The Taxation of Equity Derivatives and Structured Products

TAXATION OF EQUITY DERIVATIVES AND STRUCTURED PRODUCTS Tony Rumble with Mohammed Amin and Edward D Kleinbard TA X AT ...

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TAXATION OF EQUITY DERIVATIVES AND STRUCTURED PRODUCTS Tony Rumble with

Mohammed Amin and Edward D Kleinbard

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

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TAXATION OF EQUITY DERIVATIVES AND STRUCTURED PRODUCTS TONY RUMBLE with Mohammed Amin and Edward D Kleinbard

© Tony Rumble 2003 except Chapter 4 © Mohammed Amin 2003; Chapter 5 © Edward D. Kleinbard 2003 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their right to be identiﬁed as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2003 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–0339–5 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. Editing and origination by Aardvark Editorial, Mendham, Suffolk 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 07 06 05 04 03 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

CONTENTS

Foreword

vii

PART I THE CORPORATE FINANCE DRIVERS OF FINANCIAL INNOVATION 1

2

3

1

Financial Innovation, the Capital Markets and the Efficient Risk Transfer Mechanism

3

What is the efficient capital market? The role of ﬁnancial derivatives How do ﬁnancial derivatives transfer risk? Innovative structured products and the efficient capital market: validation of the efficiency of structured products Structured products and market completeness

3 10 10

Personal Investments and Financial Innovation

28

The economics of saving Portfolio theory and innovative ﬁnancial products Active asset allocation v. passive index replication Capital protection, income enhancement and ﬁnancial products Case study: Instalment warrants

28 31 36 42 42

Modern Capital Management Techniques and Financial Innovation

58

Theories of capital structure (that is, when does capital structure matter?)

58

13 21

v

CONTENTS

Optimal capital structure and structured products as shareholder value drivers Case study: Tier I capital instruments Case study: AMP reset preference shares

62 70 78

PART II TAX TECHNICAL ANALYSIS – UK, US AND AUSTRALIA

81

4

83

UK Taxation of Equity Derivatives and Structured Products Mohammed Amin

5

Overview of relevant parts of the UK tax system Investments by individuals Corporation tax treatment of derivatives transactions Bank capital adequacy Conclusions

83 85 94 115 119

US Federal Income Taxation of Equity Derivatives

120

Edward D Kleinbard Section 1: Introduction Section II: Straddles, wash sales, short sales and other risk-reduction rules Section III: Stock loans Section IV: Basic equity derivatives: forwards, futures and equity options Section V: Equity swaps Section VI: Publicly traded instruments based on forward contracts: mandatory exchangeables and mandatory convertibles Section VII: Option-based instruments

6

Australian Taxation of Equity, Debt and Structured Products Overview of the Australian tax system Basic tax rules for debt, equity and structured products Taxation of Instalments Anti-avoidance and tax deductions General anti-avoidance rule: Part IV A Franking credit trading rules

120 121 127 131 136

143 158

183 183 185 196 205 210 217

References

240

Index

248

vi

FOREWORD

Financial derivatives are practical examples of innovations which touch the lives of many of us. They are used by the managers of everyday savings and superannuation plans, as well as by sophisticated individual investors who explicitly use them to generate arbitrage proﬁts. Yet the theory and pricing models which drive modern derivative ﬁnance date only from the early 1970s, when the Black–Scholes model, and its variants, were ﬁrst conceived. Coincidentally, the corporate and taxation regulation of derivatives, whether they are used on their own or as part of a package known as a structured product, has failed in many ways to keep pace with these ﬁnancial developments. Of course, many Western economies have embarked on regulatory reform programmes, and have as a result modernized key aspects of regulation. Progress has not been uniform, however, and as a general rule it can still be said that inappropriate regulation prevails in many countries. This can be bad for business and investors, as well as bad for the Revenue. This book has its origins in two critical questions which were kindly posed to me, in relation to the fundamental nature of derivative ﬁnance. The ﬁrst was a question put by Roger Paul, of the Australian Taxation Office, probably as early as 1990, when he asked rhetorically, ‘what is the difference between debt and equity?’ The answer, of course, is not a lot; and at one level of abstraction, there is no difference – they both provide ﬁnance and are ephemeral in their prospect of repayment. It might be argued that debt returns are ﬁxed and equity returns are variable, but in this scenario, how do we differentiate between contingent debt and redeemable preference shares? Roger’s question led to the idea that a tax system which differentiated between debt and equity – or which treated derivatives as an afterthought – might be unsound, a vii

