article - innovative financial products tax aspects

8/9/2019 Article - Innovative Financial Products Tax Aspects

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1 The present paper was prepared by the Organisation for Economic Cooperation andDevelopment, Paris, France. The views and opinions expressed therein are those of the authors anddo not necessarily represent those of the United Nations.

ST/SG/AC.8/2001/CRP.8________________________________________________________________________________

19 July 2001

English_________________________________________________________________________________

Ad Hoc Group of Expertson International

Cooperation in Tax Matters

Tenth meeting

Geneva, 10 - 14 September 2001

Innovative Financial Transactions: Tax Policy Implications

(A Report by the Special Sessions on Innovative

Financial Transactions of the OECD)1


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EXECUTIVE SUMMARY

The increased use of innovative financial transactions in recent years is primarily due to theneed for greater risk management by businesses and financial investors and the development of

sophisticated instruments tailored to meet such demands.

A broad group of innovative financial instruments, referred to as "derivative" contracts, call for

specified cash flows to be made between the counterparties over time. Unlike traditional debt andequity securities, these instruments generally do not involve a return on an initial investment. Rather,

derivative contracts are constructed and priced by reference to values "derived" from an underlyingindex, commodity, or other asset, and their value fluctuates with the market movement of thatreferenced item.

The basic building blocks of derivative instruments -- forward contracts and options -- can becombined in any number of ways as specified by the counterparties. In particular, derivative contracts

can separate each of the discrete economic attributes of a particular position or recombine them intonew forms. Significantly, they can also be constructed to replicate any specified set of economicattributes (including those of debt or equity instruments) in a variety of forms.

Traditional patterns of investment have also been expanded through securities lending andrepurchase agreements. These arrangements permit the owner to transfer title or possession of

underlying securities, while retaining the economic attributes of the position.

Derivative instruments and other innovative financial transactions serve legitimate business andinvestment purposes. The holder can use such products either to take a position carrying specificallydefined opportunities for profit and loss, or to offset (i.e., "hedge") the inherent risks of otherinvestments or business activities. This ability to shift, substitute, or transform risks through the use

of financial products is an essential tool of modern business and investment.

In addition to their critical role in risk management, innovative financial instruments also

present a number of serious challenges for income tax systems.

1) The traditional income tax issues of character, source, and the timing and amount of

income are generally based on an initial classification of the type of income in question.

These systems of categorisation are difficult to maintain and administer given theemergence of instruments that can mirror economic attributes of investments in any

number of diverse forms.

2) Similarly, the fundamental distinctions in most income tax systems between debt and

equity are challenged by instruments providing for returns and risks that are economicallyequivalent to the financial attributes of debt and equity investments, or any "hybrid"combination thereof.


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3) The critical issue of determining the "owner" of an instrument for tax purposes is alsotested by contracts that replicate, shift or eliminate some or all of the returns and risks of

an investment. On the other hand, securities lending and repurchase arrangements thattransfer legal title but retain economic attributes of an investment present similarproblems of identifying the "tax owner" of a position.

4) Finally, tax systems are challenged by two broad and sometimes competing concerns --(a) removing artificial tax barriers to effective risk management strategies; and (b)limiting the opportunities for tax arbitrage.

Tax systems that have addressed these issues have adopted a number of different approaches.

In general terms, these approaches can be classified as follows:

(1) Reliance on Financial Accounting Rules. Aligning the tax and financial accounting

treatment of innovative financial transactions can in some cases offer greater consistencyand reduced compliance costs. Financial accounting standards, however, are far fromsettled in this area, and in some circumstances allow greater subjectivity and discretion

than would be acceptable for tax purposes.

(2) Bifurcation. This approach relies on the disaggregation of financial instruments, treating

each of their discrete economic components separately for income tax purposes. Thepurpose of this approach is to isolate and identify each element with the goal of applyingtax rules consistently to the particular components. This goal is often frustrated in

practice, however, since there is little agreement on the appropriate method of bifurcation,or on the taxation of the constituent elements.

(3) Integration. Some tax systems allow taxpayers the election to "match" the tax attributesof their "hedging instruments" with the attributes of specified business or investmenttransactions. By integrating the two offsetting positions, the income tax system permits

the hedging strategy to be effective on an after tax basis. Similarly, some tax systemsimpose mandatory integration of certain offsetting transactions to prevent potentialabusive transactions. In each case, integration of transactions raises difficult issues

regarding scope of the rules and identification of appropriately "matched" transactions.

(4) Mark-to-Market Systems. Many of the timing and classification problems described

above can be avoided to the extent that a mark-to-market system applies for income tax

purposes. Under such an approach, financial instruments are treated for income taxpurposes as if they are sold at year-end, and all resulting gain or loss is taken into account.

Difficulties in making such systems work in practice include valuation of illiquidpositions and the cash flow (and potential abuse) problems resulting from imposition oftax effects in advance of market transactions. However, where a mark-to-market system

is limited to particular sectors that have adopted the method for accounting purposes(such as financial intermediaries trading in financial instruments), its expansion to covertaxation may offer an appropriate measure of profits and losses without the numerous


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practical concerns associated with bifurcation and integration methods.

(5) Anti-Abuse Measures. Some tax authorities have applied broad anti-abuse rules which

impose "substance over form" rules to combat tax arbitrage. To the extent such rulestarget specific abuse transactions they are often adopted too late to be effective. On theother hand, broad rules that give tax authorities discretion to consider the "facts and

circumstances" may result in uncertain and inconsistent administration of the rules.

Allof the above approaches should be considered, either individually or in combination, in

developing appropriate responses to the challenges presented by innovative financial transactions.New tax rules designed to meet these challenges must address the overall tax policy objectives ofneutrality and equity in order to promote the efficiency of the financial markets and protect the

revenue base. This must be accomplished, however, with appropriate attention to the goals ofcertainty and administrability. Moreover, as the use of new financial products continues to expand,

they will inevitably test the viability of the fundamental rules and classifications on which income taxsystems and international tax agreements are currently based.


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Table of Contents

Page

Executive Summary 1

I. Background6

A. Developments in Financial Markets

6B. Risk Management

6

C. Participants7

II. Overview of Innovative Financial Transactions8

A. Traditional Financial Products

9B. Building Blocks for Derivative Instruments

9

1. In General9

2. Forwards/Futures Contracts

10

3. Options10

C. Multiple Payment Period Derivatives - Notional Principal Contracts 101. In General

11

2. Swaps11

3. Caps/Collars/Floors

114. Equity Derivatives and other Total Return Swaps

11

D. Replication and Synthetic Instruments12

E. Securities Loans and Repurchase Agreements

14

III. Income Tax Issues and Problems Presented by Innovative

Financial Instruments15


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A. In General15

B. Traditional Tax Issues

161. Character of Income

16

2. Timing and Amount of Income16

3. Source of Income

184. Treaty Classification

18C. Instrument Classification

19

1. Debt/Equity/Derivative Distinctions 192. Synthetics and Hybrids

20D. Breakdown of Ownership Concepts

21

E. Matching Positions for Effective Risk Management22

F. Tax Arbitrage

23

IV. General Tax Policy Goals

23

V. Policy Options

25A. General Approaches vs. Specific Rules

25

B. Reliance of Financial Accounting Rules

26C. Bifurcation

271. In General

27

2. Problems with Bifurcation 283. Practical Issues 294. Alternative Methodology: Estimating the Yield 29


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D. Development of Elective Hedging Systems 291. The Demand for Risk Management 292. The Need for Effective Tax Rules 30

3. Characteristics of Elective Hedging Systems 304. Problems of Scope C Portfolio and Anticipatory Hedging 315. Partial vs. Full Integration 32

E. Non-Elective Integration 331. Use of Integration to Prevent Tax Avoidance 332. Problems with Mandatory Integration 34

3. Non-Elective Integration through Uniform Characterisation Rules 34F. Are Bifurcation and Integration Compatible? 35

G. Mark-to-Market Valuation Systems 35H. Anti-Abuse Measures 36

VI. Summary 37

Appendix I: Examples of Replication39

Appendix II: Examples of Bifurcation

42Appendix III: Hedging Examples

44


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I. Background

A. Developments in Financial Market

1. During the last twenty years, there has been a tremendous increase in the availability and variety

of innovative financial transactions. In many cases, domestic tax systems have proved ill-equipped tokeep pace with the dynamic evolution of these instruments.

