represent gambling for federal tax purposes. The essence of gambling, as defined by the nature of its return and risks, is not present in prediction derivatives. Gambling pools do not normally allow an individual to cut his losses short. Further, society simply does not accord it the same stigma traditionally associated with activities falling under the purview of section 165(d). Prediction derivative traders do not fit into the traditional demographics of gambling. Prediction markets have a tremendous amount of intellectual support in both the public and private sectors. There is evidence that the Service is cognizant of this reality. In the very recently issued Revenue Procedure 2007-57, the Service reiterates the withholding obligation under section 3402(q) for taxpayers sponsoring online wagering pools. (138) The guidance focuses on online poker tournaments and there is no mention of political and financial event-based prediction contracts. (139) This silence is perhaps confirmation that trading prediction contracts belongs to the world of finance and not gaming.
D. Taxation of Prediction Derivatives as Contractual Income
One of the few certainties of prediction markets is that they create contractual relationships between parties. In exchange for cash, the trader obtains a contractual right to income, the amount of which depends on the occurrence of an event. Because this contract is readily marketable, the taxpayer can be said to hold the contract as property. Contracts have sometimes been considered property for tax law purposes. Humphreys, for example, describes the consequences of treating a weather derivative as income or loss from a contract right. (140) This contract, if considered property, is presumably a capital asset in the hands of the taxpayer. This is because section 1221 defines a capital asset simply as property held by the taxpayer (whether or not connected with his trade or business). (141) In addition, none of the exceptions to capital asset treatment apply under section 1221. Capital gain treatment, however, is predicated upon the capital asset being sold or exchanged. (142) An extinguishment--a settlement or termination of the right--for example, does not constitute a sale or exchange.
Humphreys describes payments under the weather derivatives as business income--that is, ordinary. (143) He notes that the payments would be deductible (when paid or accrued), assuming it was an ordinary and necessary business expense. (144) Likewise, the extinguishment of a weather derivative contract would mean any gain would be ordinary because the cancellation would not meet the sale or exchange requirement. (145)
A corresponding analysis of prediction markets is not nearly as straightforward. For instance, Humphreys approaches the issue from the point of view of a business entering into the transaction for a business purpose, and thus presumably but not necessarily, hedging. (146) Prediction markets, in contrast, are generally used by individual taxpayers, who are presumably not in the trade or business of trading prediction derivatives. In addition, traders do not have zero bases in prediction derivatives. Thus, Humphreys does not discuss how individual taxpayers would account for losses on contracts generating ordinary income. (147) There is also no discussion of one party transferring the property to another party. In prediction markets, positions taken by trading information futures may be closed out before settlement, effectively transferring the position to someone else and immediately recording a gain or loss.
This leads to an odd result. Traders who close out their position before settlement might well be considered to have sold or exchanged their contract and thus receive capital gain treatment. In contrast, if a trader waited until settlement, the payment due might be considered ordinary because the contract expires (is extinguished) without a sale or exchange. Compare the following two examples.
Example 5: Buyer believes Hillary Clinton will be the next President of the United States and on June 1, 2007 buys a contract for $40 which pays out $100 upon the election of Hillary Clinton as the next President. Seller sells him this contract by putting up $60. Later, on the eve of the election, the contract is trading at $95, and the buyer decides to sell the contract in order to securely capture the difference between $95 and $40 as profit. To do so, buyer must "sell" the same kind of contract to another participant. Buyer does so, and the exchange immediately credits his account with the $55. Buyer claims long-term capital gain because the exchange tells him that his contract has effectively been transferred to the new buyer. Example 6: Buyer believes Hillary Clinton will be the next President of the United States and on June 1, 2007 buys a contract for $40 which pays out $100 upon the election of Hillary Clinton as the next President. Seller sells him this contract by putting up $60. Upon the election of Clinton to the Presidency, Buyer's account is credited with the $100. Because there was no sale or exchange, but rather the fulfillment of the contract's terms, the buyer treats the $60 as ordinary income.