FOREWORD

proposition which was conﬁrmed as I sat in the lecture theatres of the University of Sydney Law School, as a (relatively) young postgraduate student. At the University of Sydney I was fortunate to be taught by three scholars whose teaching has followed me since then: Professor Richard Vann, Professor Graeme Cooper and Professor Bob Deutsch. Richard in particular taught in the close analytical style pioneered in Australia by Professor Ross Parsons, who I was fortunate to be acquainted with brieﬂy during his later years. The style was more than black letter law, for it emphasized a search for the reasons behind the legislation – but it also proceeded on the assumption that taxes and tax legislation ought to make sense and be construed with precision, so as to give effect to core notions of income taxation. The classes they taught supplemented the practical training I received as a lawyer and then investment banker, and my gratitude to their ﬁne minds and selﬂess attitude to teaching and learning is huge. Bob in particular encouraged my thinking about derivatives, and ultimately led to me joining the academic programme at the Australian Taxation Studies Program (ATAX) in the Faculty of Law, at the University of New South Wales. At ATAX my immediate gratitude must be acknowledged to Professor Yuri Grbich. Yuri encourages a vigorously inquiring mind, but without any allowance for arrogance or pedantry. As founding director of ATAX, Yuri was kind enough to allow me to teach and write in my areas of interest, and always had a perspective on difficult issues. To my ATAX colleagues, Chris Evans, Binh Tran Namh, Mike Walpole, Neil Warren, Paul and Tania Serov, Colin Fong, Helen Chapman and the rest of the team, many thanks. This book had its origins in the PhD thesis I completed while at ATAX. Bob Deutsch was my supervisor and helped the process considerably. In his later role as director of ATAX, Bob once again was kind enough to support my teaching and professional education seminars at ATAX, and continues to be a friend and mentor. Dr Terry Dwyer provided many helpful perspectives on the notions of corporate tax integration which were integral to this work. As part of my research for the PhD thesis, I found myself reading and returning to the writings of Professor Alvin Warren of Harvard Law School. Alvin was kind enough to correspond with me, and upon ﬁnally meeting Alvin at Harvard, I was fortunate to have many of my half-formed ideas crystallized through discussions with him. As we parted, Alvin posed a Socratic question which goes to the heart of the issues discussed in this book. Alvin’s question was deceptively simple and its resolution framed the work in my thesis. Having identiﬁed many practical examples, in Australian and US taxes, of how debt and equity were treated differently, Alvin asked simply, why does it matter? The answer, I think, is that it matters where taxpayers are taxed at different rates, and (in the Australian context) where imputation beneﬁts are provided only to resident taxpayers. This conclusion seems to direct the viii

FOREWORD

inquiry towards an attempted resolution of the debt/equity problem, not only within the context of a domestic tax system, but also as it relates to crossborder taxation. Australian reforms have gone a long way towards reducing the domestic problem, and part way towards curing the cross-border problem, and the ongoing work of the government’s Board of Taxation and its inquiry into international taxation should help to complete some of this work. Alvin’s Reporter’s Study on Corporate Tax Integration contained within it mention of the concept of a bondholder credit, which I translated into my proposal for a system of franked debt. Ironically, it was Professor Tim Edgar of the University of Western Ontario who pointed out to me the practical implications for my thesis of the concept of franked debt. Tim is one of the few scholars globally who have devoted attention to the ﬁeld of taxation of derivative ﬁnance, and is also one of the supporters of the ATAX Derivatives Spring Schools, an annual event which has been the occasion for the presentation of much of the work which now appears in this book. Alvin and Tim’s work pick up on some of the issues which have also been canvassed by two others whose support and assistance has been invaluable, Malcolm Gammie of Temple Court, London, and Ed Kleinbard of Cleary Gottlieb Steen and Hamilton, New York City. Both Malcolm and Ed have written extensively in the area, and my thanks go also to Ed for agreeing to contribute the US country chapter in this book. Thanks also to Mohammed Amin and Emma Lubbock of PwC UK, Mohammed for his contribution of the UK country chapter, and Emma for her friendship and support during my time as a partner at PwC. There have been some personal friends and colleagues who have helped and inspired me over the last decade, without whom I am sure this book would never have been thought of or written. Peter Kennedy who taught me the fundamentals of derivatives as we worked on the launch of the Australian warrant market, Greg Stoloff who reminds us that integrity and friendship as well as intelligence are the hallmarks of the true professional and Rod Cox of Blake Dawson Waldron, who has always been there for me. It has been my aim to work with the regulators towards a common goal of an efficient and equitable tax system, and in particular I would like to acknowledge the support and great intellectual stimulation provided to me by Richard Wood, now a consultant to the Australian Treasury and previously the Treasury team leader on the Taxation of Financial Arrangements project; and from Peter Walmsley, Assistant Commissioner at the Australian Taxation Office. Richard was kind enough to seriously engage the concept of franked debt, and as part of our work together during the government’s Review of Business Taxation, Richard’s perceptive mind picked the ﬂaws in, and improved the positives of, that idea. Richard’s contribution to Chapter 6 is acknowledged. Peter of course is one of the intellectual leaders of the ATO, and has been a friend and professional colleague for some time. In more recent years, Murray ix