2. Many related factors have contributed to the needs of business for more sophisticated financial

instruments, as well as to the financial world=stechnological ability to meet that demand.Developments in international financial markets that have influenced this dramatic change include the

following]

! increased volatility of interest and currency exchange rate! expansion of multinational operations of corporations! deregulation of financial markets! elimination or liberalisation of exchange controls! increasing speed of transmission of information and money! the evolution in the power and availability of computer technology for use in pricing

and risk management

3. As a consequence of those changes, innovative financial transactions have been developed tomeet the specific risk-return needs of companies and others engaged in the financial markets.

4. Domestic tax legislation and international tax agreements generally lag behind developmentsin the financial markets, with the consequence that the domestic and international tax treatment of

financial instruments is often uncertain. In many cases, tax rules and policies that were developed toaddress more traditional financial instruments are not suited to deal with modern financial

instruments. That may holdtrue whether or nota country's tax rules are largely in harmony with

accounting standards and practice, or are largely independent of the accounting rules.

B. Risk Management

5. One of the central themes reflected in these developments is the evolution of the ways inwhich market participants manage risk. As financial products become more tailored to discrete

business specifications, they have evolved into more sophisticated tools for allocating risks betweenparties.6. Indeed, the original purpose of derivative transactions was to allocate risk in ways that other

instruments did not. For example, commodity futures and options have allowed persons to hedge orto take a position in commodities without the transaction costs of the market in physical commodities.Similarly, the subsequent expansion of derivatives activities to financial markets, particularly the

over-the-counter market, has allowed participants to tailor the risks in a way that traditional debtinstruments did not.


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7. Because the prices of derivatives generally respond more quickly to changes in marketconditions than prices of primary instruments, derivatives allow investors to leverage their investmentin a particular risk. The more narrowly crafted the risk exposure, the more leverage is possible.

8. Market risk that is allocated through an instrument=s cash flows can be created byintermediaries so that the participation of the object of the transaction is not necessary. All that is

required is a benchmark to determine which of the parties must pay the other. In response to thisdemand, financial institutions and large pools of capital have emerged that are willing to take on thisrisk and perform an intermediation function.

9. For example, over the past decade, many financial intermediaries issued cash-settled equity

warrants with respect to the shares of industrial companies or baskets of companies in particularindustrial sectors. Payment due upon exercise would be determined by the public trading price of thestock. Although the intermediary frequently hedged its risk by owning shares of the underlying equity

securities, such hedging was not necessary and in any event did not need to involve the issuer sincethe intermediary could purchase the shares in the public market.

10. Risk management involves not only the traditional protection against interest rate and currencyexchange fluctuations, but also recognises that "risk" may consist of failure to take advantage of abusiness opportunity.

! Asset managers use derivative instruments to tailor the risk profile of a security orportfolio to particular investment objectives. For example, they can choose to keep

long-term exposure to a particular security while swapping away the short-term exposureby entering into a two-year (or shorter) single-stock equity swap. Alternatively, the

manager can use small "baskets" of currencies to hedge larger portfolio credit riskbecause of correlations in movements between different currencies, reducing transactioncosts of hedging. Similarly, banks may use real estate swaps relating to a reasonablysmall number of buildings to hedge a large portfolio of real estate.

! On the liability side, issuers of securities can lower cost of funds by issuing debt intoglobal capital markets and entering into a derivative transaction with an intermediary tolay off the inherent risks in the cross-border positions.

11. Counterparty credit risk in some cases is addressed through exchanges. Standard contracts aretraded on exchanges. The contracts have regular performance dates and the parties negotiate only on

price. The exchange manages counterparty risks by requiring the posting of margins on a daily basis.

These types of contracts have generally been highly regulated.

12. In contrast, instruments offered over the counter have not been as fully regulated bygovernment authorities or industry. Over the counter contracts can be structured with any termsrequired by the party. This flexibility comes with the cost of increased counterparty risk.

C. Participants

13. The tax treatment of financial instruments is sometimes determined based on the roles played


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by the various parties to the transaction. Moreover, there is a growing recognition that uniform taxtreatment among the various counterparties is not necessarily required, and that the function of eachseparate party may be an important determining factor for the method of taxation. For example, the

availability of the mark-to-market valuation system for measuring taxable income with respect tofinancial products has in some contexts been limited to certain types of activity, generally conductedby financial intermediaries. Where such a limitation applies, tax "consistency" based on the functions

of the participants with respect to the transactions would take precedence over tax "consistency"among the counterparties to a single transaction.

14. Participants with respect to innovative financial transactions can be classified to include thefollowing broad categories:

! End-Users typically use financial instruments to manage their levels of risk with respectto their business or investment activities. End-users can be corporations, insurance

companies, mutual funds, pension funds, and other persons with business risks or assetsor liabilities subject to fluctuations in value.

! Financial Intermediaries, primarily banks and securities firms, generally take on onlycounterparty credit risk, and fully or partially hedge the risks of one party by passing themon through contracts to another. Previously, these institutions served as traditional

intermediaries between parties who had surplus capital for investment and parties whowere seeking additional capital. The development of innovative financial transactions hasexpanded this role, allowing the financial institution to enter into transactions directly

with customers, and to modify, manage, and spread the resulting risks more efficiently.

II. Overview of Innovative Financial Transactions

A. Traditional Financial Products

15. Traditional financial instruments were generally limited to securities that could be classified aseither debt or equity investments. Moreover, the traditional rules of taxation presumed a sharpdistinction between these two forms of instruments. In particular, it was assumed that debt provided

for a relatively fixed return of income and principal, whereas returns on equity investments werecontingent on the performance of the issuing corporation. These classifications lead to tax rulesreflecting differences in the timing and character of the income from these discrete classifications.

For example, due to the greater perceived risk in the investment, equity instruments tended to be

taxed on a realisation basis and, in some cases, on capital account. In contrast, debt tended to betaxed on an accruals basis and on revenue account.

16. The explosive growth in the use of new financial products during the last several decades hasrevealed an underlying weakness in the above assumptions. Both the development of newinstruments and the application of financial engineering techniques to existing products have

demonstrated that the risk-return relationship between debt and equity is a continuum rather than adifference in kind.


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17. One of the factors which fuelled this breakdown of traditional debt/equity distinctions was thedevelopment of securities that combined elements of both categories. Examples of such instrumentsinclude the following:

! Perpetual Debt. Debt instruments have been issued in a number of forms that have nofixed maturity date or uncommonly long terms. In some cases, these instruments

developed in response to bank regulatory requirements. In other cases, the instrumentshave been solely tax-motivated, employing interest prepayments and related partyrepurchases to inflate the income tax benefits of interest deductions and other tax

attributes.

! Equity Notes. Debt instruments have been issued in a variety of forms that reflectcharacteristics of equity investments while claiming the tax benefits associated with debt.For example, interest returns can be linked to dividends (or otherwise contingent on

performance or earnings of the issuer), and the instruments could be subordinated to rankbelow all other securities issued to creditors. Tax advantages may be multiplied by suchinstruments where they are issued cross-border to take advantage of the differing tax

classifications between two jurisdictions.