Although the difference of holding period may be measured in hours and the exact source of income shifts slightly, the character of what is essentially the same income changes. The information futures contract becomes subject to the arbitrary machinations of a Code not equipped to handle this new kind of derivative.
This odd result is not thwarted by section 1234A, which provides that "[g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of ... a right or obligation ... with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer ... shall be treated as gain or loss from the sale of a capital asset." As described above, this section eliminates the sale or exchange requirement. Although cash payments from prediction markets are not pursuant to a sale or exchange, section 1234A would operate to render the payments as capital gain. This section, however, applies only if the underlying property must be a capital asset in the hands of the taxpayer. If prediction derivatives are considered to have underlying property, however, then they are certainly nothing more than a forward contract based on intangible property, as discussed above (150)
Viewing prediction derivatives as income-producing contracts only creates further difficulties. For instance, the problem of settlement versus transfer of ownership complicates the treatment of losses. If the losses are the result of disposition of the contract, then they are capital in nature. These losses could not only be deducted from the taxpayer's capital gains but any excess (net capital loss) could be deducted against any of the taxpayer's ordinary income up to $3000 annually and carried forward indefinitely, subject to the same annual limitation. If the losses are the result of extinguishment of the contract, then they are ordinary in nature. The treatment of losses becomes even more complicated. For the purposes of this note, it has been assumed that the taxpayer is not engaged in the trade or business of trading prediction futures. This is a warranted assumption because under existing case law it is not easy for an individual taxpayer to demonstrate that he or she is in the business of trading financial instruments. (151) If prediction markets are considered income from contracts held as property by taxpayers, this assumption creates more difficulty, particularly if the income or loss is ordinary in character due to the lack of a sale or exchange. Theoretically, losses could be deducted against gains from prediction markets as well as other items of income because they are an expense of collecting income under section 212. (152) This is not necessarily the case. A taxpayer, under these circumstances, might be subject to the so-called hobby loss rules if his primary motivation was recreational. (153)
Section 183, known as the hobby loss provision, limits a taxpayer's right to claim deductions in activities not engaged in for profit to the extent of gross income from the activity. (154) Congress enacted the statutory predecessor to section 183 in response to taxpayers fashioning veritable personal expenses as expenses in ostensibly profit-seeking activities, some of which, no matter their duration, never witnessed a profit. (155)
Therefore in order for taxpayers to deduct losses as expenses associated with prediction contracts held as property, they would have to show the losses are necessary and ordinary in the production or collection of income under section 212. If the losses did not come under the realm of section 162 or 212, then the hobby rules would presumably apply to disallow the deduction of any ordinary losses stemming from a regime where prediction derivatives are considered contracts held as property.
E. Summary: Why Predictive Derivatives Are Not Contracts Held as Property
In sum, prediction contracts should not be taxed as a contract held as a capital asset. In a way, all financial instruments, novel or well-established, are contracts held as property. And yet, they are not taxed as such. There is a precedent for treating a similar contract as a financial instrument: forward contracts. Like forward contracts, prediction derivatives are not explicitly mentioned in the Code. Like forward contracts, the accession of income from prediction derivatives is not certain until a certain point in the future. Like forward contracts, prediction derivatives allow individuals to hedge against events affecting their pecuniary well-being. It is for these reasons that forward contracts, while being contracts held as property, have been brought into some kind of penumbra of the world of financial instruments. The same treatment should be extended to prediction derivatives. To decide otherwise, would bring into play very complicated rules. Some rules could threaten to turn the taxation of prediction derivatives into an annual facts-and-circumstances test for every individual taxpayer.
Prediction markets are here to stay. Our tax laws cannot afford to continue to ignore their presence. This note comes almost twenty years after the founding of the Iowa Electronic Markets. The taxation of prediction markets is complicated. These markets blur the Code's distinction between a forward contract and a futures contract. They also do not fall under one of the types of financial instruments enumerated in the Code. And yet, prediction contracts resonate with the nature of financial instruments. The online exchanges imitate established financial markets and sometimes involve the same clientele.