FOREWORD

Edwards, Secretary of the government’s Board of Taxation, Dick Warburton, Chair of that Board, and John Harvey (also on the Board and the CEO of PwC during my tenure there) have provided great support and encouragement. Portions of the book have appeared in previous versions as chapters in books I have edited, including Innovative Financial Products, Derivatives Tax Reform and Australian Business Tax Reform. The article ‘Franked Debt: A Capital Markets Savings Cure’ appeared in the latter book. A previous version of the analysis of convertible preference shares has also appeared in the 1996 Global Special Edition of Financial Derivatives and Risk Management, edited by Sajayit Das, whose inspiration is one of the motives for this book. Other articles in which portions of this work have appeared are footnoted and detailed in the references. Capital management is a key theme of this book and my friend and colleague Chandu Bhindi has provided a sharp focus to my perspective in this area. Dr Justin Wood, then of the Australian Graduate School of Management and now CEO of Barclays Global Investors Australia helped to clarify some of the difficult corporate ﬁnance issues. And as part of the great tax reform debate in this country in recent years, Dr Peter Burn, immediate past Assistant Director of the Business Council of Australia/Business Coalition for Tax Reform, as well as Mark Paterson (previously of ACCI), have been good mentors. Andrea Harthill and Jacky Kippenberger at Palgrave have helped move this book from an idea to reality – thanks for your assistance and encouragement. Finally, it is fundamentally important for me to record my eternal gratitude to my wife and children, for their inspiration and love. My parents have supported me in my studies and professional career and, without this, the book would not have been written.

Errors are the author’s responsibility, and unless otherwise stated, the book reﬂects the law as at 30 June 2002. TONY RUMBLE Savings Factory (www.savingsfactory.com) Aurora Place Sydney

x

PA R T I

THE CORPORATE FINANCE DRIVERS OF FINANCIAL INNOVATION

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CHAPTER 1

FINANCIAL INNOVATION, THE CAPITAL MARKETS AND THE EFFICIENT RISK TRANSFER MECHANISM

WHAT IS THE EFFICIENT CAPITAL MARKET? Various economic systems have been proposed by social scientists through the centuries, as the basis for the ordering and interaction of humans in society. Liberal market capitalism prevails in various forms in many countries, and its tenets reﬂect the view that a free market will allocate most efficiently the ﬁnite resources of the globe. At the core of liberal market capitalism is the idea that human progress reﬂects the process of risk taking; and the concept of risk transfer is the essential ingredient of the market through which economic units interact. Of course, free markets can engender extremes of behaviour, and the process of legal regulation is designed to balance the norms of the market against the justiﬁable demands of society for fairness and justice. The essence of modern market regulation is to facilitate the free interaction of participants in the market economy, while at the same time maximizing social justice. Contemporary tax policy in liberal market economies, for example, strives to achieve an optimal balance between market efficiency and taxpayer equity. Financial arbitrage is a vital ingredient in a properly functioning capital market. It facilitates the risk transfer process, allowing investors to minimize 3

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

risk and increase returns. Because investment markets are volatile, the process of ﬁnancial innovation seeks continuous improvements in the risk management function. Financial derivatives are the spearhead of the efficiency drive. By combining these derivatives in structured or synthetic ﬁnancial products, tailored to meet speciﬁc investor requirements, the risk management process is improved, and the market nears ‘completeness’.

The nature of modern ﬁnancial innovation The rapid development of innovative ﬁnancial contracts over the last 30 years has been lauded as one of the primary drivers in the increasing economic prosperity of major Western economies. Financial contract innovation has produced a diverse range of new ‘market-completing’1 instruments which facilitate a much greater range of sophisticated risk transfers, investment products and new corporate ﬁnancing techniques. At the same time, governments have been concerned that some elements of this activity have been the source of tax avoidance. As a consequence, tax authorities have been forced periodically to take action to deny, or constrain, tax beneﬁts to a variety of innovative ﬁnancial contracts. Financial contract innovation utilizing structured derivative or synthetic equity products is an intricate and complex phenomenon engendered by the competitive, globalizing ﬁnancial markets. The surge in popularity of these securities is driven by the ﬁnancial beneﬁts offered by them, both for investors and the issuers of the securities. These ﬁnancial beneﬁts typically include a superior investment rate of return compared to more traditional products and a lower cost of capital to the corporate issuer. Not surprisingly, these innovative contracts utilize the techniques of ﬁnancial derivatives, and often bundle or replicate a variety of option or futures contracts to provide a precise set of cash ﬂows which deliver ﬁnancial beneﬁts to suit the requirements of both investor and issuer. These ﬁnancial beneﬁts are most evident in speciﬁc market conditions, which are capable of being deﬁned or predicted at the time of creation or investment in the instrument. For example, a capital-protected financial product may outperform traditional assets in falling markets, but may underperform a cheaper unprotected asset in a rising market. This example illustrates the notion of a deﬁned-outcome ﬁnancial product: its behaviour can be predicted at the time of purchase, and the ﬁnancial payoff of the instrument will be contained within defined boundaries. Common defined-outcome ﬁnancial products include capital-guaranteed or yield-enhanced instruments, or instruments whose payoff is linked to the performance of a reference asset or index. Analysis of the beneﬁts and risks of innovative ﬁnancial contracts 4

