Problems with the Taxation
of Financial Instruments
David A. Weisbach
Walter J. Blum Professor
University of Chicago Law School
Overview
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Huge growth in financial markets.
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Incoherent scheme of taxation.
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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.
Piecemeal attempts to modernize.
Increasing sophistication of taxpayers and
willingness to take advantage of tax flaws.
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Many tax shelters use financial products.
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Financial instruments
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Efficient means of moving risk and return around the
economy and around the world.
Financial instruments:
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Used for:
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Investing, borrowing, hedging, speculation.
Used by:
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Stock, debt, futures, options, forwards, swaps, hybrids (e.g.
convertible debt).
Partnership interests, leases, receivables, payables.
individuals, small businesses, large business, Wall Street.
Central to modern economy.
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Three problems
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Inconsistency
Asymmetry
Indeterminacy
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Problem: Inconsistency
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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:
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Realization of gain or loss v. Mere change in value
Ordinary income v. Capital gain
Debt v. Equity
U.S. source v. Foreign source
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Example of Inconsistency
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Debt v. “synthetic” debt.
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Example of synthetic debt.
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Synthetic debt is a set of financial instruments with the
same net cash flows as a debt instrument.
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.
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No current taxation of “interest.” Possible capital gain on
sale.
“Add on” tax rules attempt to limit inconsistency, but fail.
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Using Synthetic Debt in a Shelter
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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.
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Problem: Asymmetry
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Different sides to the same transaction taxed on
a different basis.
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Investors
Hedgers
Foreigners
Tax exempts (pensions, charities, foundations)
Dealers
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Example of Asymmetry
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Suppose a dealer supplies the positions in the
synthetic debt shelter.
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Dealer marks all its positions to market.
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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.
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.
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Problem: Indeterminacy
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Very hard to determine how new financial
instruments are taxed.
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Often a result of inconsistent treatment of similar
instruments.
Potentially slows financial innovation.
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Example of indeterminacy
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Credit default swaps.
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Have characteristics of:
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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.
Guarantees.
Options.
Swaps.
Insurance.
Nobody knows how they are to be taxed.
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Tax shelters
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Sophisticated taxpayers, aided by financial
intermediaries can take tiny flaws and drive
trucks through them.
Financial instruments make sheltering easy.
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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.
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No easy fix
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Basic tax definitions and concepts would need to be
amended to reduce inconsistencies and
asymmetries.
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Capital gain/ordinary income, debt/equity, U.S.
source/foreign source, realization/nonrealization.
Likely directions for reform:
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More mark-to-market for particular taxpayers or
instruments.
Ignore financial transactions!
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Can measure income by just taxing real transactions.
VATs ignore financial transactions. Can do the same under an
income tax.
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Appendix
Diagram of synthetic debt shelter
Dealer
Taxpayer (corporation)
Lend $100
Today
- $100
+$100
$0
+$100
- $100
$0
$100 to buy stock
Pay back $110 on loan
One year
+$110
- $110
$0
No tax
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$110 to purchase stock
- $110
+$110
$0
Interest deduction
No gain on stock sale
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Five different ways of owning equity
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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.
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Four different ways of owning debt
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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.
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Example of “add on” tax rules – domestic
financial products-related timing rules
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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
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