Prediction derivatives are best understood as forward contracts. Like forward contracts, prediction derivatives also have no specific statutory home in the Code. The pecuniary results of both instruments are not initially known. They allow parties to hedge in future movement of the market's perception of the value of a commodity. Prediction derivatives differ only in that they deal with intangibles, including the informed expectations of the occurrence of an event. What truly underlies prediction derivatives is information, not events. It is the possession of and ability to disclose this information via the prediction market that makes for an intangible property interest under tax law. There are plenty of cases where the Code has accommodated the existence of intangible property. Further, these events are usually mere proxies for trading in more traditional commodities. Political and economic events are interrelated and savvy investors know this. This is the kind of intellectual activity that should not suffer the effects of tax distortions because of vague and ancient notions of morality. Instead, absent congressional action, they should be taxed like their predecessor, the forward contract.
Furthermore, prediction derivatives are neither an example of wagering nor a contract held as the taxpayer's property. The true extent of what gambling is under section 165(d) is a vague inquiry but suffice it to state that it does not encompass prediction derivatives. To a certain extent, the income tax label of gambling turns on society's perception of an activity. Prediction markets simply do not follow in the stead of online poker and off-track betting. They are targeted to different markets. The events of prediction markets are not one-time games but are connected to the socioeconomic events which shape our well-being. Even the nature of the return is more like that of financial instruments and not some oversized jackpot. Whereas wagering involves vice, prediction derivatives exhibit genuine social usefulness. At the very least, they help disseminate useful information.
For similar reasons, these event based derivatives cannot be considered to be a piece of personal property held by the taxpayer as a capital asset. The consequences of such a classification would also needlessly complicate the taxation of what is essentially a financial instrument based on intangible property. That would be a regime of taxation which would affect the accuracy of the market itself because taxpayers might be induced to sell contracts to realize capital gains instead of receiving ordinary income upon settlement. The possible presence of hobby loss rules threatens to generate thousands of inquiries into the facts and circumstances of a taxpayer's motivations for investing in prediction markets. These results are avoided if prediction derivatives are logically seen as instruments of finance and taxed as their natural predecessor forward contracts based on tangible commodities. This approach is the correct one under current tax law.
Of course, this note could be wrong. Perhaps, the best approach to correctly predict their ultimate taxation is to simply set up a prediction market.
Philip Robin Cleary *
* J.D. February 2008, Brooklyn Law School. The author would like to thank Professor Steven Dean for supervising this note. In addition, the author would like to thank his family and Zhanna Baranets for their intellectual support throughout the composition of this note. Finally, he thanks his friend of many years, Andrew Goldberg, for asking the simple question, "Do I actually have to pay taxes on this?"
(1) See generally Wikipedia, Prediction Market, http://en.wikipedia.org/wiki/ Prediction_market. For a list of definitions of these and other terms, see Prediction Market Vortal--Vertical Portal to Prediction Markets, Event Derivatives and Prediction Exchanges, http://www.chrisfmasse.eom/3/3/. For a virtual directory of all online prediction markets as well as blogs and other resources, see generally Midas Oracle, http://www.midasoracle.org.
(2) Professor Cass Sunstein's book Infotopia provides a great introduction to prediction markets and the enthusiasm from the academic, political, entertainment, and business worlds. See CASS R. SUNSTEIN, INFOTOPIA: HOW MANY MINDS PRODUCE KNOWLEDGE (2006).
(3) Justin Wolfers, Best Bet for Next President: Prediction Markets, Wall St. J., Dec. 31, 2007, available at http://online.wsj.com/article/SB11990255934065S043.html (Online Edition).
(4) Michael Totty, Business Solutions: Payoffs for Pioneers, Wall St. J., June 19, 2006, at R.9.
(5) An example would be the Hollywood Stock Exchange. See generally Hollywood Stock Exchange, http://www.hsx.com.
(6) See infra Part II.
(7) See generally lowa Electronic Markets Home Page, http://www.biz.uiowa. edu/iem.
(8) Joyce E. Berg & Thomas A. Rietz, The Iowa Electronic Markets: Stylized Facts and Open Issues, in INFORMATION MARKETS: A NEW WAY OF MAKING Decisions 142,144 (Robert W. Hahn & Paul C. Tetlock eds., 2006).