F I N A N C I A L I N N O VAT I O N , T H E C A P I TA L M A R K E T S AND THE EFFICIENT RISK TRANSFER MECHANISM

highlights the function of these instruments as vehicles for the packaging and transfer of risk. Financial contract innovation operates at the ﬁrm and intermediary level. Generally, companies issue structured derivative products, which utilize ﬁnancial engineering techniques to replicate the cash ﬂows of derivative ﬁnancial contracts, meet their own ﬁnancing requirements and suit market needs. For example, companies may perceive that the market will value a ﬁxed return security with limited characteristics of equity more highly than a simple ordinary share. In this case, the corporate issue of a structured product will be attractive to the company and investors. Corporate issues of structured products, as part of capital management programmes, are usually seen by management as a means of improving shareholder value. In situations where a company does not perceive a need to raise capital or reconstruct its balance sheet in this way, a market intermediary such as an investment bank may construct a security which synthetically replicates the ﬁnancial proﬁle of the corporate issued structured product. The synthetic security typically will be constructed using ﬁnancial building blocks such as ordinary shares or debt issued by the underlying company as well as ﬁnancial derivatives. Synthetics are created to meet market needs and generate proﬁts for the issuer. The typical innovative ﬁnancial contract provides exposure to an underlying equity, basket or index, with a modiﬁed (normally reduced) risk proﬁle, and often with an enhanced yield, measured in comparison with the simple proﬁle of the underlying position. These contracts provide ﬁnancial beneﬁts to the issuer and investor, but may also resemble a tax arbitrage or tax beneﬁt transfer device. The modiﬁed ﬁnancial exposure may occur internally, that is, within the security, for example where a company or ﬁnancial intermediary issues a new class of share or other security which provides the altered exposure. Hybrid instruments often involve this internal engineering. Alternatively, the exposure may be generated by a structure, that is, a combination of two or more other ﬁnancial instruments, which is erected externally, that is, outside a security, such that the instrument and the structure, taken together, provide the altered exposure.

Risk reduction and yield enhancement The global trend in structured or synthetic equity is to reduce investor downside risk and enhance yield. This trend responds to the dominant market conditions of the late 20th and early 21st century, which are characterized by increased volatility and prospects for loss, coupled with a low-inﬂation/low5

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

yield environment. These products are making a vital contribution to the global savings market. The leading Australian structured equity product – the converting/convertible preference share (CPS) – offers investors the ﬁnancial beneﬁts of both downside protection and enhanced yield. These beneﬁts are produced by the ﬁnancial derivatives which are embedded in the security, and which derive value from the process of ﬁnancial arbitrage. In Part I we look in some detail at the mechanics and ﬁnancial proﬁle of converting preference shares, to illustrate their capacity to provide improved investment returns and reduced capital costs for their corporate issuers. In Part II the current tax treatment of a range of structured and synthetic equity products is considered in the context of the efficiency gains which the new products produce. Despite the multi-level efficiencies of structured products, questions about their tax treatment abound. The debate is generated primarily by the resemblance of the capital protection, inherent in many equity-based structured products, to the ﬁnancial proﬁle of a debt instrument. The tax confusion is exacerbated by the inclusion of derivatives in many of those instruments. Alteration of the risk proﬁle attaching to ordinary equity by embedded or related derivatives often deﬁes rational analysis using traditional tax analytical tools. As a result, issuers and packagers of these products, and their tax, legal and accounting advisers, often work within the context of a rapidly changing and ﬂuid regulatory environment. One of the major aims of this book is to demystify this environment and help market participants and regulators to understand the intrinsic orthodoxy of these new products. Regulatory uncertainty is often an unnecessary impediment to the further development of these products, which sophisticated pricing and risk management technology is capable of delivering. Sound regulatory systems should provide a facilitative legislative basis for structured and synthetic securities, in conjunction with a rational understanding of the nature and function of derivatives. The power of derivatives is that they disaggregate securities, as well as allowing for an inﬁnite recombination to produce new ﬁnancial contracts, often with slight resemblance to their forebears. For example, buying shares and either buying put options or selling call options can produce a ﬁnancial proﬁle now akin both to equity and debt. This ﬁnancial versatility means that when derivatives are combined with positions in stock, questions arise concerning the availability of tax beneﬁts attributable to simple equity or debt positions. This can stiﬂe the rational use by companies and investors of derivatives as risk management tools, as well as the issuance of structured or synthetic products.

