An overview of innovative financial instruments

1
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 Tax Advisory
  Services, Ernest Young.
• Mr. Richard Collier Tax Partner
  PriceWaterHouseCoopers (PwC).
• Prof. Diane Ring Professor of Law, Boston
  College, United States.

2
Financial Sector

• The core functions of the financial sector are
  to intermediate between, and share risk across,
  savers and borrowers, providing the credit and
  liquidity upon which business activity hinges
• (ITD, Background Paper, 2009)

3
Innovative Financial Instruments (IFI)

• Derivative instruments and other innovative
  financial transactions serve legitimate business
  and investment purposes.
• use such products to take a position carrying
  specifically defined opportunities for profit or
  loss (speculation) or to offset (hedge) the
  inherent risks of other investment or business
  activities.
• This ability to shift, substitute, or transform
  products is an essential tool of modern business
  and investment.
• However, complexity and opacity of financial
  instrument is a challenge.
• While playing a critical role in risk
  management, innovative financial instruments also
  present a number of serious challenges for the
  income tax system
• (ITD, Background Paper, 2009)

4
Questions posed to Presenters

• What are the various complex instruments emerging
  on the global financial sector?
• Why do they exist and what circumstances have
  given rise to each?
• Examine (i) hedging transactions, (ii) credit
  default swaps, (iii) repos, (iv) securitized
  mortgage instruments, (v) etc.
• How are they, and should they be characterized
  from a tax standpoint.
• Issues more questions
• a. Timing and accounting issues accrual
  mark-to-market, relation of tax and financial
  accounting
• b. International mismatches in treatment, how
  does tax planning exploit these difference?
• c. Distinction between debt and equity for
  tax purposes is it sustainable?

5
Innovative Financial Instruments for Natural
Disaster Risk Management

• During the past decade, catastrophes have
  periodically strained the insurance industrys
  capacity to provide catastrophe risk insurance.
  Hence, new instruments were introduced to
  transfer and finance catastrophe risk exposure,
  such as catastrophe risk swaps, and contingent
  capital and risk-linked securities that are
  placed through the global capital market.
• Torben J. Andersen, Innovative Financial
  Instrument for natural Disaster 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 perform risk
  management?

7
Measuring and managing risk

• In an environment where there is constant flux
  and innovations, senior management is often
  ignorant about the exact nature of the
  innovations and refuses to acknowledge their lack
  of knowledge, relying on their traders and quants
  for guidance. 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 to price different types of
  collateralized debt obligations (CDO)
• To measure systemic risk, all major institutions
  including hedge funds need to come under
  regulatory monitoring.
• Stuart M. Turnbull, Measuring and Managing Risk
  in Innovative Financial Instrument, University of
  Houston Bauer College of Business, May 2009

8
Hedging

• In broad terms, reducing a firms exposure to
  price and rate (interest rates, exchange rates,
  etc.) fluctuations is called hedging.
• Hedging cannot change the fundamental economic
  reality of business. What it can do is allow a
  firm to avoid otherwise expensive and troublesome
  disruptions that result from short-term,
  temporary price fluctuations. Hedging also gives
  a firm time to react and adapt to changing market
  conditions.
• Intelligently dealing with volatility has become
  an increasingly important task for financial
  managers

9
Swaps

• A swap contract is an agreement by two parties
  to exchange or swap specified cash flows at
  specified intervals.

10
Debt vs. Equity

• Corporations are very adapt at creating exotic,
  hybrid securities that have many features of
  equity but are treated as debt. One of the
  reasons that corporations try to create debt
  security that is really equity is to obtain the
  tax benefits of debt and the bankruptcy benefits
  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 as the 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 and mutual funds)
• No money changes hands, and no tax consequences
  until a gain or loss is realized 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 blocks of 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 and managed more
  efficiently than in the past and at a lower cost
  than a direct investment.

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NEW FINANCIAL INSTRUMENTS

• Debt with Embedded Options (Hybrid Instrument)
• Shows attributes of debt except that interest or
  principal payments are contingent
• 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 issuing corporation
• Transactions by a corporation in its own stock
  and options on its own stock have no tax
  consequences.

13
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 pay
  investor 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

14
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 stated indebtedness 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
  SPs index of 500 stocks, if any. Accordingly,
  if the index doubles, the holder will receive a
  total of R20 000. The holder is guaranteed 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.

16
(The limits of self-regulations?)

• .. our progress toward a resumption of work
  require two safeguards against a return of the
  evils of the old order there must be a strict
  supervision of all banking and credits and
  investments there must be an end to speculation
  with other peoples money, and there must be
  provision for an adequate but sound 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 bad
  economics.
• FDR, in 1937, in the midst of the Great
  Depression.
• (Time, Septeber 21, 2009)