4-0 session 4_financial instruments - taxation oct2009_itd

8/13/2019 4-0 Session 4_Financial Instruments - Taxation Oct2009_ITD

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An overview of innovative

financial instruments & their

implications for tax policy

Session 4

Chair: Cecil Morden: National Treasury,South Africa

Presenters:

Mr. Satya Poddar: Partner, Global TaxAdvisory Services, Ernest & Young.

Mr. Richard Collier: Tax Partner

PriceWaterHouseCoopers (PwC). Prof. Diane Ring: Professor of Law,

Boston College, United States.


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Financial Sector

The core functions of the financial

sector are to intermediate between, and

share risk across, savers andborrowers, providing the credit and

liquidity upon which business activity

hinges(ITD, Background Paper, 2009)


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Innovative Financial Instruments

(IFI)

Derivative instruments and other innovative financialtransactions serve legitimate business and investmentpurposes.

use such products to take a position carrying specificallydefined opportunities for profit or loss (speculation) or to offset

(hedge) the inherent risks of other investment or businessactivities.

This ability to shift, substitute, or transform products is anessential tool of modern business and investment.

However, complexity and opacity of financial instrument is achallenge.

While playing a critical role in risk management, innovativefinancial instruments also present a number of seriouschallenges for the income tax system(ITD, Background Paper, 2009)


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Questions posed to Presenters

1. What are the various complex instruments emerging on theglobal financial sector?

2. Why do they exist and what circumstances have given rise toeach?

3. Examine: (i) hedging transactions, (ii) credit default swaps,

(iii) repos, (iv) securitized mortgage instruments, (v) etc.4. How are they, and should they be characterized from a tax

standpoint.

5. Issuesmore questionsa. Timing and accounting issues: accrual; mark-to-market, relation

of tax and financial accounting

b. International mismatches in treatment, how does tax planningexploit these difference?

c. Distinction between debt and equity for tax purposesis itsustainable?


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Innovative Financial Instruments

for Natural Disaster Risk

Management

During the past decade, catastrophes haveperiodically strained the insurance industryscapacity to provide catastrophe risk

insurance. Hence, new instruments wereintroduced to transfer and financecatastrophe risk exposure, such ascatastrophe risk swaps, and contingent

capital and risk-linked securities that areplaced through the global capital market.Torben J. Andersen, Innovative Financial Instrument for naturalDisaster Risk Management, Inter-American Development Bank


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IFIs

Swaps

Look back options

Exchange options

Credit derivatives

Catastrophe (cat) bonds

Derivatives on volatility

How do we price such instruments and performrisk management?


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Measuring and managing risk

In an environment where there is constant flux andinnovations, senior management is often ignorant about theexact nature of the innovations and refuses to acknowledgetheir lack of knowledge, relying on their traders and quants forguidance. This affects their ability to exercise independent

judgment about the risk characteristics of an innovation. At the centre of the credit crisis has been the issue of how toprice different types of collateralized debt obligations (CDO)

To measure systemic risk, all major institutions includinghedge funds need to come under regulatory monitoring.Stuart M. Turnbull, Measuring and Managing Risk in Innovative Financial Instrument, University ofHouston Bauer College of Business, May 2009


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Hedging

In broad terms, reducing a firms exposureto price and rate (interest rates, exchangerates, etc.) fluctuations is called hedging.

Hedging cannot change the fundamentaleconomic reality of business. What it can dois allow a firm to avoid otherwise expensiveand troublesome disruptions that result fromshort-term, temporary price fluctuations.

Hedging also gives a firm time to react andadapt to changing market conditions. Intelligently dealing with volatility has become an

increasingly important task for financial managers


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Swaps

A swap contract is an agreement by

two parties to exchange or swap

specified cash flows at specifiedintervals.


