Taxation of Financial Instruments: Is the DebtEquity Distinction Relevant

1
Taxation of Financial Instruments Is the
Debt/Equity Distinction Relevant?

• Presentation to the Presidents 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.