! Bonds with Equity Warrants and Convertible Debt. In some debt issues, the holder

receives a package of a bond and a warrant entitling the holder to subscribe for shares ofthe issuer or a related party. The warrant is a separate instrument traded independentlyfrom the bond. The issuer benefits from lower financing costs, since the value of the

warrant is taken into account in the pricing of the bond. Other debt obligations consist ofa single instrument that is convertible into equity of the issuer. In both cases, the holder

receives a mixture of fixed and contingent returns. The distinction between the twopackages of rights, as well as the tax treatment of the different components embedded ineach, challenge the traditional tax classification system.

18. Although the issuance of these and other "hybrid" instruments have been a factor in thecontinued erosion of the debt/equity distinction, they are not the sole cause. As discussed below,challenges have also arisen from the introduction and market development of new types of

"derivative" instruments, from the increased ability to disaggregate and recombine the constituentelements of all financial products, and from the breakdown in the concepts of ownership with respectto particular instruments.

B. Building Blocks for Derivative Instruments

1. In General

19. A "derivative" instrument is simply a contractual right or obligation that "derives" its value

from the value of something else, such as a debt security, an equity or commodity, or a specifiedindex. In general terms, derivative instruments are constructed from two basic types of contractswhich are described in more detail in the following sections: (i) contracts that provide for fixed


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contractual rights that will be executed in the future are referred to as "forward contracts" (or, in theirstandardised form, "futures contracts"); and (ii) contracts that are contingent on one party's decision toexecute in the future are referred to as "options contracts". These basic building blocks are used in

both developing and pricing the numerous derivative products available on the market today.

2. Forwards/Futures Contracts

20. A forward contract is an executory agreement to buy or sell a specified amount of an asset at aspecified price on a certain future date. The forward price is not based on a projection of the parties'

expectation of the value of the asset on that future date; rather, it generally reflects the current marketprice of the asset plus the net costs of carrying the underlying asset during the term of the contract.

21. Where the forward contract is entered into at market prices, the parties' obligations are matchedand no cash is exchanged up-front. If the terms of the agreement reflect an "off-market" price,

however, one party will generally pay an up-front premium amount to reflect that differential. At theclose of the forward contract, the parties can settle the contract by exchanging the underlying asset forthe predetermined price, or simply offset their obligations by a net exchange of cash that reflects the

then current price of the underlying asset.

22. A futures contract is a type of forward contract that is traded through an exchange in a

standardised form. The futures exchange serves as a clearinghouse and an intermediate counterpartybetween sellers and purchasers of futures contracts. Credit risks are reduced through the exchange byrequiring each party to post daily margin amounts reflecting the fluctuation in value of their positions.

Normally, the futures contract will be closed before delivery of the underlying asset through the entryof offsetting contracts, so that settlement is effected through a cash payment.

3. Options

23. An option is an agreement which gives the purchaser (or "holder") the right, but not the

obligation, to buy (in the case of a "call option") or to sell (in the case of a "put option") an underlyingasset for a specified price during a certain period or on a specified future date. Options often involvethe future purchase of shares (an "equity warrant"), but they can involve any underlying asset, such as

foreign currency, a stock index, or interest rate futures. The seller (or "writer") of the option receivesan up-front premium in exchange for the obligation to perform at the specified future time. Thepricing of the option reflects the relationship between the current market price of the underlying asset

and the option price, as well as the duration of the agreement and the volatility of the price of the

underlying asset.

C. Multiple Payment Period Derivatives -- Notional Principal Contracts

1. In General

24. Derivative contracts can be written to cover more than one payment period. In general, suchcontracts are written with reference to an index applied to a hypothetical (or "notional") amount of


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principal, which is not actually exchanged by the parties. These "notional principal contracts" can bebased on a series of forward agreements covering each of the payment periods ("swaps") or on aseries of options agreements ("caps", "collars", and "floors").

2. Swaps

25. A swap is a financial transaction in which two parties agree to make a series of payments toeach other calculated by reference to a notional principal amount that is not in fact exchanged. In an

interest rate swap, for example, one party may agree to pay an amount calculated as a specified fixedrate of interest on the notional principal amount in exchange for the counterparty's agreement to payan amount calculated as a floating rate of interest on the same notional principal amount. The cash

streams received by each party can be used to meet its respective business needs and the transactionas a whole can be structured to meet the complementary market strengths of both parties.

26. Swaps have been expanded beyond interest rate agreements to reflect a number of categoriesof risks and returns in which the cash streams exchanged are calculated by reference to specifiedindices. Equity swaps, for example, involve an exchange of payments based on the value of an equity

index or a notional amount of shares in a specific company. Currency swaps involve an exchange ofpayment streams denominated in different currencies. Commodity swaps involve the exchange ofpayments calculated by reference to notional amounts of a commodity without a physical exchange of

the commodity.3. Caps/Collars/Floors

27. An agreement consisting of a series of options can provide for multiple payments depending onmovements in an index or in the price of the underlying asset during specified periods. In a "cap"

agreement, for example, the purchaser will receive periodic payments whenever the underlying indexrises above the level specified in the agreement. Similarly, a "floor" agreement will provide thepurchaser with payments whenever such value drops below the specified level. A "collar" agreementprotects both parties through a combination of a cap and a floor; one party makes periodic payments

to the other if the value rises above a specified range, and the counterparty makes periodic paymentsif the value drops below the range. For example, an interest rate "collar" could be used by a borrowerof floating rate debt to limit the risk of higher interest rates through the "cap" element of the

agreement. The "collar" may be used to reduce the "cap" premium since the specified "floor" levelwill allow the counterparty to share in the benefits if interest rates fall.

4. Equity Derivatives and other Total Return Swaps

28. Certain notional principal contracts, such as equity swaps, are designed to have the general

economic effect of a leveraged purchase of underlying securities. When the index referenced in theswap consists of a single stock (so that the swap purchaser captures all appreciation value, as well asdividend equivalent payments, and bears the risk of loss in value) the contract challenges the notion

of whether the holder should be treated as an "owner" of the underlying stock itself for tax purposes.

Such contracts can also be used by the counterparty to offset (or effectively to transfer) the economicbenefits and burdens of equivalent shares that the counterparty continues to hold, similarly raising


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ownership questions.

29. Where the swap is based on an index of multiple securities (such as an equity index swap),

there is less clearly a transfer of "ownership" rights in the underlying asset. Such transactions,however, raise the issue of whether tax laws should have a separate definition of the owner of asecurity applicable to single-stock equity swaps vs. equity index swaps.

30. Equity swaps can be combined with caps, collars, and floors so that the instrument conveys onlya specified range of risk with respect to the underlying stock or equity index.

D. Replication and Synthetic Instruments

31. In broad terms, each of the financial transactions described above involves contractual orquasi-contractual rights to receive and obligations to pay money or money's worth, or to enter into

other financial transactions. The high degree of financial innovation that has occurred in recent yearsis exemplified by the many different ways in which these rights and obligations have been structured.

32. At the heart of the innovation is the aggregation and disaggregation of some basic types ofrights and obligations to create new sets of rights and obligations. For example,

! an interest rate swap is economically equivalent to a series of cash settled interest rateforward contracts

! caps, collars and floors options based on interest rates

! a swaption is an option on a swap.

33. Together with 'physical' securities such as debt and equity, forward contracts and optioncontracts form the basic building blocks for financial transactions. The rights and obligations

involved can be combined in various ways with the result that cash flows can, for example, be:

! certain as to amount, timing and direction

! certain as to timing and direction but not amount

! certain as to timing but not direction or amount

! contingent on a specific event.

34. Cash flows can be denominated in a specified foreign currency or calculated by reference to, orcontingent on, variables such as exchange rates, interest rates, commodity prices, equity prices orindices.