6

F I N A N C I A L I N N O VAT I O N , T H E C A P I TA L M A R K E T S AND THE EFFICIENT RISK TRANSFER MECHANISM

Regulatory policy obstacles to structured and synthetic equity The traditional regulatory approach often forces new financial products into existing legal pigeonholes – debt, equity, option, futures contract – which may bear no resemblance to the true financial characteristics or function of the new security. Rational regulatory analysis is hindered by the pigeonholing approach, which adds delay and complexity to the introduction of any new security. The removal of the regulatory incoherence this fosters must be a vital goal of the microeconomic reform agenda of governments functioning within modern liberal market economies. A tax policy motivated by efficiency needs a new approach to the characterization of innovative ﬁnancial products. The second major impediment is the incoherence contained within most tax systems in relation to tax arbitrage and tax avoidance. The typical approach to tax arbitrage relies on an intuitive or ‘smell test’ approach, and there is often little or no formulation of the basis upon which the ﬁnancial analysis of innovative products can be included in consideration of them. The hard question for tax lawyers which is thrown up by these products is whether they are motivated by real commercial purpose, or whether they are tax beneﬁt transfer devices. The incoherence here is exacerbated by the inclusion within these products of derivatives, which, by allowing for the ready transformation of the proﬁle of the product before, during and after the initial investment, exaggerate the possibilities for tax arbitrage.2 An example of a progressive approach to the regulation of structured or synthetic products can be observed in the 1997 Australian reforms to the taxation of transactions involving integrated stock and derivative positions, and in the more recent provisions of the New Business Tax System (Debt/Equity) Act 2001. These reforms seek to overlay an economic substance tax approach to supplement the more traditional taxation based on legal form. Although this approach needs to be carefully implemented – particularly to ensure that the economic fundamentals of the tax rules accurately reﬂect the transactions they regulate – it is consistent with a tax system design which seeks to promote economic efficiency. The 1997 reforms set up a ﬁnancially motivated speciﬁc anti-avoidance provision, designed to prevent trading in ‘franking credits’.3 The measures rely on a calculation of the net equity exposure of the combined stock/derivative position (that is, the ‘delta’ of the position), but do not clarify the threshold question concerning the initial allocation of equity tax beneﬁts to structured or synthetic equity. This work is now done by the Debt/Equity Act. Both these areas are covered in more detail in Chapter 6.

7

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

Efficient structured products The efficiency of regulatory outcome can be notoriously difficult to measure, and the common intuitive response is to lampoon ﬁnancial engineering as mere paper shuffling.4 Nevertheless, ﬁnancial markets are adept at measuring the real value of structured or synthetic equity products. Financial analysts customarily allocate value by benchmarking a new corporate issue of a structured product against the corporate issuer’s existing cost of capital5 or by comparing the return on a structured or synthetic product against that available for securities offering comparable investment exposure. For example, many of the Australian converting preference share issues of the early 1990s were earnings per share positive: either absolutely, or compared to alternative equity raising methods, such as discounted rights issues. Combined with this ﬁnancial efficiency at the issuer level was the attractive investment proﬁle which the capital protection, enhanced yield and equity upside provided to investors. These investment attributes of converting preference shares offer a trifecta of beneﬁts which are common to most structured products and operate in a range of circumstances: 1. capital protection insures against downside risk and will generate outperformance for the product compared to the unprotected physical if the ordinary stock price drops; 2. enhanced yield generates higher present income than the physical and will be attractive if the yield on the ordinary stock drops, but will underperform if the ordinary stock yield appreciates; and 3. products with exposure to the upside will generate additional proﬁt if the ordinary stock price rises, but will normally produce underperformance if the ordinary stock price rises dramatically in price. Well-structured and priced ﬁnancial products truly display the risk transfer features, and beneﬁts, of the ﬁnancial arbitrage function.

Efficiency analysis Although efficiency considerations are a cornerstone of tax policy, and despite massive progress in recent years, the quality of analysis in the area of innovative ﬁnancial products is relatively unsophisticated. Financial contract innovation is often resisted by tax regulators, who typically are primarily motivated by revenue risk management issues, at the expense of the broader socio-economic beneﬁts which good innovation provides.6 The search for 8

F I N A N C I A L I N N O VAT I O N , T H E C A P I TA L M A R K E T S AND THE EFFICIENT RISK TRANSFER MECHANISM

efficiency is hindered most unhelpfully by the confusion of legitimate tax system design objectives (equity, efficiency) with a purely political concern about sufficiency of revenue. The sufficiency concern is properly about tax rate levels, and should not be allowed to distort tax system design to capture additional tax revenue by stealth. At this point in time we may do well to remember the innovative efficiency analysis of the 19th-century industrialist, Frederick Winslow Taylor. Taylor has been described by Peter F. Drucker, the doyen of management consultants, as being, along with Einstein and Freud, ‘one of the three seminal makers of the modern world’.7 The Taylor story has remarkable resemblance to the search for an appropriate control mechanism for the taxation of innovative ﬁnancial products. (In fact, the same issues also trouble securities’ regulators.) During the late 1880s, Taylor had cajoled the skilled machinists in his Philadelphia steelworks to a doubling of their output. The cost of this increased output was a rebellious and unhappy workforce: Taylor reached the point where he considered resigning rather than face the hostile workers. The remedy Taylor hit upon was to engage in a scientiﬁc analysis of the process he was supervising. As a result of his experiments into the engineering aspects of locomotive construction, Taylor replaced the intuitive and inefficient practices of his contemporaries with a more precise and rational approach. Hours worked went down, whilst output went up. Prior to this turning point: much of their wisdom was guesswork, built up over the years into serviceable rules of thumb … For them informed guesses were good enough … Traditional craft know-how, reduced to scientiﬁc data, was passing from workman to manager, from shop ﬂoor to front office.8

