Date post: | 04-Jun-2018 |
Category: |
Documents |
Upload: | dp-dileepkumar |
View: | 217 times |
Download: | 0 times |
of 19
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
1/19
1
Session 4: AN OVERVIEW OFINNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR
IMPLICATIONS FOR TAX POLICY
Sample Financial Instrument
TransactionsProfessor Diane Ring, Boston College Law School, USA
International Tax Dialogue
Global Conference
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
2/19
2
1. OID Arbitrage
2. Debt/Equity Hybrid
3. Swaps/ Hedging ForeignCurrency Risk
4. Credit Default Swaps
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
3/19
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
4/19
4
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
OID (Original Issue DiscountArbitrage)Analysis: Is there any reason US CO should be denied an interestdeduction for the deemed interest payments on the zero couponduring the life of the instrument? Should the existence of crossborder tax arbitrage matter?
In this case, the deductions would likely be:
Year 1: Interest deduction of $10xYear 2: Interest deduction of $11xYear 3: Interest deduction of $12x
Although Investors would not include their corresponding $33x inincome until year 3.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
5/19
5
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Debt/Equity Arbitrage: Scenario #1
US Co
Country X Investors
Zero Coupon Bonds
Facts: US CO needs financing and issues bonds to Country X investors.Country X treats the bonds as equity. Under its exemption system, Country Xexempts from tax the income earned by its Country X holders of the instrument.
Analysis: Should US CO be denied its interest deduction on the zero
coupon bonds?
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
6/19
6
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Debt/Equity Arbitrage: Scenario #2
X Co.
US Investors
Zero Coupon Bonds
Facts: X Co., a Country X corporation, needs financing and issues zero
coupon bonds to US investors. Country X treats the instrument as debt;the US treats the instrument as equity (and thus does not require accrualtaxation on the interest).
Analysis: Is there any reason that the US investors should be denied anindirect foreign tax credit in the US (presuming they otherwise qualify) for theCountry X taxes?
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
7/19
7
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency Hedging
Questions: What are swaps?
Answer: They are a type of notional principal contract under which a party agreesto make payments to a counter party using a specified variable rate asapplied to a specified notional amount. In return, the counter party
agrees to make periodic payments based on a different rate or index asapplied to a notional amounte.g., in the case of an interestrate swap.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
8/19
8
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency Hedging
Basic Example: Plain Vanilla Fixed to Floating Interest Rate Swap
A B
B agrees to pay an amount equalto LIBOR + 2% on $1 million, peryear, for 10 years
A agrees to pay an amount equalto 7% on $1 million, per year,for 10 years
Note:
-The parties do notexchange the underlyingnotional amount of$1 million.-The parties may nettheir annual payments
and have one flow.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
9/19
9
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency HedgingQuestion: Why enter into an interest rate swap?
Answers: There are a variety of uses(1) Change existing debt. For example, A may have an existing debt of $1 millionwith a floating rate of LIBOR +2%, but wish to change it to a fixed rate debt.Instead of refinancing, A could enter into a floating-to-fixed interest rate swap, andreplace its LIBOR + 2% rate with 7%. Note that there now is counter party risk
with B that did not exist before.
(2) Effectively hedge a mismatch of flows between assets and liabilities.
Alternatively, if A holds fixed rate assets and floating rate obligations, it faces apotential mismatch. If A enters into the swap, it satisfies its annual fixed rate leg ofthe swap using the income from its own fixed rate assets, and A takes the floating
rate annual payment it receives under the swap and uses that to meet its ownfloating rate obligations.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
10/19
10
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency Hedging
ComplexityThe swap described constitutes a straightforward, uncomplicated swaptransaction. However, there are innumerable ways in which parties modifythis basic model. For example, swaps might have:
-significant, up-front, nonperiodic payments
-termination payments
-prepayments
-contingent payments
-options to enter into swaps
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
11/19
11
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency HedgingBasic Example: Plain Vanilla Foreign Currency Swap
A B
At the start of the swap, B pays A $1 million,
and A pays B 620,000. At the end of theswap term, A will return the $1 million, and Bwill return the 620,000.
During the life of the swap, B agrees to payan amount equal to 5% on 620,000per year, for 10 years, and A pays 6% on$1 million
Note- unlike interest rate swaps, whereprincipal is not exchanged, in a foreigncurrency swap, the principal amountsin different currencies, are exchanged.
$1 million at outset
5% on 620,000 per year, for 10 years
620,000 at the end of the term
620,000 at outset
6% on $1 million per year, for 10 years
$1 million at the end of the term
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
12/19
12
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency HedgingQuestion: Why enter into an foreign currency swap?