35. Reduction of financial instruments into separate flows of cash payments allows for theconstruction of a series of equivalent relationships between them. These equations are simplified for


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equation described earlier in the previous paragraphs:

Equity - Debt = Forward Contract

40. Further examples of these equations are illustrated (again, in simplified form) in Appendix I.Although application of these equivalent relationships may be complex in practice (depending on the

transaction costs and the particular characteristics of actual securities) the fundamental principle theydemonstrate is simple: each type of financial product, whether classified as debt, equity, forwardcontracts, options or combinations thereof, can be structured through positions taken in other types of

instruments. Moreover, in spite of the more complex form required for actual market transactions,the relationships between forwards, options and physical securities would still hold when real world

costs and characteristics of the instruments are incorporated.

41. This put-call parity framework is central to the pricing methodology for swaps and other

derivatives. As discussed further below, the ability to "replicate" one instrument type through acombination of others presents a significant challenge to any tax system that bases the income taxtreatment of financial products on traditional classifications.

E. Securities Loans and Repurchase Agreements

42. In a securities lending transaction, the owner of securities (the "lender") transfers them toanother party (the "borrower") subject to a contractual agreement that identical securities will bereturned upon the lender's demand or within a specified time. In a typical transaction, the borrower

seeks the temporary ownership of the securities for use in a separate transaction (for example, to meetthe borrower's obligations in a short sale to another party). Credit risk is generally controlled by the

transfer of collateral subject to daily valuation and margin requirements. At the end of thearrangement, the borrower purchases and returns to the lender equivalent securities plus a lending feein exchange for the return of the collateral. Significantly, during the term of the loan, the borroweragrees to make "substitute" or "in lieu of" payments that return to the lender the amount of income

that it would have received with respect to the security if the loan had not taken place.

43. In a repurchase agreement, the owner of securities sells them to a counterparty and

simultaneously agrees to repurchase equivalent securities at a later date from the counterparty at aspecified price. As in the case of securities lending, the exchange of a "purchase price" for thetemporary transfer of securities of equivalent value reduces the credit risk for both parties, and the

counterparty agreement to make substitute payments with respect to the income that would have

accrued on the securities during the term of the repurchase arrangement putsthe original owner backin the same position as if ownership had not been transferred. Moreover, the "repurchase price"normally includes an interest component measuring the benefit of the use of the cash during the

agreement term. If the counterparty receives the right to dispose of the securities in the interim, thetransaction closely resembles the securities loan described above. Where the counterparty does nothave such a right, then the transaction more closely resembles a collateralised financing, with the

"repurchased" securities serving merely as collateral against a loan of cash.


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44. Both types of transactions challenge the traditional tax concepts of ownership. The originalowner of the securities generally transfers the securities themselves, but retains through thesecontractual arrangements the "benefits and burdens" of economic ownership. A series of loans or

repurchase arrangements can pass such economic attributes of ownership through severalcounterparties, and yet only one entity will hold the right to convey legal title to the underlyingsecurities themselves.

45. In the absence of effective rules addressing these issues, securities lending and repurchaseagreements present significant opportunities for abuse. Obvious examples of the type of transaction

which would not take place at all but for the asymmetries of tax treatment of the participants are"dividend stripping" and "bond washing". These strategies involve the short-term "sale" of an asset to

an entity which can safely maximise the advantages of receiving income without a tax penalty and thesubsequent return of the asset to the original owner after the dividend/interest date at a price whichreflects at least part of the value of the tax advantage gained by the linked sale and repurchase.

46. Similarly, certain trading strategies using securities loans can terminate a taxpayer's economicinterest in owning the security while possibly deferring the tax costs of an immediate disposition. For

example, a taxpayer who holds specific securities could enter into a short sale of equivalent securities,but meet the short sale obligations with securities borrowed in a securities loan. The disposition fortax purposes could be deferred in this case until the borrower closes the securities loan by transferring

the original securities to the counterparty in the securities lending transaction. The borrower thusenjoys the full sales proceeds from the short sale, and has eliminated the risks of continued ownershipin the securities, but potentially defers recognition of tax on the disposition. This deferral would not

be possible, however, in those countries that recognise the disposition upon the closing of the shortsale.

III. Income Tax Issues and Problems Presented by Innovative Financial Instruments

A. In General

47. Innovative financial instruments raise a number of issues and problems for the development andadministration of an income tax system. They not only present new challenges with respect to the

traditional tax issues of character, amount, timing and source; in addition, they raise wholly newquestions regarding the most basic classifications on which traditional tax rules are based. Moreover,unique issues are presented by the need to eliminate artificial tax barriers on the legitimate use of risk

management tools, while at the same time reducing potential tax arbitrage opportunities.

48. In some cases, governments have developed specific rules tailored to meet one or more of these

issues. In other cases, the policy options discussed in part V below could be used to address acombination of these problems. For certain financial transactions, it may not be possible to addresseach of these issues in a complete and satisfactory manner, and a trade-off must be accepted. Before

addressing the relevant goals and policy options, however, this section provides a general overview ofthe type of issues and problems presented by innovative financial transactions.


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B. Traditional Tax Issues

1. Character of Income

49. Many tax systems distinguish between transactions that are entered into in the ordinary courseof a business, which will give rise to "trading" or "ordinary" income or revenue, and those that are

entered into with an investment motive, which will give rise to "capital" treatment. In some cases, thetaxation of capital gain will be benefited by lower rates, deferral or exemption. In contrast, the use of

capital losses to offset ordinary income, as well as income or gains realised inother taxable periods

may be limited.

50. Innovative financial transactions present the traditional issues of the relationship between the

taxpayer and the financial instrument in question to determine the character of any income or loss thatmay arise. Character issues can become increasingly important in this context, however, due to the

use of financial instruments as risk management tools. A critical question in this regard is whetherthe purpose for which a taxpayer entered into a transaction should affect the treatment and thecharacter of the income arising from the transaction. In particular, as discussed below, both thetaxpayer and the government have an interest in ensuring that character is preserved between financial

instruments used for hedging purposes and the underlying transactions to which they relate.

51. A similar issue is whether the characterisation of income and loss from financial products

should depend on the economic characteristics of particular instruments, or alternatively, whether allinstruments should be characterised the same, in order to avoid tax arbitrage opportunities. Systemsof income taxation must take into account the ease with which financial products can be tailored to fit

within any particular category while maintaining the same economic characteristics.

2. Timing and Amount of Income

52. In general, the amount and timing of items of income and loss are determined either as theincome and loss accrues over time (the "accruals basis") or at the time the contractual right to

payment becomes fixed (the "realisation" or "cash flow" basis). For example, the interest income anddeduction attributable to a discount bond would be recognised over the term of the instrument underthe accruals basis, but would be deferred until redemption or sale of the bond under the cash flow

basis.53. Innovative financial instruments present a number of issues in reconciling these two methodsand determining when each should apply in particular contexts. Inadequate timing rules can be found

in several different circumstances. One is that tax may be payable on income that does not representthe true economic gain because largely offsetting cash flows that will be outlaid in a later income yearare not taken into account. Alternatively, tax relief may be provided in relation to losses that

misrepresent the taxpayer's overall economic position. Another is where, in relation to instrumentssuch as deep discount securities, not only is payment of tax deferred by the holder of the instrument,but the issuer is granted tax relief on an accruals basis. Tax deferral, which in itself can result in tax

arbitrage, is compounded by the differential tax timing treatment as between the holder and the issuer.


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3. Source of Income

59. Source rules are critical for purposes of determining whether a particular jurisdiction is

permitted to impose withholding taxes on specific cross-border payments, and whether a jurisdictionis required to provide double taxation relief through credits or exemptions on income received by itsresidents. Different types of innovative transactions have raised new challenges to the ways source

rules apply.

