Financial Market Instruments and Innovative Debt Instruments - 2 | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• An income tax system traditionally classifies financial instruments as either debt or equity and typically accords each a different tax treatment, for example: (1) the return to debt (interest) is tax deductible as a business expense to the issuer, but the return to equity (dividends) is not; (2) interest is taxed on an accrual basis, while dividends are taxed on a realization basis; and (3) unlike interest, dividends are taxed as ordinary income only when realized; they are taxed (often preferentially) as capital gains when capitalized in stock prices. Furthermore, interest and dividends paid to nonresidents may be taxed at different domestic rates and be subject to different withholding rates.
• Given the above asymmetrical tax treatments between debt and equity, taxpayers could realize substantial tax benefits by transforming the instruments from one into the other—or into some new instruments—at will to suit their individual circumstances. Derivatives provide them with the means to do so.

Creating Instruments Using Derivatives

Instruments created by derivatives could be grouped under two broad categories: hybrids and synthetics. Each category, either by itself or in combination with the other category, would provide taxpayers with virtually limitless tax arbitrage opportunities under traditional income tax systems.

Hybrids

A hybrid is a new instrument created by combining debt, equity, and, possibly, other derivatives. The new instrument may not be recognized by existing tax laws and, hence, its tax treatment could be uncertain. Many hybrids are available, but contingent debt (or structured notes) and swaps are probably the most popular.

Contingent Debt

• Consider two portfolios: (1) a traditional bond with a principal B that matures in n years with yearly coupon payments at the rate r and a long forward contract on a stock S in the nth year for a delivery price X; and (2) an instrument requiring the same initial investment B and with the same coupon rate r and a maturity of n years, like the bond in the first portfolio, but whose payoff in the nth year is contingent on the performance of the stock—specifically, its final payoff is [B + (S - X)].
• While the two portfolios would return the same stream of cash flows, their tax treatments might be very different. The first portfolio’s tax treatment is clear: the coupons from the bond would be taxed each year as ordinary income, and the capital gain/loss from the forward contract would be taxed upon the contract’s settlement. In contrast, the tax treatment of the contingent debt in the second portfolio is unclear, since the debt’s yield each period cannot be calculated until its final payoff is ascertained. If the tax point is delayed until the entire investment is closed, there would be a substantial deferral of tax liabilities, compared with the first portfolio, even though, for each of the periods before the last, the contingent debt resembles the traditional bond in all substantive aspects. Moreover, the character of the final payoff is also uncertain as to whether the difference, if any, between B and (S - X) represents capital gain/loss or ordinary income.

Swaps

• Swaps are popular largely because of their inherent flexibility: they can be used to exchange (swap) almost any profile of cash flows for a different one to suit the needs of the swappers (see the appendix for a brief description of some standard swaps). Since a forward contract is equivalent to an agreed exchange of cash flows occurring at a specific date, a swap is also a convenient instrument for packaging a series of forward contracts.
• The correct tax treatment of swaps is not straightforward, as the nature of the swapped profiles of cash flows could be characterized in different ways. An interest rate swap, for example, could be viewed simply as the exchange of a fixed-rate bond for a floating-rate bond, and the cash flows received by both parties of the swap could be viewed as interest payments and taxed accordingly. However, if the swap is viewed as a series of forward contracts, one party could be regarded as having bought from the other party, for the same and identical price in each contract, a distinct asset whose price is a priori uncertain. In this case, the gain and loss from each contract would have to be ascertained separately for tax purposes.
• Swaps could also give rise to difficulties in determining the owners of the assets being swapped. If individual 1, who owns stock S1 and individual 2, who owns stock S2, agree to swap the dividends from, and price changes of, their stocks with each other over a fixed period of time, then, in effect, the two individuals would have swapped the economic consequences of stock ownership without changing legal ownership. Certain tax rules, however, are predicated on ownership (for example, corporate restructuring, withholding taxes). Thus, the separation of legal from economic ownership is a problematic issue for taxation.

Synthetics

• A synthetic instrument is one constructed from a combination of different instruments (which could themselves include hybrids and other synthetics) in such a way as to replicate the cash flows of another instrument. As described earlier, options and forward contracts can be used to create synthetics of varying degrees of complexity.
• Tax rules that are applied differentially on the basis of how instruments are classified—as is the case with traditional income tax systems—will clearly have problems dealing with synthetics, since, by implication, taxpayers would have the ability to transform one instrument into another to maximize tax benefits. For example, an individual owning a substantially appreciated stock who is interested in selling the stock for a bond could defer the realization of the capital gain by creating a synthetic bond with a short forward contract (see equation (3)). The contract’s delivery price, which would be equal to the stock’s current appreciated value compounded over the life of the contract, once set, would not change regardless of the future movements in the stock price; thus, the price of the contract takes on the character of the principal of a bond. In this way, investors are able to achieve their objectives and defer tax on both the capital gain (from selling a stock) and the interest income (from acquiring a real bond) until the forward contract matures.
• Synthetics constructed from multiple components also allow taxpayers to selectively realize losses of some components without realizing offsetting gains in other components at any given point in time. Continuing with the above example, suppose the stock appreciated further after the short forward contract had been struck by the individual, in which case the value of the contract would have gone down.2 Instead of waiting for the contract to mature, the individual could now choose to close out the contract and hold on to the stock.3 In this way, a loss is realized (on the forward transaction) without realizing the accrued gain (on the stock) at the same time, which would allow the individual to reap substantial tax benefits stemming from the deferred recognition of the gain.