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

1. 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

2. 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

3. 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

4. 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

5. 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.

6. 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.

7. 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

8. 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

9. 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.

10. Growth in Derivatives: Swaps and Exchange-Traded Options Sources: Chicago Board Options Exchange and ISDA

11. 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.

12. 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

13. 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

14. 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.

15. 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.