Answers: There are a variety of uses
(1) Change existing debt from one currency to anotheroften where the party
has a borrowing advantage in one currency. For example, A may be able to borrowat advantageous rates in British pounds, but may desire a dollar loan. Conversely, Bmay be able to borrow at advantageous rates in the dollar, but desire a pound loan. By
entering into the currency swap, A and B both borrow in their best currency buteffectively switch it, or swap it, into their desired currency.
(2) Change an existing asset from one currency to another. For example, A ownsa dollar denominated asset with a dollar return, but would prefer a pound denominatedreturn. The currency swap effectively moves A from a dollar denominated asset with afixed return of 6%, to a pound denominated asset with a pound denominated return.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
13/19
13
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency HedgingQuestions:What kinds of tax questions do interest rate swaps and foreigncurrency swaps raise?
Answer:(1) What is the character (ordinary v. capital) of the periodic payments madeduring the term (e.g., the LIBOR + 2% on $1 million that B pays annually in theinterest rate swap)?(2) What is the categoryof such periodic interest rate swap payments?Are they treated like interest? Something else?(3) When are periodic payments included in income? When and how are theydeducted by the payor?(4) What is the characterof various nonperiodic payments (including up-front
payments, termination payments, etc.)? Whenare they reported?
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
14/19
14
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency Hedging
(5) What is the sourceof the different payments under a swap?
(6) How are any foreign currency gains or lossesgenerated through a foreigncurrency swap treated? Are they analyzed separately? What is the characterand timing of such income or loss?(7) What happens if A enters into an offsettinginterest rate (or foreign currency)swap?(8) Does taxation of the instrument vary depending on the identity of the taxpayer
for example a dealer, an investor, a business, a speculator?(9) What if a taxpayer uses a swap as a hedge? Does the tax treatment ensurethat the resulting economic hedge (neutralizing risk economically), is matched byunified hedging treatment at the tax level?
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
15/19
15
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency Hedging
Basic Example of a Foreign Currency Hedging Transaction
A(a US dollar
based business)
The Problem: Taxpayer A incurred a Yen denominated liability and mustpay 90 million Yen in 5 years, and pay interest of 10% per year on that liability.Taxpayer A, however, operates it business entirely in the US dollar, and does notwant to bear the risk of currency fluctuationsbetween the Yen and the US dollar.
The Solution: A foreigncurrency swapthecombination of flows onthe swap and debtresult in A having a
$ debt
BAnnual Payments equal to 10%on 90 million Yen, plus 90 millionYen at the end of 5 years
Annual payments equal to 7% onUS$1 million, plus US$1 million at the
end of 5 years
A owes C 10%
per year, &90million in 5 yrs
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
16/19
16
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Swaps and Foreign Currency HedgingRemaining Concern:
Even though the foreign currency swap economically hedges As foreigncurrency risk, which was the business goal that A sought, does it produce aTax Hedge? Are the swap and underlying debt integrated or coordinated for taxpurposes so that from a tax perspective A is treated as if A has a dollardenominated obligation?
Depending on what rules governthe character, source and timing of swap payments,and how those rules compare with the taxation of As debt to C (the interest and
repayment of principal), there could be tax mismatchesin timing, character or source ifno special hedging or integration rules apply.
Some countries provide special hedging rulesthat allow two or more transactions to
be integrated for tax purposes and treated as one single economic transaction,here it would be a dollar denominated debt.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
17/19
17
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Credit Default Swaps CDSWhat are they? Bilateral, over-the-counter (OTC) contracts.
Basic Example:
Writer
(protectionseller)
Holder
(protectionbuyer)
Periodic or upfrontpayment
Payment, if aspecified credit eventoccurs with respect toCorp X bond during the termof the CDSe.g., default,bankruptcy, restructuring
Note:--There are many variations
on this basic structure
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
18/19
18
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Credit Default Swaps CDS
Why enter into the CDS? Again there are a variety of reasons that parties enter into
a financial instrument, such as a CDS. For one example:
If the protection buyer holds a $150 million Corp X bond as part of itsinvestment portfolio, and is worried about the credit quality of Corp X,it may enter into the CDS as protection against a decline in the credit of Corp X.
Who is buying and selling this credit protection in the form of a CDS?
The two biggest groups of both buyers and sellersof CDS protection areHedge Fundsand Banks/Brokers. The market of credit default swaps grewtremendously from 2006 to 2007.
*AIGs role as a seller of credit default swapshas been consideredan important trigger in the recent financial crisis.
8/14/2019 4-Diane Ring Session 4 an Overview of Innovative Financial Instrumetns 10 15 09
19/19
19
Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL
INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX
POLICY
Sample Financial Instrument Transactions
Credit Default Swaps CDS
For tax purposes, what is a credit default swap?
-The answers here may not be clear.
-There is debate over a number ofanalogies, including insurance, notional principal contracts, and options.
-The choices made, among these and other possibilities, could impacttaxation and regulation of credit default swaps.