(9) See generally Intrade Prediction Markets Home Page, http://www.intrade.com.
(10) John Delaney, Remarks at the AEI-Brookings Prediction Markets Conference (Jan. 22, 2007), available at http://www.intrade.com/news/news_101.html.
(11) See generally HedgeStreet Home Page, http://www.hedgestreet.com.
(12) Paul W. Rhode & Koleman S. Strumpf, Historical Presidential Betting Markets, 18 J. ECON. Persp. 127,128 (2004).
(14) Justin Wolfers & Eric Zitzewitz, Five Open Questions About Prediction Markets, in Information Markets, supra note 8, at 13,14.
(15) Jill Rickershauser, Volatility in Prediction Markets: A Measure of Information Flow in Political Campaigns 4-5 (Apr. 12, 2007) (unpublished manuscript, available at http://www.duke.edu/~jcrl2/Rickershauser_Volatility_10-06. pdf).
(16) Id. at 6.
(17) Id. at 13.
(18) Rhode & Strumpf, supra note 12, at 140.
(19) Berg & Rietz, supra note 7, at 163.
(20) HedgeStreet Home Page, supra note 11.
(21) Berg & Rietz, supra note 7, at 146 (internal quotation marks omitted).
(22) There are naturally some other differences between the exchanges. Upon expiration, for example, Iowa Electronic Markets (IEM) contracts pay $1, Intrade contracts pay $10, and HedgeStreet contracts pay $100. Unlike the for-profit exchanges, IEM does not pay interest on balances and caps all accounts at $500. Also, IEM does not allow users to see the prices and amount of outstanding bids and offers; it only shows the last price at which a contract was made. See HedgeStreet Homepage, supra note 11; Intrade Prediction Markets Home Page, supra note 9; Iowa Electronic Markets Homepage, supra note 7.
(23) 720 III. COMP. STAT. 5/28-l(a)(2) (2002).
(24) I. NELSON ROSE & MARTIN D. OWENS, JR., INTERNET GAMNING LAW 72 (2005).
(25) 31 U.S.C. [section][section] 5361-67 (2006).
(26) 18 U.S.C. [section][section]1081-84(2008).
(27) Rose and Owens provide an excellent discussion of the regulation of internet gambling under the Wire Act in their book. See Rose & Owens, supra note 24. (28) 7
(28) U.S.C. [section][section] 1-25 (2000).
(29) Whether prediction markets are under the jurisdiction of the Commodity Futures Trading Commission (CFTC) is a point of contention. The best academic analysis of the legality of prediction markets was written by two nonlawyers, Robert Hahn & Paul Tetlock. See Robert W. Hahn & Paul C. Tetlock, A New Approach for Regulating Information Markets, 29 J. Reg. Econ. 265 (2006). Professor Bell has commented on their analysis in the context of scientific prediction markets. See Tom W. Bell, Prediction Markets for Promoting the Progress of Science and the Useful Arts, 14 Geo. Mason L. Rev. 37 (2006).
(30) U.S. Commodity Futures Trading Comm'n, Iowa Electronic Markets, CFTC No-Action Letter (Feb. 5, 1992), available at http://www.cftc.gov/files/foia/repfoia/ foirf0503b002.pdf.
(31) See U.S. Commodity Futures Trading Comm'n, Designation Memorandum (Feb. 10, 2004), available at http://www.cftc.gov/files/opa/press04/opahedgestreet designationmemo_web.pdf.
(32) Press Release, U.S. Commodity Futures Trading Comm'n, U.S. Commodity Futures Trading Commission Assesses Penalties Against Irish Company Trade Exchange Network Limited for Offering Illegal Commodity Option Contracts (Oct. 4, 2005), available at http://www.cftc.gov/opa/enf05/opa5124-05.htm.
(34) Email from Joyce Berg, Director, Iowa Electronic Markets, to Philip Robin Cleary, Student, Brooklyn Law School (June 19, 2007, 09:15:00 EST) (on file with author).