‘Taylorism’ is now described as ‘the application of scientiﬁc methods to the problem of obtaining maximum efficiency in industrial work or the like’.9 The desire of many Western governments to boost microeconomic efficiency and national savings should encourage a regulatory approach which facilitates these inherently efficient new ﬁnancial products. Governments and regulators must also acknowledge that this ﬁnancial engineering is recognized in major economies as totally consistent with the normal operation of an efficient capital market. Speaking of the North American experience, it has been said that: in addition to derivatives, participants may use tools called ‘structuring techniques’ often in combination with derivatives, to exploit anomalies in the market. Investment bankers, working with clients to raise money, use structuring techniques to convert one set of risk/return relationships into a different set of risk/return relationships 9

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

often involving the issuance of new securities. By decomposing risks and returns into component parts, they can then repackage those risks and returns to make them more appealing to different segments of the investor market. In the process, they use the resulting savings to lower the costs of raising money to the issuer and to increase their own returns. Investment bankers also use structuring techniques with investors to increase the returns on their assets without increasing their risks.10

This role of derivatives exposes the difficulty for a tax system which gives certain tax beneﬁts to equity and others to debt, or which has an incoherent approach to tax arbitrage. Modern ﬁnancial markets operate to break up or ‘unbundle’ the investments into separate components, retaining those desired by the investor and selling off the residue using the derivative market. The basis of the contemporary risk management approach to disaggregation of risk is the recognition by corporate ﬁnance theory that the value of the ﬁrm is dynamic, and reﬂects the multitude of risks assumed by the ﬁrm.11

THE ROLE OF FINANCIAL DERIVATIVES Although the simple understanding of derivatives as a risk management tool is that they insulate against principal ‘price’ risk, the reality is much more sophisticated and subtle. A ﬁrm which manufactures jeans in Asia for import into Australia and export to the rest of the world will assume a wide variety of risks. These will include: interest rate risk (on its debt); currency risk; transport risk; wage risk; labour market risk; management risk; fraud risk; climate risk; counterparty risk; environmental risk; country risk; and religious risk. Derivatives are used by the ﬁrm and investors to insure against the undesired risks but to retain others, and in so doing maximize the risk/return equation in their favour. Over- or underweight positions in one stock relative to others can also provide the desired insurance at the investor level. Derivatives are tools for ﬁne-tuning that economic exposure, and their use will be indicated where transaction and ﬁnancial costs are cheaper for the derivative than a physical transaction. Accordingly, a tax system which only operates rationally when the idealized concepts of ‘simple’ (that is, not unbundled) debt or equity exist is inefficient, and probably inequitable.

HOW DO FINANCIAL DERIVATIVES TRANSFER RISK? To understand the value of ﬁnancial product innovation, it is necessary to understand the role of arbitrage to ﬁnancial markets. One of the fundamental 10

F I N A N C I A L I N N O VAT I O N , T H E C A P I TA L M A R K E T S AND THE EFFICIENT RISK TRANSFER MECHANISM

principles of arbitrage is that it allows securities which are mispriced against their fair value to be repriced by the arbitrage process. The mispricing can occur because of a distortion of the supply/demand calculus, generally because of a disparity between the market prices of functionally similar but legally different products, or products provided by differentially credit-rated institutions. The value of arbitrage to the national or global wealth is a function of the enhanced liquidity promoted by the process, which combined with the actual mechanics of the arbitrage process leads to enhanced risk reallocation possibilities for investors.

Analysis 1 A simple analysis can illustrate the point. The example is practised every day in the Australian stock market. It is replicated across the world in every market where a liquid stock and stock futures market exists. Consider: ■ Investor A, an Australian superannuation fund manager who owns a basket

of 15 shares now worth $100m which replicates the All Ordinaries Index (AOI). The investor purchased these shares (fortunately) when the AOI level was (say) 2300 points and the bank bill rate was, say, 4% pa; ■ The AOI has appreciated since then and is currently trading at (say) 2800

points. However, because of market concerns about impending ﬁnancial statistics and currency levels (which may prompt an official increase in interest rates, for example from currently, say, 5% to 6%) the AOI is volatile and market expectations include the possibility that it will dip to 2750 points if interest rates rise; ■ Reﬂecting market concerns, the near-date Share Price Index (SPI) futures

contract traded on the Sydney Futures Exchange (essentially a futures contract over the AOI) is trading at a discount to fair value, for example, say, 2780 points. This represents market expectations of a future weakness in the AOI; ■ Investor B, an American institutional investor, has just reappraised its global

equity investment portfolio, and has accorded Australia an ‘overweight’ position. Because of the high levels of the US stock market, its global ranking model shows Australia to be very good investment value at this time. It will ﬁll the overweight position by increased buying in the stocks selected as being optimal investments in the Australian market. These stocks are very nearly the stocks owned by Investor A; ■ Investor A and Investor B are separately approached by their friendly

