# Presentation: 044085

## Taxation of Financial Instruments: Is the Debt/Equity Distinction Relevant?

- Presentation to the President’s Advisory Panel on Federal Tax Reform
- Robert McDonald
- Erwin P. Nemmers Distinguished Professor of Finance
- Kellogg School of Management
- Northwestern University

## Overview

- Traditional distinctions among kinds of financial income
- The role of dealers
- Prevalence and growth of derivatives
- Examples
- Complexity of rules governing taxation of financial transactions

**Notes:**
As David Weisbach pointed out, there are numerous issues; I am touching on one particular issue.

## Types of Financial Income

- The tax code distinguishes between debt and equity and between interest, dividends, and capital gains
- It is well-known that in certain cases the debt-equity distinction is problematic, for example junk bonds and convertible bonds have both debt and equity characteristics
- Distinctions between forms of financial income are not economically meaningful
- All represent returns to a financial investment

## Derivatives Blur the Distinctions

- In modern financial markets, *derivatives *can be constructed that have characteristics of both debt and equity.
*Derivatives* are financial claims that have a payoff determined by the price of some other asset
- Futures, options, and swaps are examples of derivatives (as is automobile insurance!)
- The technology for creating new financial claims is well understood and creation of new claims is common

## What do Dealers Do?

- Securities dealers make markets in financial instruments, accommodating customer demand to buy and sell financial instruments
- Dealers buy and sell stocks, forward contracts, options, and customized financial claims
- A *forward contract* is an agreement to buy or sell in the future at a price fixed today
*Call options* and *put options *are like forward contracts --- the transaction price is fixed today --- except that the customer only buys the asset (call) or sells (put) if they profit by doing so.
- This activity leaves dealers with exposure to price risk
- Dealers generally *hedge* this resulting exposure, i.e., they acquire an offsetting position that makes money if the position due to their customers loses money.

## The Role of Dealers: Example

- A customer owning shares worth $100 wants to sell the shares 5 years from today for a guaranteed price of $125 (this is a *forward sales contract)*
- The dealer agrees to buy the shares in 5 years for $125.
- The dealer has the risk that the share price in 5 years will be less than $125
- To offset the risk stemming from this agreement, the dealer needs a position that will make money if the stock price declines. Thus, the dealer *short-sells*: borrows shares from a third party and sells them, investing the sale proceeds in bonds.
- If the share price falls, the dealer can buy replacement shares at a low price, making money on the short sale.
- The dealer has a forward purchase contract and an economically equivalent offsetting position that is short stock and long bonds.

## The Role of Dealers, cont.

- With the help of the dealer, the customer has converted a share position into the economic equivalent of a bond (a certain return in 5 years)
- The dealer bears no share price risk
- This particular transaction would be deemed a sale under the constructive sale rules, but there are close variants in which the customer retains some risk and can defer tax

## The Revolution in Financial Technology

- Black, Scholes, and Merton showed in the early 1970s how to price and hedge options and other derivatives more complicated than forward contracts; their analysis created *financial engineering*
- Dealers routinely use this technology to price and hedge claims such as options
- Dealers trade stocks and bonds to hedge options and other derivatives
- Dealers can also create synthetic stocks and bonds by trading derivatives
- Dealers mark-to-market, and all dealer income is ordinary, so distinctions between kinds of income are often not preserved when dealers are intermediaries
- Virtually all derivatives are equivalent to a long position in some asset and a short position in some other asset.
- For example, a call option has a synthetic equivalent of borrowing to buy stock

## Effects of the New Technology

- With dealers able to create hybrid claims --- or assist firms in designing them --- traditional distinctions between debt and equity and types of financial income are harder to identify and support
- The market for derivatives has grown tremendously in the last 30 years.

## Growth in Derivatives: Swaps and Exchange-Traded Options

- Sources: Chicago Board Options Exchange and ISDA

## The Traditional View of Debt and Equity

- Equity has no promised maturity payment and is risky
- Debt has a promised maturity payment and is relatively safe
- It is easy to design “hybrid” instruments that have characteristics of both debt and equity.

## What are These?

- “DECS” (Debt Exchangeable for Common Stock) is here used as generic shorthand for a hybrid debt-equity claim
- Both payoffs have characteristics of debt and equity
- Depending on circumstances, characteristics, or documentation, claims like these can resemble debt or equity for tax purposes.
- Existing positions can be modified to resemble these diagrams by adding options and forward contracts

## Example: Individual Capital Gains Deferral 

- Suppose a wealthy investor has $1 billion dollars in appreciated stock.
- The investor collars the position: in 5 years the investor has the right to sell the stock to a dealer for $1 billion and is required to sell to the dealer for $1.75 billion if it is worth more than that. The investor pays nothing for this position.
- The investor is protected against losses and gives up gains above a certain level
- Capital gains on the position are deferred for at least 3 to 5 years
- At the outset, such a position might be economically equivalent to 75% debt and 25% equity, yet it is completely untaxed (except for dividends paid on the stock) for 3-5 years
- The implicit interest income on the position is taxed as capital gain, if at all

## Example: Corporate Uses of DECS-like Structures

- In one well-known transaction, Times Mirror (which owned an appreciated position in Netscape stock) sold a DECS-like note with a principal payment linked to the price of Netscape. Times Mirror effectively deferred tax on $75 million of capital gains. The net result was like a collar.
- In a common transaction, firms issue a DECS-like security (also called “Feline PRIDES”) in the form of a bond coupled with a forward sales contract. The economic result is a deferred issue of equity, but a portion of payments on the security are deductible as interest.

## A Multitude of Rules for Investors

- Rules have been added *ex post* to stop egregious abuses. Examples include:
- Income on a position that looks like a bond should be taxed as interest
- Bonds that do not pay explicit interest should be taxed as if they do pay interest.
- A completely hedged position is deemed to have been sold
- Hedging stops the capital gains holding period
- But there are special exceptions for exchange-traded options
- There are special rules for the taxation of futures contracts
- The tax law tries to draw distinctions that are not economically supportable.
- Sophisticated taxpayers can use tax rules and financial instruments to obtain substantial tax benefits.