(36) See Intrade, New Accounts, https://www.intrade.com/aav2/rulesAndFaqs.jsp? helpPage=new Accounts.
(37) Id. In addition, friends who trade on Intrade have never experienced withholding or reporting of their profits.
(38) Email from HedgeStreet Customer Service to Philip Robin Cleary, Student, Brooklyn Law School (Mar. 19, 2008, 05:08:00 EST) (on file with author).
(39) I.R.C. [section] 1256(a)(3).
(41) I.R.C. [section] 3406(a).
(42) I.R.C. [section] 3406(b)(3).
(430 I.R.C. [section] 6045(c)(1), (3).
(44) I.R.C. [section] 3406(h)(4).
(45) See supra notes 34-35.
(46) There is actually an additional issue of concern with respect to withholding. Subject to certain exceptions, a 30% flat tax is imposed on U.S. source items, received by a nonresident alien and listed in section 871(a)(1), that are not effectively connected with a U.S. trade or business. I.R.C. [section] 871(a)(1). Under section 871(a), the 30% tax is imposed specifically on items of fixed or determinable annual or periodical items of income (FDAP income). I.R.C. [section] 871(a). This phrase has been held to encompass proceeds from gambling as well as prizes. See Barba v. United States, 2 Cl. Ct. 674 (1983). FDAP income generally does not include capital gain income. Under section 1441, a domestic withholding agent is charged with the responsibility of withholding this tax upon payment to the nonresident alien. I.R.C. [section] 1441(a). Currently, IEM is the only U.S. prediction market to allow foreigners to trade information futures contracts. It does not withhold on payments to foreigners. Because these payments might be a fixed or determinable amount within the meaning of section 871, and IEM might be a withholding agent under section 1441, the exchange might be in violation of the withholding rules. However, if the income from prediction markets is capital gain, then it is generally exempt from the withholding tax. Further, tax treaties might eliminate the withholding tax for nonresident aliens from certain countries.
(47) U.S. DEP'T OF THE TREASURY, OFFICE OF TAX POLICY, A COMPREHENSIVE STRATEGY FOR REDUCING THE TAX GAP 5 (Sept. 26, 2006), available at http://www.ustreas.gov /press/releases/reports/ otptaxgapstrategy%20final.pdf.
(48) Id. at 2.
(49) Id. at 5.
(50) Id. at 5, 8.
(51) I.R.C. [section] 61(a).
(52) See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-30 (1955); see also Commissioner v. Banks, 543 U.S. 426 (2005) (holding that the definition of gross income extends broadly to all economic gains).
(53) I.R.C. [section] 61(a)(3).
(54) I.R.C. [section] 74(a).
(55) Thomas Humphreys, Gambling on Uncertainty--The Federal Income Tax Treatment of Weather Swaps, Cat Options, and Some Other New Derivatives (Tax Forum No. 528, Nov. 2,1998).
(56) Id. at 4.
(57) Id. at 14.
(58) ANDREA S. KRAMER, FINANCIAL PRODUCTS: TAXATION, REGULATION AND DESIGN [section] 6.01 (2006).
(59) For an excellent summary of the tax treatment of these three financial derivatives, see STAFF OF JOINT COMM. ON TAXATION, 110TH CONG., PRESENT LAW AND ANALYSIS RELATING TO THE TAX TREATMENT OF DERIVATIVES (Comm. Print 2008), available at http://www.house.gov/jct/x-21-08.pdf.
(60) I.R.C. [section] 1256.
(61) See Rev. Rul. 94-63, 1994-2 C.B. 188; Rev. Rul. 88-31, 1988-1 C.B. 302; Rev. Rul. 78-182,1978-1 C.B. 265.
(62) See Rev. Rul. 78-182,1978-1 C.B. 265.
(63) See Id.
(64) Id. In the third case, the eventual tax consequences for the writer remain unclear until one of the first two events occur. Id.
(65) I.R.C. [section] 1234(a)(1).
(66) See, e.g., Wolff v. Commissioner, 148 F.3d 186 (2d Cir. 1998), rev'g Estate of Israel v. Commissioner, 108 T.C. 208 (1997).