Australian stockbroker, who suggests the following ‘portfolio trade’: 11

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■ Investor A sells $20m of its basket of shares, the majority of which are

‘crossed’ by the broker to Investor B and the rest are sold at market prices, the aggregate value correlating to an AOI level of 2800 points; ■ Investor A places $15m of the sale proceeds in a short-term cash deposit

account and invests the remaining $5m in SPI futures (trading, it will be recalled, at 2780 points); ■ By this process, Investor A has retained its desired equity exposure but has

enhanced its portfolio return by selling physical stock at fair value and replacing the exposure synthetically at a discount to fair value; ■ Investor B has obtained its desired equity exposure in the stocks it has

chosen at market prices (that is, not at the premium which it could have been required to pay but for the ‘portfolio’ offered to it). It is self-evident that, through this process of risk reallocation, the value of the investments of both A and B, each managers of the retirement assets pledged to their control by superannuation investors, has been both protected and enhanced. This example illustrates the social good which can often be facilitated by ﬁnancial product arbitrage. The result of the strategy outlined above, performance enhancement and risk reallocation, can also be identiﬁed increasingly in markets where liquid traded options or futures do not exist. In those cases, the function of the listed derivative referred to in the example is performed by over-the-counter (OTC) ﬁnancial securities, which may be either simple or structured products. For example, the complex steps described above may now be collapsed by transacting through the OTC equity swap market, with lower transaction costs and quicker execution.12 In the case of both the simple arbitrage strategy and the structured equity swap, it will be seen that the ﬁnancial product innovation is consistent with the process described by Professor Alvin Warren of Harvard Law School as deﬁning the contemporary role of derivatives: they allow for disaggregation of traditional securities into their constituent parts; they facilitate the recombination of desired portions of those constituent parts into new products; and the ﬁnancial function of the new products may provide for a risk reallocation both to the product provider and the product purchasers.13 But it is precisely these three powerful attributes of derivatives which introduce a chaotic tax outcome. Warren makes it clear that this is not just an Australian phenomenon: in the context of US revenue law, he notes that US realization-based tax reflects a dichotomy between fixed and contingent returns, which is incoherent and exasperated by ﬁnancial product innovation.14

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Growth of structured and synthetic securities Structured and synthetic equity products are a global phenomenon, popular because of the beneﬁts they offer to issuers and investors. Writing in the mid1990s and speaking of the US experience, Daniel L Hutchinson of Morgan Stanley and Co. described these beneﬁts, in an early recognition of a surge in the supply of structured products: With the combination of record high equity values producing low dividend yields, sustained low interest rates, tight spreads and a paucity of high yield equity, investor appetite for yield enhanced equity has become an increasingly signiﬁcant factor in the new issue market … Since 1991 there have been 60 offerings of [synthetic equity such as] PERCS, DECS and similar securities … Driven primarily by issuers’ capital and rating requirements, but successful because of investors’ sustained willingness to forgo a certain amount of equity upside in exchange for higher current income.15

In the example given above, it was suggested that the social good of risk reallocation utilizing derivative contracts provides the momentum for a positive attitude towards ﬁnancial product innovation. It is appropriate for the process of risk management through structuring to be facilitated for both intermediaries (that is, the marketplace) and intending corporate issuers (that is, at the level of the ﬁrm). The need for a facilitative framework for corporate issuers can be veriﬁed by turning to a worked example of the role of structured derivative products in reducing the cost of capital of a ﬁrm. Additionally, ﬁnancial theory sees beneﬁts in facilitating new corporate issues, because they add to the available stock of risk transfer tools available to investors.

INNOVATIVE STRUCTURED PRODUCTS AND THE EFFICIENT CAPITAL MARKET: VALIDATION OF THE EFFICIENCY OF STRUCTURED PRODUCTS It has been suggested that the efficiency gains from ﬁnancial product innovation ﬂow from three driving forces.16 First, new products expand the opportunities for risk sharing by tailoring outcomes to individual investor requirements. For example, some institutional investors are prevented by their constituent documentation from purchasing unlisted securities: as a permissible alternative to unlisted OTC transactions many stock exchanges have introduced listed stock futures contracts. Secondly, new products may operate to lower transaction costs or increase liquidity: the equity swap referred to above may do both, when compared with the stock futures arbitrage to which it correlates. 13

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Thirdly, new products may reduce agency costs stemming from information asymmetries: the stock futures arbitrage and the equity swap referred to in the example above both reduce the possibility of negative portfolio price movement should the awaited economic data prove to be consistent with or more than the negative market expectations.

