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

3/16/052 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.

3/16/053 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.

3/16/054 Three problems Inconsistency Asymmetry Indeterminacy

3/16/055 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

3/16/056 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.

3/16/057 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.

3/16/058 Problem: Asymmetry Different sides to the same transaction taxed on a different basis.  Investors  Hedgers  Foreigners  Tax exempts (pensions, charities, foundations)  Dealers

3/16/059 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.

3/16/0510 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.

3/16/0511 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.

3/16/0512 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.

3/16/0513 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.

Appendix

3/16/0515 Diagram of synthetic debt shelter Today One year DealerTaxpayer (corporation) Lend $100 $100 to buy stock Pay back $110 on loan $110 to purchase stock - $100 +$100 $0 +$100 - $100 $0 - $110 +$110 $0 +$110 - $110 $0 Interest deduction No gain on stock sale No tax

3/16/0516 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.

3/16/0517 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.

3/16/0518 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