(67) Taxpayer Relief Act of 1997, Pub. L. No. 105-34, [section] 1003(a)(1), 111 Stat. 788, 909-10.
(68) See STEVIE D. CONLON & VINCENT M. AQUILINO, PRINCIPLES OF FINANCIAL Derivatives, U.S. & International Taxation [section] A1.02 (2008), available at 1999 WL 1336858.
(69) Id. [section] B1.02.
(72) I.R.C. [section] 1256.
(74) I.R.C. [section] 1234A.
(75) I.R.C. [section] 1234(b)(2)(B).
(76) Humphreys, supra note 55, at 17.
(77) Id at 18.
(79) Id.at 17.
(81) DAVID L. CAMERON & THOMAS KITTLE-KAMP, FEDERAL INCOME TAXATION OF INTELLECTUAL PROPERTIES & INTANGIBLE ASSETS [section] 1.01 (2008), available at 1998 WL 1038663.
(82) Although Professor Sunstein does not expressly describe information as a commodity, he notes the ability of prediction markets to aggregate and evaluate dispersed information like markets do for commodity prices. Sunstein, supra note 2, at 197.
(83) Id. at 104-05.
(84) See E.I. Du Pont de Nemours & Co. v. United States, 471 F.2d 1211, 1218 (Ct. CI. 1973) ("[C]ourts have advocated a generous definition of 'property'. ... ").
(85) H.R. Rep. No. 105-148, at 453-54 (1997).
(88) Id. at 454.
(90) I.R.C. [section] 1234(b)(2)(B).
(91) I.R.C. [section] 1211.
(92) Note, to claim these expenses the taxpayer must itemize deductions and the expenses are subject to the 2%-of-AGI floor on miscellaneous itemized deductions. I.R.C. [section] 67.
(93) Treas. Reg. [section] 1.446-3(c)(l) (1994).
(94) Treas. Reg. [section] 1.446-3(c)(2)(iii) (1994).
(95) I.R.C. [section] 1256(a)(3).
(96) See I.R.C. [section] 1222(3).
(97) I.R.C. [section] 1256(g)(1).
(98) I.R.C. [section] 1256(g)(7)(B).
(99) S. Rep. No. 97-144, at 158 (1981).
(100) U.S. Commodity Futures Trading Comm'n, supra note 31, at 29.
(101) S. Rep. No. 97-144, at 157 (1981).
(102) See Murphy v. United States, 992 F.2d 929 (9th Cir. 1993).
(103) Erika W. Nijenhuis, Taxation of Securities Futures Contracts, in TAX STRATEGIES FOR CORPORATE ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS 2005, at 891, 908 (2005).
(105) See generally Boris I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS [section] 6.4 (3d ed. 1999).
(106) See generally Boris I. Bittker, Taxing Income from Unlawful Activities, 25 CASE W. RES. L. REV. 130 (1974).
(107) A very recent case makes this point and provides a summary of cases on point. Tschetschot v. Commissioner, T.C. Memo. 2007-38 (holding poker was wagering as contemplated under section 165(d) even when played in a tournament format).
(108) ROSE & OWENS, supra note 24, at 11 (citation omitted).
(109) 31 U.S.C. [section][section] 5361-67 (2006).
(110) Matt Richtel & Heather Timmons, The Gambling Is Virtual; The Money Is Real; U.S. May Push lts Crackdown, but Internet Casinos Won't Die Easily, N.Y. Times, July 25,2006, at C1.
(111) Stephen A. Zorn, The Federal Income Tax Treatment of Gambling; Fairness or Obsolete Moralism?, 49 TAX LAW 1, 3 (1995).
(112) Id. at 2-4.
(113) I.R.C. [section] 165(d).
(116) Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).
(117) Zorn, supra note 111, at 9.
(118) I.R.C. [section] 3402(q)(3)(A). It should be noted that before 1992, the withholding amount was payouts in excess of $1000. The pursuant regulations have apparently not been updated to reflect that fact. See, e.g., 26 C.F.R. [section] 31.3402(q)-l (2000).
