Taxation of Financial
Instruments: Is the Debt/Equity
Distinction Relevant?
Presentation to the President’s Advisory Panel on
Federal Tax Reform
Robert McDonald
Erwin P. Nemmers Distinguished Professor of Finance
Kellogg School of Management
Northwestern University
7/11/2016
1
Overview
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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
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2
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
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All represent returns to a financial investment
3
Derivatives Blur the Distinctions
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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
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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
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What do Dealers Do?
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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.
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The Role of Dealers: Example
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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.
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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.
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The Role of Dealers, cont.
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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
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The Revolution in Financial Technology
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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.
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For example, a call option has a synthetic equivalent of borrowing to
buy stock
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Effects of the New Technology
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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.
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9
Growth in Derivatives: Swaps and
Exchange-Traded Options
Growth in Derivatives
90
180000
80
160000
70
120,000,000
100,000,000
60
120000
100000
50
4080000
60000
30
Billions of Dollars
80,000,000
Millions of Contracts
140000
East
West
40,000,000
North
60,000,000
40000
2020000
10 0
1st Qtr
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
0
19
73
0
20,000,000
Year
2nd
Qtr 3rd
Qtr
4th Qtr
Option Open Interest
Interest Rate and FX Swaps
Sources: Chicago Board Options Exchange and ISDA
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The Traditional View of Debt and Equity
Equity
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Debt
Payoff
Payoff
Stock Price
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D
Stock Price
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.
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What are These?
Collar-style payoff
Payoff
Payoff
DECS-style payoff
Stock Price
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Stock Price
“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
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Example: Individual Capital Gains
Deferral
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Suppose a wealthy investor has $1 billion dollars in
appreciated stock.
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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
13
Example: Corporate Uses of DECS-like
Structures
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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.
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A Multitude of Rules for Investors
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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
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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.
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