Problems with the Taxation of Financial Instruments

1. Problems with the Taxation of Financial Instruments David A. Weisbach Walter J. Blum Professor University of Chicago Law School

2. 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. 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.

4. Three problems • Inconsistency • Asymmetry • Indeterminacy

5. 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

6. 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.

7. 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.

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

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. Appendix

15. Diagram of synthetic debt shelter Dealer Taxpayer (corporation) Lend $100 - $100 +$100 $0 +$100 - $100 $0 Today $100 to buy stock Pay back $110 on loan - $110 +$110 $0 +$110 - $110 $0 One year $110 to purchase stock Interest deduction No gain on stock sale No tax

16. 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.

17. 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.

18. 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