60. In general, tax authorities have not imposed withholding taxes on income from derivative

financial instruments. This reflects a general recognition that such gross basis taxation would beinappropriate. Since the offsetting contractual obligations generally result in net payments flowing in

one or both directions, cross-border withholding on a gross basis would be impractical to administerand would destroy the economic relationship underlying the contract. Moreover, given the mobilityof these contracts, withholding taxes would not be an effective means of raising revenue. There is

variation, however, in how specific tax systems reach this result. Some adopt source rules thatexclude derivative instrument income from gross basis withholding, while others simply classify thetransactions as not being within the withholding tax rules.

61. Securities lending transactions and repurchase agreements present unique issues with respect tothe taxation at source of substitute or "in lieu of " payments. Since these transactions "replace" the

economic benefits of the income on the transferred securities during the term of the agreement, thequestion is presented whether the source and withholding rules should apply to these payments in thesame manner as the income they replace. For example, a "look-through" approach would reduce the

potential for abusive dividend washing schemes by sourcing the substitute payments for withholdingand credit purposes in the same manner as the underlying income.

4. Treaty Classification

62. The tax issues presented by each the above traditional issues are further modified by the

application of treaty provisions. The initial application and type of treaty benefits may be determinedbased on the classification of a particular payment as "dividend", "interest", or "other" income.Definitions of the types of payments that receive particular treaty benefits are often provided within

the treaty itself. In the absence of specific definitions, the domestic law of the country applying the

treatygenerally determines the treaty classification of the payments at issue. Moreover, the characterof a particular payment as "ordinary" or "capital", as well as its timing and source, can affect whetherthe income in question is afforded treaty benefits.

63. Each of the above distinctions are subject to challenges presented by innovative financialproducts. The tailored reproduction and repackaging of specific economic attributes afforded byderivative transactions may allow the parties to select whether the payments fit within the parameters

of specific treaty provisions. In particular, the treatment of income from derivative transactions as"other income" (that is potentially exempt from withholding tax) may allow taxpayers to obtain taxexemption under treaties for payments that bear the same or similar economic attributes of income

that would otherwise be subject to tax.


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C. Instrument Classification

1. Debt/Equity/Derivative Distinctions

64. Because tax systems have traditionally relied on categories of transactions, it frequently willbe necessary to determine what category of transaction an instrument falls under before addressing

any other tax issues. Under traditional tax systems, there are a number of fundamental differencesbetween the tax treatment of instruments depending on whether they are classified as debt or equity.Some of these distinctions include the following:

! interest is deductible but dividends are not! interest is taxable but some dividends get concessional treatment, including

qualification for favoured treatment under integration/imputation systems! interest may accrue for tax purposes, but dividends generally are taxed on realisation!

there is greater likelihood that disposal of debt will be on revenue account and disposalof equity on capital account! interest withholding tax and dividend withholding tax rates differ, with interest

generally being subject to lower rates or exemption

65. In general, the effect of these differences favour the classification of instruments as debt,

although this presumption is less clear where a corporate integration system applies.

66. The expanded use of derivative instruments has introduced a new category of transactions, and

substantially increases these classification problems. As discussed above, derivative instruments maybe taxed for some purposes like debt or equity or a combination of the two. In particular, recognition

of income and loss for derivative contracts may beon the cash flow basis, and the payments aregenerally exempt from withholding taxes. In contrast, these disparities could be reduced by adopting

a uniform system in certain contexts regardless of the instrument type (for example, as discussedbelow, by applying a mark-to-market system for all instruments held by financial dealers).

67. These distinctions lead to significant issues of how to place particular transactions within oneof the debt/equity/derivative classifications. There is difficulty in classifying financial instrumentsbecause:

! there are many different forms of instruments! some have complex structures

! at the margin, the dividing line between primary instruments (debt and equity) andtheir derivatives (futures, options, swaps, forward rate agreements, etc.) is not alwaysclear.

68. One way of explaining the existence of the distinction, without making the distinction muchclearer, is by reference to the degree of certainty attached to the direction, timing and amount of cash

flows. Debt is traditionally described as providing an investor with cash flow rights that are certain asfar as the amount invested is concerned. Thus, an example of cash flow rights that are relatively


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certain include those found in zero coupon bonds, debentures and floating rate notes. Of course, thecash flow rights in respect of the excess above the amount invested can vary -- they can be fixed, orcan be contingent on an external interest rate variable.

69. Examples of cash flow rights whose value and direction is relatively uncertain include arm'slength cash settled forward transactions and typical interest rate swaps (where payment on the floatingleg is netted against payment on fixed leg). In an option, the value on issue of the holder's right to a

future cash flow is typically uncertain unless it is quite deep in the money. In these cases, thepayments are generally wholly contingent on external variables.

70. In contrast, dividends (payable at the discretion of non-controlled directors) and ordinaryshares are examples where there is no right to a cash flow as a result of issue of the transaction.

71. The development of innovative financial products, however, shows that each of theseelements can be structured with varying levels of risks. Thus the risk/return distinction on which

these classifications are based ismore in the nature of a continuum. Moreover, as discussed in the

next section, the introduction of new combinations that replicate instruments from one classificationusing building blocks from another one, brings into question the very foundation of these distinctions.

2. Synthetics and Hybrids

72. Perhaps the most fundamental challenge to tax systems from the use of innovative financial

instruments is their ability to replicate the economic properties of other instruments. A combinationof financial products that closely reproduces the economic attributes of an existing instrument (butthat may be classified differently for tax or regulatory purposes) is generally referred to as a

"synthetic" form of the existing instrument. Similar issues are presented by transactions that combine

only selected attributes of different instruments to create new "hybrid" forms of financial transactions.

73. To the extent such strategies can be implemented (given applicable transactions costs andcounterparty credit risk), they present the possibility that any distinction for tax purposes betweentraditional classifications will be fully elective for taxpayers. In short, instruments can be designed to

replicate any desired set of economic attributes, but tax attributes could be independently crafted intothe instrument to obtain the most advantageous results.

74. These potential advantages would be particularly clear where the parties to the synthetic orhybrid instrument were not subject to offsetting tax constraints. For example, if one of the parties

was a tax-exempt entity or had losses that could fully absorb current income, it would be easier to

implement a transaction that shifted tax benefits to the other party. Similarly, where the rules of twojurisdictions classify the transaction differently (or offer different forms of tax advantage),

cross-border instruments can be structured to maximise tax advantages with respect to both systems.

D. Breakdown of Ownership Concepts

75. Determining ownership for tax purposes is a critical threshold issue for many purposes.Income or gains (either capital or ordinary) will generally be recognised only upon a transfer of


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ownership. In cross-border transactions, the imposition of withholding tax on income will be basedon the identity and residence of the "beneficial owner" of the income in question. Moreover, ownersof certain securities may qualify for benefits, either domestically or pursuant to tax treaties, such as

tax-exempt or tax-favoured income, credits and deductions.

76. Common law systems traditionally identify the owner of an asset for tax purposes as the

person that bears the economic burdens and benefits of ownership. In the case of financial assets, thesignificant factors in this regard are (i) which party has the right to dispose of the asset; and (ii) whichparty bears the risk of profit or loss with respect to the asset. The rule can be more complicated in

some civil law jurisdictions where it is possible to create and sell partial interest in property (such as ausufruct).

77. Innovative financial transactions present significant challenges to these traditional views of

tax ownership. Derivative instruments offer the ability to receive or to transfer the benefits or

burdens of economic ownership with respect to a specified "underlying" security or other asset,regardless of the counterparties' legal ownership of the asset. In short, these instruments are capable

of separating the attributes of risk and reward from legal ownership.

