Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICY Sample Financial Instru

1. International Tax Dialogue Global Conference Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions Professor Diane Ring, Boston College Law School, USA

2. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions OID Arbitrage Debt/Equity Hybrid Swaps/ Hedging Foreign Currency Risk Credit Default Swaps

3. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • OID (Original Issue Discount Arbitrage) Country X Investors Investors paid $100x for bond that will pay $133x in 3 years Zero Coupon Bonds US CO Facts: US CO needs financing and issues zero coupon bonds to Investors in Country X. Country X does not have OID rules, thus holders of OID bonds in Country X can defer inclusion of the bond income. They are taxed on the $33x of 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 US bond holders to current taxation.

4. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • OID (Original Issue Discount Arbitrage) Analysis: Is there any reason US CO should be denied an interest deduction for the deemed interest payments on the zero coupon during the life of the instrument? Should the existence of cross border tax arbitrage matter? In this case, the deductions would likely be: Year 1: Interest deduction of $10x Year 2: Interest deduction of $11x Year 3: Interest deduction of $12x Although Investors would not include their corresponding $33x in income until year 3.

5. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Debt/Equity Arbitrage: Scenario #1 Country X Investors “Zero Coupon Bonds” US Co Facts: US CO needs financing and issues bonds to Country X investors. Country X treats the bonds as equity. Under its exemption system, Country X exempts from tax the income earned by its Country X holders of the instrument. Analysis: Should US CO be denied its interest deduction on the zero coupon bonds?

6. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Debt/Equity Arbitrage: Scenario #2 US Investors “Zero Coupon Bonds” X Co. Facts: X Co., a Country X corporation, needs financing and issues zero coupon bonds to US investors. Country X treats the instrument as debt; the US treats the instrument as equity (and thus does not require accrual taxation on the “interest”). Analysis: Is there any reason that the US investors should be denied an indirect foreign tax credit in the US (presuming they otherwise qualify) for the Country X taxes?

7. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Questions: What are swaps? Answer: They are a type of “notional principal contract” under which a party agrees to make payments to a counter party using a specified variable rate as applied to a specified “notional” amount. In return, the counter party agrees to make periodic payments based on a different rate or index as applied to a notional amount – e.g., in the case of an interest rate swap.

8. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Basic Example: Plain Vanilla Fixed to Floating Interest Rate Swap B agrees to pay an amount equal to LIBOR + 2% on $1 million, per year, for 10 years Note: -The parties do not exchange the underlying notional amount of $1 million. -The parties may net their annual payments and have one flow. A B A agrees to pay an amount equal to 7% on $1 million, per year, for 10 years

9. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Question: 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 million with 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, and replace 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 a potential mismatch. If A enters into the swap, it satisfies its annual fixed rate leg of the 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 own floating rate obligations.

10. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Complexity – The swap described constitutes a straightforward, uncomplicated swap transaction. However, there are innumerable ways in which parties modify this basic model. For example, swaps might have: -significant, up-front, nonperiodic payments -termination payments -prepayments -contingent payments -options to enter into swaps

11. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Basic Example: Plain Vanilla Foreign Currency Swap At the start of the swap, B pays A $1 million, and A pays B £620,000. At the end of the swap term, A will return the $1 million, and B will return the £620,000. During the life of the swap, B agrees to pay an amount equal to 5% on £620,000 per year, for 10 years, and A pays 6% on $1 million Note- unlike interest rate swaps, where principal is not exchanged, in a foreign currency swap, the principal amounts in 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 A B £620,000 at outset 6% on $1 million per year, for 10 years $1 million at the end of the term

12. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Question: Why enter into an foreign currency swap? Answers: There are a variety of uses – (1) Change existing debt from one currency to another – often where the party has a borrowing advantage in one currency. For example, A may be able to borrow at advantageous rates in British pounds, but may desire a dollar loan. Conversely, B may 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 but effectively switch it, or swap it, into their desired currency. (2) Change an existing asset from one currency to another. For example, A owns a dollar denominated asset with a dollar return, but would prefer a pound denominated return. The currency swap effectively moves A from a dollar denominated asset with a fixed return of 6%, to a pound denominated asset with a pound denominated return.

13. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging • Questions: • What kinds of tax questions do interest rate swaps and foreign • currency swaps raise? • Answer: • What is the character (ordinary v. capital) of the periodic payments made • during the term (e.g., the LIBOR + 2% on $1 million that B pays annually in the • interest rate swap)? • (2) What is the category of such periodic interest rate swap payments? • Are they treated like interest? Something else? • (3) When are periodic payments included in income? When and how are they • deducted by the payor? • (4) What is the character of various nonperiodic payments (including up-front • payments, termination payments, etc.)? When are they reported?

14. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging (5) What is the source of the different payments under a swap? (6) How are any foreign currency gains or losses generated through a foreign currency swap treated? Are they analyzed separately? What is the character and timing of such income or loss? (7) What happens if “A” enters into an offsetting interest 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 ensure that the resulting economic hedge (neutralizing risk economically), is matched by unified hedging treatment at the tax level?

15. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Basic Example of a Foreign Currency Hedging Transaction The Problem: Taxpayer A incurred a Yen denominated liability and must pay 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 not want to bear the risk of currency fluctuations between the Yen and the US dollar. A (a US dollar based business) Annual Payments equal to 10% on 90 million Yen, plus 90 million Yen at the end of 5 years B The Solution: A foreign currency swap– the combination of flows on the swap and debt result in A having a $ debt Annual payments equal to 7% on US$1 million, plus US$1 million at the end of 5 years “A” owes “C” 10% per year, & 90million ¥ in 5 yrs

16. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Swaps and Foreign Currency Hedging Remaining Concern: Even though the foreign currency swap economically hedges A’s foreign currency risk, which was the business goal that A sought, does it produce a “Tax Hedge”? Are the swap and underlying debt integrated or coordinated for tax purposes so that from a tax perspective A is treated as if A has a dollar denominated obligation? Depending on what rules govern the character, source and timing of swap payments, and how those rules compare with the taxation of A’s debt to C (the interest and repayment of principal), there could be tax mismatches in timing, character or source if no special hedging or integration rules apply. Some countries provide special hedging rules that 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.

17. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • Credit Default Swaps “CDS” What are they? Bilateral, over-the-counter (“OTC”) contracts. Basic Example: Periodic or upfront payment Note: --There are many variations on this basic structure Writer (“protection seller”) Holder (“protection buyer”) Payment, if a specified credit event occurs with respect to Corp X bond during the term of the CDS – e.g., default, bankruptcy, restructuring

18. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • 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 its investment 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 sellers of CDS protection are Hedge Funds and Banks/Brokers. The market of credit default swaps grew tremendously from 2006 to 2007. *AIG’s role as a seller of credit default swaps has been considered an important trigger in the recent financial crisis.

19. Session 4: AN OVERVIEW OF INNOVATIVE FINANCIAL INSTRUMENTS AND THEIR IMPLICATIONS FOR TAX POLICYSample Financial Instrument Transactions • 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 of analogies, including insurance, notional principal contracts, and options. -The choices made, among these and other possibilities, could impact taxation and regulation of credit default swaps.