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An overview of innovative financial instruments & their implications for tax policy – Session 4

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.

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An overview of innovative financial instruments & their implications for tax policy – Session 4

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  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 industry’s 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

  6. 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 firm’s 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)

  11. 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.

  12. 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 S&P’s 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.

  15. 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 people’s 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)

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