78. If tax systems respond to this challenge by treating the economic indicators of risk and reward

as being equivalent to ownership for tax purposes, the result would be to accept the existence ofmultiple owners for a single piece of property. This could lead to further arbitrage opportunities inany case where the income from such property were tax-favoured. For example, in a securities

lending transaction involving the transfer of tax-exempt bonds, the substitute payments returned tothe lender are the economic equivalent of the underlying interest flows; but if each lender in a chainof securities loans is classified as the "owner" of the bond for tax purposes, then the tax-exempt

interest benefits would be multiplied. For this reason, domestic tax rules generally clarify that only asingle recipient of tax-favoured income is permitted to obtain the beneficial treatment, and otherparties that may receive "equivalent" payments (or payments measured by reference to such amounts)

do not receive the same tax benefits.79. Accordingly, any attempt to address this breakdown of traditional "ownership" concepts will

require a balanced approach to prevent abuses that can occur under either broad or narrow definitionsof when a taxpayer is recognised as "owning" an asset.

E. Matching Positions for Effective Risk Management

80. The marketplace developments in the last twenty years, described in section (I) above,demonstrate a growing need for effective risk management. There has been a correspondingacceptance among tax authorities that, to the extent possible, tax rules should not impose a barrier to

effective hedging strategies. This development, however, leads to the principle that tax rules can, andin some circumstances should, treat taxpayers differently with respect to the same transactiondepending on the purpose of the transaction. In particular, to hedge an underlying asset or liability

with one or more financial instruments, the offsetting tax attributes of the hedging instruments mustbe "matched" with that underlying position.


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81. On the other hand, where certain positions are offsetting, the failure to take such economiceffects into account presents opportunities for abuse, allowing taxpayers to choose the most

advantageous application of character, timing and source rules.

82. As discussed in Part V below, one general approach to these problems is to permit taxpayers to

"match" offsetting positions through elective hedging regimes. In addition, it may be appropriate insome circumstance for the tax system itself to impose a linkage between offsetting positions in orderto more clearly apply specific tax attributes to related transactions. Yet any approach that "integrates"

discrete transactions, whether through an elective or mandatory system, presents a number ofsignificant and difficult issues:

! What type of activities should the regime apply to? For example, should a voluntarysystem permit hedging of "investment" activities, or should it be limited to "business" or

"inventory" activities? How should such distinctions be defined and administered?

! Should the regime apply to net hedges of an aggregate risk of interest rate, price changes

and/or currency risks, or should the linkage require identification of separate transactions?If net hedges are permitted, how will the rules establish that the "overall risks" of thetaxpayer have been effectively reduced through the hedge?

! May a transaction qualify as a hedging transaction if it hedges an anticipated risk? If so,how will the system address cases where the future risk does not materialise?

! How should the system treat the linked transactions if they are not each entered into and

disposed of at the same time?

! Where the integration system is elective, will the taxpayer be required to identifytransactions as hedges in order to treat them as such? If so, when and how? Must the

identification be made on the basis of individual transactions or by identifying particularclasses of transactions? Will there be penalties for misidentification to prevent abuses ofthe system?

83. An alternative to elective hedging regimes is to define the tax treatment of specific derivativeinstruments in a uniform manner based on how the instruments are most often used for hedging

purposes. As discussed in Part V, this more generalised approach may help to produce similar results

as elective hedging without presenting the problems described above.

F. Tax Arbitrage

84. Tax arbitrage involves taking advantage of differences in the tax treatment, either of persons

undertaking transactions or of the transactions themselves, where these differences arise either as aresult of the asymmetries within or between tax systems or as a consequence of the specific taxposition of the persons themselves. In many cases, tax arbitrage transactions are entered into merely


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to obtain tax benefits, and have no significant business or financial effects apart from such benefits.Accordingly, the term broadly refers to any type of abusive transaction that may be available withrespect to each of the categories of issues described above in this section. If the tax system does not

include adequate rules to prevent such abuse, taxpayers can construct arbitrage transactions tomaximise the tax benefits of character, timing, source, ownership, or hedging rules.

85. It is clear that innovative financial transactions have expanded the opportunities for taxarbitrage. Particular concerns are presented by synthetic and hybrid instruments that carry taxattributes of one classification of investment, but provide the economic risks and returns of a different

classification.

86. Arguably, tax authorities should be concerned where transactions are entered into, not forgenuine commercial reasons, but solely to obtain tax arbitrage benefits available either within anindividual system or through cross-border transactions between tax systems. Tax authorities will also

be concerned by potential distortion effects where cross-border movement of funds is designed by theparties to share tax benefits from asymmetries between jurisdictions.

IV. General Tax Policy Goals

87. Since innovative financial transactions are essential risk management tools of modern business,

systems of taxation must strive to reduce or eliminate obstacles to their effective use. On the otherhand, tax authorities have a strong interest in reducing the opportunities for tax arbitrage presented bythese transactions. It is perhaps a moot point as to whether rules of taxation with respect to such

transactions should facilitate market efficiency and financial innovation rather than narrowing thescope for tax avoidance. Both overall goals must be taken into account.

88. A tax system should raise revenue as neutrally, simply and equitably as possible. The selectionof rules for imposing tax in this context will depend on the weight given to each of the followingpolicy goals:

89. Neutrality and Equity. Tax neutrality fundamentally requires that transactions with the sameeconomic substance attract the same tax treatment. Non-neutrality is evident when tax laws are basedon the legal form rather than the economic substance of the transaction. This is particularly so for

financial transactions, which can be easily structured in different ways, without altering their non-taxeconomic effects. Asymmetries and mismatch have the potential to cause significant threats to therevenue and inefficiencies in the way finance decisions are made. A more neutral tax law in this area

therefore both promotes the efficiency of the financial markets and protects the revenue base.Neutrality also promotes the related goal of equity, by ensuring that tax burdens are imposed based onthe parties that realise the economic benefits of the income at issue. In the context of financial

products, an equitable system of taxation will select the appropriate party as the "owner" of particularitems of income, and will ensure that the measure and timing of the tax reflects the underlyingeconomic results of each transaction as closely as possible. On the other hand, equitable application

of the rules also is required to limit the ability of parties to avoid or defer tax through arbitrage andother strategies.


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90. Simplicity and Lower Compliance Costs. The goal of simplicity should take into account theease or difficulty in administering the law as well the taxpayers' costs in complying with it.

Compliance by taxpayers is affected by the degree of certainty in the law and the clarity of theconcepts. Cost of compliance is also affected by the amount and type of information that taxpayersmust be keep or produce to meet tax obligations, as well as the degree of difficulty for tax authorities

to verify taxpayers' claims.

91. Certainty. When entering into transactions, taxpayers have an interest in knowing the taxresults in advance. Economic efficiency can be harmed if transactions are avoided or financial

products are not developed because of the uncertainty of the tax treatment. Uncertainty can alsofacilitate avoidance or deferral through transactions which take best advantage of differentinterpretations of the rules, allowing for timing mismatches or differential tax treatments between

transactions that are economically similar but different in strict legal form. In addition, uncertainty

about the application of tax laws can lead to greater levels of controversy between taxpayers andrevenue authorities.

92. Robustness. Particularly in the case of financial products that evolve at an increasingly rapidrate, tax rules must be both broad and flexible in order to address new transactions and variations of

existing transactions. To the extent the rules are crafted to reflect the general economic structure ofthe transactions at issue, they are more likely to impose an appropriate level of income tax on theparties with respect to new transactions as well. The ideal is a set of broad rules that are sufficiently

flexible to reflect market activity and facilitate innovation, yet resistant to easy manipulation fortaxation advantage.

93. These varying goals inevitably require trade-offs. For example, "bright-line" tests are simpleand administerable, but, because they are arbitrary, may not serve the goals of neutrality androbustness. Similarly, tests based on a broad reliance on the facts and circumstances provide

flexibility and are harder to avoid, but may not provide sufficient certainty.

94. Although each country's approach to the taxation of innovative financial transactions will be

determined by many factors, the usefulness of those approaches can be evaluated by considering howwell they meet each of the above goals. As discussed in the following section, the tax policy optionscurrently used or considered for addressing the taxation of innovative financial transactions illustrate

the difficult issues and inevitable compromises that must be accepted in this area.