(119) I.R.C. [section] 4421(a). The regulations accompanying section 4421(a) define "wager" for purpose of the excise tax as: "(1) Any wager placed with a person engaged in the business of accepting wagers upon the outcome of a sports event or a contest; (2) Any wager placed in a wagering pool with respect to a sports event or a contest, if such pool is conducted for profit; and (3) Any wager placed in a lottery conducted for profit." Treas. Reg. [section] 44.44214(a) (1959). Most interestingly, the regulations define "contest" as "any type of contest involving speed, skill, endurance, popularity, politics, strength, appearances, etc., such as a general or primary election, the outcome of a nominating convention, a dance marathon, a log-rolling, wood-chopping, weight-lifting, corn-husking, beauty contest, etc." Treas. Reg. [section] 44.4421-1(c)(3) (1959).
(120) Humphreys, supra note 55, at 34-35.
(121)See I.R.S. Tech. Adv. Mem. 200417004 (Apr. 23, 2004).
(124) See supra note 108.
(125) Jasinski v. Commissioner, 37 T.C.M. (CCH) 1, 3 (1978).
(127) See supra note 111 and accompanying text.
(128) Humphreys, supra note 55, at 35 (internal quotation marks omitted).
(129) Id. at 35-36.
(130) Of Coups and Coverage; Political-Risk Insurance, Economist, Apr. 7, 2007, at 71.
(131) Zorn, supra note 111, at 3.
(132) Warren E. Buffett, Chairman's Letter, in BERKSHIRE HATHAWAY INC., 2002 ANNUAL REPORT 3,13 (2003), available at http://www.berkshirehathaway.com/2002ar/2002ar.pdf.
(133) See Noam Scheiber, Futures Markets in Everything, N.Y. TIMES MAG., Dec. 14, 2003, at 68.
(134) Id. In addition, Robin Hanson has compiled an archive of publications about the failed Policy Analysis Market. See Robin Hanson, The Policy Analysis Market (and FutureMAP) Archive, http://hanson.gmu.edu/policyanalysismarket.htmI.
(135) Mike Brunker, Bullish on Bush? Accumulating Kerry?: "Political Futures" Markets Take Stock of Presidential Race, MSNBC.COM, Sept. 10, 2004, http://www. msnbc.msn.com/id/5943565.
(136) See generally Humphreys, supra note 55.
(137) I.R.C. [section] 11.
(138) Rev. Proc. 2007-57. 2007-36 I.R.B. 547.
(140) Humphreys, supra note 55, at 26-27.
(141) I.R.C. [section] 1221(a).
(142) I.R.C. [section] 1222(l)-(4).
(143) Humphreys, supra note 55, at 27.
(146) Id. at 31-33.
(148) I.R.C. [section] 1234A.
(149) See supra Part IV.B.
(150) See supra Part IV.B.
(151) See, e.g., Moller v. United States, 721 F.2d 810, 815 (Fed. Cir. 1983) (taxpayers, whose stock transactions were "continuous, regular, and extensive" nevertheless had no trade or business because they were investors, not short-term traders and thus the issue of the deductibility of home-office expense was not reached). Furthermore, assuming otherwise does not change many of the tax results under either the financial or gambling analyses. If prediction markets are gambling, then the "professional gambler" (he who is engaged in a trade or business) would be allowed business deductions but would still be subject to the limitations of section 165(d), as explained above. If prediction markets are a financial instrument, then the "professional trader" would be able to deduct expenses under section 162 instead of section 212 (and thus not be subject to the 2% floor of adjusted gross income limitation imposed by section 67).
(152) Note also, however, that these losses effectively cannot be carried over to other tax years because these ordinary losses are not due to the taxpayer's trade or business. I.R.C. [section] 172(d)(4).
(153) I.R.C. [section] 183.
(155) BITTKER & LOKKEN, supra note 105, [section] 22.5.
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|Author:||Robin Cleary, Philip|
|Publication:||Virginia Tax Review|
|Date:||Mar 22, 2008|
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