# Presentation: 424518

## Problems with the Taxation of Financial Instruments

- David A. Weisbach
- Walter J. Blum Professor
- University of Chicago Law School

## Overview

- Huge growth in financial markets.
- Any type of ownership or risk can be created with financial instruments.
- Can be moved to any part of the world, into and out of our tax system.
- Incoherent scheme of taxation.
- Piecemeal attempts to modernize.
- Increasing sophistication of taxpayers and willingness to take advantage of tax flaws.
- Many tax shelters use financial products.

- 3/16/05

## Financial instruments

- Efficient means of moving risk and return around the economy and around the world.
- Financial instruments:
- Stock, debt, futures, options, forwards, swaps, hybrids (e.g. convertible debt).
- Partnership interests, leases, receivables, payables.
- Used for:
- Investing, borrowing, hedging, speculation.
- Used by:
- individuals, small businesses, large business, Wall Street.
- Central to modern economy.

- 3/16/05

## Three problems

- Inconsistency
- Asymmetry
- Indeterminacy

- 3/16/05

## Problem:  Inconsistency

- Same economic positions taxed differently depending on form.
- Similar economic positions taxed differently depending on which side of a line they fall on.
- Results from basic distinctions in tax law:
- Realization of gain or loss v. Mere change in value
- Ordinary income v. Capital gain
- Debt v. Equity
- U.S. source v. Foreign source

- 3/16/05

## Example of Inconsistency

- Debt v. “synthetic” debt.
- Synthetic debt is a set of financial instruments with the same net cash flows as a debt instrument.
- Example of synthetic debt.
- Buy an asset and agree to sell it at a fixed price on a specified date in the future.
- Ex.  Buy for $100 and sell in one year for $110.
- Fixed return based on time between purchase and sale.
- Same as lending money.
- This transaction is not taxed like lending money.
- No current taxation of “interest.”  Possible capital gain on sale.
- “Add on” tax rules attempt to limit inconsistency, but fail.

- 3/16/05

## Using Synthetic Debt in a Shelter

- Issue synthetic debt on your own stock.
- Buy your own stock on the market and agree to sell it back for a fixed price on a specified date (sell it forward).  Equivalent to lending money.
- Borrow money to finance this position.
- Cash flows:
- Today:  borrow $100 and use it to buy stock.
- $0 net cash flow.
- One year:  Sell stock for $110 and pay back $110 on loan ($100 principal plus interest).
- $0 net flow.
- Tax consequences:  get an interest deduction on loan and pay no tax on stock transactions.
- Basic borrowing and lending scheme is typically hidden in complex transactions, making it hard for auditors to find.

- 3/16/05

## Problem:  Asymmetry

- Different sides to the same transaction taxed on a different basis.
- Investors
- Hedgers
- Foreigners
- Tax exempts (pensions, charities, foundations)
- Dealers

- 3/16/05

## Example of Asymmetry

- Suppose a dealer supplies the positions in the synthetic debt shelter.
- Lends $100 to the corporation; gets paid back $110 in one year.
- Sells stock to the corporation for $100 and agrees to buy back for $110 in one year.
- No net cash flows.
- Dealer marks all its positions to market.
- Each year, measures gain and loss by the net value of its positions.
- Tax consequences:  No gain or loss.
- Overall:  corporation gets interest deduction, dealer has no gain or loss.

- 3/16/05

## Problem:  Indeterminacy

- Very hard to determine how new financial instruments are taxed.
- Often a result of inconsistent treatment of similar instruments.
- Potentially slows financial innovation.

- 3/16/05

## Example of indeterminacy

- Credit default swaps.
- A financial instrument that pays off when and to the extent to which a specified debt instrument (or set of debt instruments) is in default.
- Have characteristics of:
- Guarantees.
- Options.
- Swaps.
- Insurance.
- Nobody knows how they are to be taxed.

- 3/16/05

## Tax shelters

- Sophisticated taxpayers, aided by financial intermediaries can take tiny flaws and drive trucks through them.
- Financial instruments make sheltering easy.
- Simple to enter into in any size -- just add zeros.
- Not like building a building.
- Many designated tax shelters (“listed transactions”) are driven by problems with financial instruments taxation.

- 3/16/05

## No easy fix

- Basic tax definitions and concepts would need to be amended to reduce inconsistencies and asymmetries.
- Capital gain/ordinary income, debt/equity, U.S. source/foreign source, realization/nonrealization.
- Likely directions for reform:
- More mark-to-market for particular taxpayers or instruments.
- Ignore financial transactions!
- Can measure income by just taxing real transactions.
- VATs ignore financial transactions.  Can do the same under an income tax.

- 3/16/05

## Appendix

## Diagram of synthetic debt shelter

- Today

- One year

- Dealer

- Taxpayer (corporation)

- Lend $100

- $100 to buy stock

- Pay back $110 on loan

- $110 to purchase stock

- - $100
- _+$100_
-       $0

- +$100
- _- $100_
-       $0

- - $110
- _+$110_
-       $0

- +$110
- _- $110_
-       $0

- Interest deduction
- No gain on stock sale

- No tax

- 3/16/05

## Five different ways of owning equity

- Direct ownership of stock.
- Buy a call, sell a put (or enter into a forward contract).
- Equity swap.
- Equity-linked note.
- Prepaid forward on equity.
- These are roughly equivalent economically (and can be made very closely equivalent).
- They are all taxed differently.

- 3/16/05

## Four different ways of owning debt

- Direct ownership of debt (say with a fixed term and fixed payments).
- Series of zero coupon bonds that match each payment.
- Series of cash and carry transactions (or any similar hedged transactions).
- Own equity and enter into a swap or collar.
- All of these are roughly equivalent economically and all are taxed differently.

- 3/16/05

## Example of “add on” tax rules – domestic financial products-related timing rules

- Realization rule
- Capital loss limitations
- Wash sale limitations
- Original issue discount rules
- Discounted preferred stock rules
- Straddle loss limitations
- Straddle capitalization rules
- Mark-to-market of exchange traded contracts
- Dealer mark-to-market
- Swap timing rules
- Contingent debt rules
- Hedge timing rules
- Constructive sales
- Equity-linked security capitalization rules

- 3/16/05