V. Policy Options

A. General Approaches vs. Specific Rules

95. In recent years, it has become increasingly clear that if the tax treatment of financial productsdepends on the promulgation of specific rules, it will be difficult if not impossible for tax authoritiesto meet the policy goals described above. In particular, the inherent time lag between development of

new products and introduction of targeted rules both permits abuses of the system to go unchecked,


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and denies taxpayers the certainty they require for legitimate transactions.

96. In light of such difficulties, it may be necessary to consider more general approaches other than

the proliferation of discrete rules to deal with specific new products. Jurisdictions with flexibletaxation systems, or those with well-developed anti-abuse rules, may be at an advantage as comparedto systems in which the government is less able to attack abusive transactions on the basis of

substance-over-form or similar doctrines. In some countries, it may be possible to reach consensus onappropriate treatment of new transactions simply by encouraging taxpayers to enter into a dialoguewith governmental experts.

97. Attempts to prevent "tax arbitrage" between jurisdictions through harmonisation of countries=

approaches to the taxation of innovative financial transactions will have to take into account not onlythe differences in legislation in each country, but differing approaches to the administration of the taxlaw. Again, development of international norms in this context, either through model treaty

provisions or bilateral negotiations, will require greater acceptance of general policy approachesrather than adoption of narrow rules targeted at specific instruments. In particular, opportunities fortax arbitrage may be reduced, and the speed with which rules are promulgated can be increased,

through more widespread international agreement on a theoretical basis for the taxation of financialproducts and administrative co-ordination on these issues amongst tax authorities.

98. The remaining sections of this part examine some of the policy options that have been appliedby governments and discussed by commentators in addressing the challenges of innovative financialtransactions. Each approach carries its own problems and shortcomings, and none provides a

comprehensive solution to the issues and policy goals described above. In short, the problemspresented by new financial instruments often relate to underlying weaknesses of the traditional

systems of taxation that have simply been more clearly exposed by innovative transactions. Forexample, arbitrary differences in character or timing under traditional tax systems may result intransactions with similar or identical economic characteristics being subjected to significantlydifferent tax treatment. It is hoped, however, that further consideration of such general policy

approaches will lead to both a re-examination of those fundamental weaknesses, as well as assist taxsystems in developing more effective and equitable measures of addressing these problems.

B. Reliance on Financial Accounting Rules

99. Some countries follow accounting standards and principles closely in determining the amount

and timing of income subject to tax. In those cases, the accounting and tax treatment of innovative

financial products present one unified set of issues, and their resolution must balance the concerns ofboth tax policy and accounting standards. One advantage of this approach is that it simplifies

compliance for both tax authorities and taxpayers. Also some countries consider that their accountingstandards reflect "real world" practices and have thus kept pace with the developments in financialinnovation. A further advantage can be that where tax laws follow accounting standards and

principles they may more easily cope with the development of new financial instruments.

100. In countries where taxation rules are largely independent of financial accounting rules, some


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have advocated legislative change that would allow taxation of innovative financial transactions to bedetermined on the same basis as for financial reporting purposes. The advantages of doing so wouldbe as described above. The disadvantages for such countries may be:

! Accounting standards for financial arrangements may not be well settled in suchcountries.

! The application of general accounting principles in particular circumstances may failtoprovide sufficiently objective, consistent and verifiable results necessary for an

administerable and robust tax system. In particular, accounting principles do notnecessarily reduce the risk that similar instruments would be given different taxtreatments on the basis of disparate interpretations of accounting rules.

! Financial accounts are designed to provide information that bears on users' needs in

relation to economic decision making and accountability. There may be a variety of users(e.g. shareholders, creditors, regulators), which can affect what information is providedand how it is provided. This has often been reflected in a principle of conservatism forfinancial and regulatory reporting purposes which is not necessarily a fundamental

principle of tax accounting. In contrast, tax laws require a single, statutorily derivedfigure to determine liability to tax.

! Accounting standards have in some circumstancesalso failed to keep pace with

innovative financial transactions or lagged behind tax rules. For example, thedevelopment of new instruments has transformed conventional balance sheet analysis asinstruments are unrecognised in the balance sheet or transactions go "off balance sheet".

While some progress has been made by accounting standard-setting bodies to improvedisclosure in this area, the accounting guidance is still not specific enough to eliminatethe problems described above.

101. Differences in accounting principles between countries may lead to different tax treatment of

transactions even where tax rules follow those principles. But there will also be different taxtreatments where countries operate specific tax rules with regard to particular transactions.

102. Financial accounting principles and standards may provide valuable guidance for some

countriesin formulating their rules for taxation of financial transactions. The financial accountingprinciples of consistency, substance over form and recognising revenues and costs in the period in

which they relate reflect sound taxation policy. Moreover, any reduction in compliance costs fromharmonising tax and financial accounting records would be a desirable outcome. Therefore, to theextent specific, consistent and objective rules can be developed as appropriate accounting standardsfor innovative financial transactions, the same solutions might be adopted for income tax purposes as

well.

C. Bifurcation


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1. In General

103. Where a financial right or obligation is taxed differently according to whether it is issued as a

separate instrument or is embedded in another instrument, it is arguable that there is taxnon-neutrality. In effect, the combination of different financial instruments into the one compositetransaction obscures the essential features of the separate components. Therefore, one approach

considered by tax authorities is to "bifurcate" (or more accurately, disaggregate) each of thecomponent parts into independent economic units, and to subject each part to appropriate tax rulesseparately.

104. An example that is often cited in this regard is a convertible bond that carries the right of

conversion into the stock of the issuer or a party related to the issuer. Economically, this instrumentconsists of a debt instrument issued at a discount and carrying below market rate interest coupons,coupled with an equity option. The fusing of the two components may obscure the discount element,

which arguably should be treated for tax purposes as additional interest. Non-neutrality occurs wherethe discount would have accrued if the debt component had been issued separately.

105. The different tax treatment of like instruments is a fundamental driving force for bifurcation.By breaking the transaction down into its component parts, bifurcation can reveal time value ofmoney elements of transactions that are not being accrued. This leaves the exposed elements to be

taxed in a consistent manner. Two simple examples of this approach are provided in Appendix II.

106. The theory for bifurcation in exposing the various components of financial instruments is that,

if issued separately, each would be taxed differently. This rationale points to the main type offinancial instrument for which bifurcation could be considered. Where the timing, character, or other

tax attributes would be different for each of the underlying components, it would arguably beappropriate to tax each element separately under its respective rules. For example, in a system thattaxed debt on an accruals basis, while options and forwards are taxed on a cash flow basis, thequestion whether or not to bifurcate would be raised in an instrument that has both debt and equity

features, or both debt and option or forward features.

2. Problems with Bifurcation

107. Although bifurcation arguably promotes consistency in tax systems that differentiate betweendebt, equity and derivatives, it raises its own questions and difficulties. Essentially, the arguments

against bifurcation are twofold:

! the economic substance argument in favour of bifurcation is illusory! the benefits of bifurcation are outweighed by the costs.

108. Since all financial transactions can be replicated by aggregating or disaggregating other

financial transactions, it is arguably pointless to disaggregate compound instruments into theircomponent parts. In short, each of the component parts in themselves can be replicated by othertransactions. Given that there are no fundamental individual particles and no unique financial


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transactions, any system of bifurcation will be arbitrary.

109. The argument taken to the extreme, though, belies the fact of tax differentiation. If the different

tax treatment of debt, equity and derivative is to continue, notwithstanding the murkiness of theboundaries, the question is what effort should be made to preserve those boundaries. Also, thecategorisation or classification of transactions that are not close to the boundaries may be relatively

straightforward.

110. Other arguments against bifurcation include:

! The non-accrual of the discount in a compound instrument approximates the deduction

the holder should get for the option premium. However, it is by no means clear that suchan outcome for the holder will always be consistent with the economic substance of thetransaction.