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Debt vs. Equity

Corporations are very adapt at creatingexotic, hybrid securities that have manyfeatures of equity but are treated as

debt. One of the reasons thatcorporations try to create debt securitythat is really equity is to obtain the tax

benefits of debt and the bankruptcybenefits of equity. (Fundamentals of Corporate Finance, Stephen Ross,

et al, 1992)


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DERIVATIVES

Their value has a strong relationship with an underlying variable such asthe price of a share, a bond or value of an index. Forward contracts (Futures and Swaps) and Option Contracts

Used by retail and institutional investors (hedge funds, private equity andmutual funds)

No money changes hands, and no tax consequences until a gain or loss isrealized on the disposal of a contract.

The value of a Derivative depends on:- (1) Strike price, (2) Price of an underlying asset (share) and its volatility, (3)

Level of interest rates, and (4) Time to expiration of the contract

Derivatives and credit-extension (debt) instruments - basic building blocksof all financial instruments Can attain the economic substance of any traditional instrument (shares, bonds

or contingent debt instruments)

Derivatives can have characteristics of both debt and equity. Synthetic instrument

Hybrid Instrument

Derivatives permit risks (credit, market and legal) to be isolated andmanaged more efficiently than in the past and at a lower cost than a directinvestment.


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NEW FINANCIAL INSTRUMENTS

Debt with Embedded Options (Hybrid Instrument) Shows attributes of debt except that interest or principal payments arecontingent

Contract involves payment that has both a debt and an equity component

Notional Principal Contracts (interest rate swap) Arrangement under which payments are made with respect to a notional

amount, which amount itself never changes hands

Disaggregated Equity (Convertible bonds, warrants) Interest paying contract that can be converted into equity of the issuing

corporation

A bond with an embedded long-call option on the equity of the issuingcorporation

Transactions by a corporation in its own stock and options on its own stockhave no tax consequences.


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INTEREST RATE SWAP

An arrangement under which payments are made w.r.t a notional

amount, which the amount itself never changes hands, Notional Principal Contract

Example: Investor A enters into a five year contract under which A is obligated to payinvestor B interest annually computed at the fixed rate of 10% on a notional amount of R1000,

while B is obligated to pay A interest annually on notional principal amount of R1000 at a

standard floating rate, such as the prime rate. The only cash that actually changes hands is the

net payment due each year.

Interest on Yield-to-Maturity basis is taxed on periodic payments (paid

at an interval of a year or less), treated as fixed-return debt, which

uses a single, blended rate of interest over the entire period.

Swap contract can be disaggregated into the traditional components

(economic substance) with interest or dividends taxed accordingly

taking into account the term structure of interest rates


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HYBRID INSTRUMENT

A Hybrid Instrument - combine elements of traditional instruments

into a single complex instrument E.g. Debt with Embedded Options

Example: An entity issues a five year Stock Index Growth Note (SIGN) with a statedindebtedness of R10 000. In five years, the holder will receive back his investment of R10 000,

plus R10 000 multiplied by the percentage increase in the S&Ps index of 500 stocks, if any.

Accordingly, if the index doubles, the holder will receive a total of R20 000. The holder isguaranteed a minimum payment of R10 000, even if the index declines. No interest is payable

on the indebtedness

US Treasury proposed that the index-linked note be disaggregated

into a zero coupon bond and a call option, with interest taxed over the

5 year period on the zero coupon bond component.

The US treasury proposed new regulations under which interest would

be imputed on the entire purchase price of the stock-index note.


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FINANCIAL INNOVATION AND

TAXATION Income tax system has not kept pace with the creation

of new financial instruments.

Distinction between debt and equity is probably no longer

economically supported

Instruments can replicate the payoffs associated with traditional

instruments in unconventional forms, attracting different tax

consequences

In most cases, financial instruments in the income tax

system are taxed according to their legal form and not

on their economic substance.


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(The limits of self-regulations?)

.. our progress toward a resumption of work requiretwo safeguards against a return of the evils of the oldorder; there must be a strict supervision of allbanking and credits and investments; there must be

an end to speculation with other peoples money,and there must be provision for an adequate butsound currency.

FDR, 4 March 1933, First inaugural address.

We have always known that heedless self-interest

was bad morals. We now know that it is badeconomics.

FDR, in 1937, in the midst of the Great Depression.(Time, Septeber 21, 2009)

4-0 session 4_financial instruments - taxation oct2009_itd

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