overview of innovative financial instrumetns

8/10/2019 Overview of Innovative Financial Instrumetns

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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


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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


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POLICY


OID (Original Issue Discount Arbitrage)

US CO

Country X InvestorsZero Coupon Bonds Investors paid

$100x for bondthat will pay$133x in 3 years

Facts: US CO needs financing and issues zero coupon bonds to Investors inCountry X. Country X does not have OID rules, thus holders of OID bonds inCountry X can defer inclusion of the bond income. They are taxed on the $33xof income at the end of the bond term. The bonds are issued at a lower rate of

interest than if they had been issued in the US, where OID rules subject USbond holders to current taxation.


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POLICY


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.


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POLICY


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.


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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.


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POLICY


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.


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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


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POLICY


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


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POLICY


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.


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(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?


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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


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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.


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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


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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.


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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.

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