! Bifurcation ignores a synergism between the option (or other non-debt) and debt portionsof the compound instrument. The argument is that bifurcation may wrongly value the

separate portions. The question is whether any distortion in this regard is greater than thedistortion of not bifurcating.

! Bifurcating a convertible security and taxing the discount on an accruals basis assumesthat there will be redemption, i.e., no conversion. It is argued that there is an assumptionthat the holder will obtain back the face value amount through redemption, whereas in

fact the holder may exercise the option to convert into equity and therefore not obtainback the face value. On the other hand, it can be argued that even if the holder does

convert, it will be obtaining the value of the face amount through the equity it obtains(and can sell for value). Otherwise, the holder would not convert; thus in fact the holderis guaranteed from the outset a minimum of the face value.

3. Practical Issues

111. It is sometimes argued that, particularly for holders, the bifurcation process of determining the

net present value of the debt component is too complex to justify a departure from financialaccounting. Given that the instruments themselves are reasonably sophisticated and are effectivelyissued at a discount, there is an issue of whether bifurcation calculations are any more complex than

deep discount legislation that might apply to the instruments if the discounted security portion was

acquired separately.

112. Another practical difficulty is determining the yield on a comparable noncontingent debtobligation issued by a comparable issuer. This will not always be easy and will often involvejudgement. One possibility may be to use a benchmark rate of the government borrowing rate plus a

risk premium, calculated by reference to certain factors such as the issuer's credit rating.

4. Alternative Methodology: Estimating the Yield


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113. The approach described above views the contingent payments under the contingent component(such as the embedded option) as being quite different from the noncontingent payments under the

debt component. An alternative approach for some contingent securities is to view the difference asone of degree, not requiring separate tax rules for the two components, but requiring instead thatestimates be made of the payment in each income period under the security. This can be used to

determine an estimated yield for accrual purposes. The estimate would be revised each incomeperiod.

114. The estimates need to be reasonable and it may be necessary to provide rules for differentsituations, e.g., where the unknown payments are based on the change in an index or variable, as

distinct from the amount of an index or variable. Estimates can be problematic where there is nomarket index, variable, value etc.

D. Development of Elective Hedging Systems

1. The Demand for Risk Management

115. Broadly defined, "hedging" is any action taken to reduce or eliminate risk. An entity may enterinto a transaction to hedge its exposure to changes in interest rates, exchange rates or to prices in anyunderlying asset or liability. A simple but common example of hedging is the use of a

fixed-to-floating interest rate swap to reduce the risk of adverse interest rate movements. AppendixIII provides additional illustrations of the use of hedging contracts to reduce business and investment

risks.

116. As previously discussed, a driving force behind financial innovation is the increasingsophistication of (and demand for) risk management. Entities are better able to isolate the risk that

they wish to reduce or eliminate. Aggregation and disaggregation of financial instruments providesthe means for more precise and effective matching between the risk and the risk managementinstrument.

117. The flexibility accorded by financial innovation facilitates the separation of sourcing of fundsfrom the management of the relevant exposures, in order to seek cheaper finance or higher yields.

Swap driven funding has sometimes been suggested asan example of this, the idea of which is that

the comparative advantage that two parties have in different markets is arbitraged through a swap andcaptured in the lower effective funding cost or higher yield.

2. The Need for Effective Tax Rules

118. Where the income tax system fails to "match" the relevant tax attributes of the hedging

instrument to the related transaction, the hedge may be ineffective on an after-tax basis. Themismatch can take different forms, depending on the tax treatment of the hedge and hedged positions.


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An example of a mismatch would be where the loss on the hedge is of a capital nature, while thecorrelated gain on the hedged position is of an income or revenue nature. If capital losses can only beoffset against capital gains, the asymmetry is to the disadvantage of the taxpayer.

119. Another example would be where a gain on a hedge is taxed on a market value basis, and theloss on the hedged position is deductible on a realisation basis (and both hedge and hedged position

straddle two income years). The taxing of the unrealised market value gain may result in cash flowproblems for the taxpayer. Moreover, the gain may in fact fail to eventuate in subsequent incomeyears.

120. Tax mismatches can cause undesirable fluctuations in taxable income; if the potential

fluctuations are very severe, companies may be discouraged from undertaking particular types ofhedge activity.

3. Characteristics of Elective Hedging Systems

121. Hedging rules have been adopted by tax systems in response to this inconsistency, and seek to

match the timing and character of the gain or loss on the hedging transaction with that of the hedgeditem. Thus a hedging system often involves changing the character of the hedging instruments andthe deferral of gains and losses on hedging instruments from the period in which they occur - and

would otherwise be recognised - to a later period when the related gains and losses on the items beinghedged are recognised.

122. One of the difficult issues for an elective hedging system is ensuring that it applies only tolegitimate and genuine cases of risk reduction. As an initial matter, the tax rules must determine

whether the hedging system will apply only to, for example, inventory purchases, to investmentsrelated to business activities, or to any financial investments.

123. In addition, tax authorities may require the taxpayer to maintain books and records identifying

hedging transactions (generally on a contemporaneous basis) and containing whatever more specificidentification is needed to verify the application of the taxpayer's tax accounting method. The onus ofcorrectly identifying hedging transactions should lie on the taxpayer, and the audit trail from hedging

transaction to hedged items should be made clear. Consideration should also be given to theconsequences of misidentification of a hedging transaction, in order to encourage correctidentification. Measures such as these assist in dealing with the inherent difficulty in determining the

subjective intent of the taxpayer in entering into a transaction; in effect they make the assessment

more objective than it would otherwise be.

124. Some form of test is also required to ensure that the hedging instrument is in fact used for riskreduction purposes. Thus some degree of correlation must be documented between the risks inherentin the underlying asset or liability, and the offsetting nature of the hedging instrument. In this regard,

it is sometimes argued thataccount must be taken of the overall "enterprise risk" of the taxpayer, with

consideration of all of the outstanding positions currently held. That is because a risk in respect of anindividual transaction may be offset by an equal and opposite exposure from another transaction of


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transactions means that safeguards such as contemporaneous designation are especially important.Transparency of the trail from the internal decision maker (e.g., the asset/liability managementcommittee responsible for the hedge program) to the dealer, together with a demonstration of how any

given transaction seeks to reduce net exposure, should be contemplated. The point of the latterrequirement would not be to track each underlying transaction back from the hedging instrument, butto obtain assurance that the hedging instrument followed an analysis of the net exposure comprising

the underlying transactions.

131. Difficult issues are also presented by the extension of tax accounting systems to permit hedging

of future anticipated risks. On the one hand, there is little commercial distinction between exposurethat an entity is subject to as a result of a transaction that it is contractually committed to, and one that

it is all but contractually committed to. For example, projections of future inventory purchases maybe a relatively certain obligation of the business, even in the absence of binding contracts. On theother hand, reluctance to extend hedging rules for tax purposes to anticipated transactions probably

stems from recognition of the opportunity presented for deferral where the entity has the power todecide whether or not to enter into the future underlying transaction.

5. Partial vs. Full Integration132. In general, hedging rules for tax purposes perform a "partial integration" function, by simplylinking and matching specified tax attributes (such as timing and character) among selected

instruments. Alternatively, a more comprehensive hedging system would permit "full integration" ofthe offsetting positions. Where full integration applies, the taxpayer would be allowed to amalgamateor combine the cash flows of the hedged instruments into one synthetic transaction for tax purposes.

Example

A company uses 6 month forward foreign exchange contracts on a rolling basis to hedge theforeign exchange exposure of holding shares in a foreign company. Assume the shares are on capitalaccount for tax purposes and are taxed on a realisation basis. Hedging rules reflecting a "partial

integration" approach could provide that any gain or loss on the hedge contracts are on capital accountor taxed on a realisation basis or both. A "full integratio

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