Arbitrage and the new issuance process The expanded risk transfer possibilities which ﬂow from new corporate issues of structured equity are clearly observable in the Australian converting preference share (CPS) market. One of the most spectacularly successful CPS was issued by TNT Ltd in 1993. The proximity of the conversion price to the underlying ordinary share price meant that investors could realize value against the CPS by selling call options with a strike price equal to the CPS conversion price.17 For the seller, this reduced its entry price into the CPS (itself a risk management strategy) and for the buyer of the call it provided risk exposure to TNT. Since the valuation of the CPS indicated that the ‘embedded’ call option in the CPS was effectively cost free,18 the seller of the call often was happy to put the trade on below prices prevailing for call options over TNT. Accordingly, as a result of the CPS issue, TNT beneﬁted by raising new equity capital when the alternative ordinary stock issue was not possible, and the market beneﬁted from a new supply of cheap optionality and related risk transfer strategies. Although most of the recent crop of CPS-type instruments issued in Australia have not contained any signiﬁcant upside optionality – since it has been argued by many issuers to be overly expensive – the fundamental value drivers of the newer instruments reﬂect those observed at the inception of this part of the market. It has also been suggested that ﬁnancial product innovation offers three practical possibilities for investors: to reduce risk by selling the source of it; to reduce risk by diversiﬁcation; and to reduce risk by buying insurance against losses.19 Since the capacity of institutional product providers (typically investment banks and brokers) to innovate will be limited by the liquidity in the underlying physical market, it is important to enhance this liquidity by facilitating the introduction of new securities by corporate issuers. The previous example concerning the TNT CPS is typical of the liquidity generated by CPS issues. Since the introduction of the CPS in the early 1990s (the CPS market now has an aggregate issue size over $10 billion, including those issues which have now converted), CPS issues have provided a significant supply of new product, underpinning further ﬁnancial engineering and hence the creation of additional risk transfer mechanisms.

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Those CPSs with conversion prices ‘close-to-the-money’ either at issue or during the life of the security20 have been integrated into mainstream arbitrage or risk management strategies, either to support ‘buy–write’ trades or – typically where the delta of the CPS is in the range 0.4 to 0.6 – as part of switch strategies (involving a switch from physical shareholding to a CPS offering equity upside but downside protection through the conversion mechanism). It will be observed that this process is consistent with the postulated ‘ﬁnancial spiral effect’: where the proliferation of new trading markets in securities makes possible the creation of new custom-designed products improving market completeness. The new product ultimately becomes standardized, underpinning more product development and so on. In this view, the markets spiral towards zero marginal transaction costs and dynamic completeness.21 To allow us to approach this perfect market, it is vital to ensure a regulatory regime which facilitates continuous product disaggregation and recombination.

Efficient corporate tax: the Australian approach to integration One of the fundamental issues for corporate tax system design is the incidence of double taxation of corporate proﬁts in those systems which tax business income at the enterprise and investor level. While Australia provides tax beneﬁts to shareholders, reﬂecting the taxes paid by the company, the other two tax systems considered in this book (the US and UK) do not. The UK abolished its system of advance corporations tax in the 1990s, and in the US a debate has raged for at least two decades about the merits and mechanics of corporate tax integration.22 Although the US tolerates a combination of mechanisms by which shareholders effectively avoid double taxation (the so-called system of ‘self-help integration’ which involves capitalization of corporate earnings and regular share buybacks at concessional capital gains tax rates), the inherent disincentive to the early distribution of proﬁts which this produces is a distortion of the market signal which the payment of a dividend provides. To avoid this type of problem, Australia runs an imputation system, where the beneﬁt of corporate tax payments is imputed to the shareholder. The Australian imputation system relies for its existence on the tax policy perspective that an integrated corporate and shareholder tax system is more efficient than a classical or double tax approach. The policy issues concerning the application of the imputation tax credit to returns on structured and synthetic equity embrace the fundamental aspects of the Australian approach to corporate tax integration, and can usefully be reviewed at this point. The Australian imputation system23 was introduced in 1988 as a means to integrate24 corporate and shareholder taxes. The system adopted is a share15

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holder credit/rebate system, ostensibly chosen to maximize the efficiency beneﬁts offered by corporate tax integration.25 The traditional view of the effect of double taxation26 of corporate earnings (the so-called ‘classical’ system) is that since dividends serve three important corporate finance purposes, corporate double taxation distorts investment through companies.27 The corollary of the traditional critique of corporate double tax is that investors will prefer non-corporate vehicles to avoid the tax (for example trusts and partnerships). Corporate tax integrationists thus propose that the classical system engenders tax non-neutrality. The competing or ‘new’ view is that double taxation of dividends has few (or none) of the ﬁnancial distorting effects which the traditional view identiﬁes, and indeed as a result of a variety of costless ‘self-help integration’ strategies which are available to shareholders, double taxation may even produce ﬁnancial efficiency.28 Corporate tax design in Australia adopts the traditional view, and prefers the integrated to the classical model. As a result of the design speciﬁcs of the Australian imputation system, involving as it does a tax credit only available to Australian taxpaying shareholders (which is thus a ‘wasting asset’ to non-taxpayers), the Australian system has been characterized by activity designed to stream the tax credits to taxpayers. This activity has been observed from the inception of the imputation system,29 and has provoked an aggressive anti-avoidance response from the Revenue which is analysed in Chapter 6 of this book.30 These specific anti-avoidance measures involve the denial of franking credits to shareholders involved in ‘trading’ of those credits, but inevitably also inflict collateral damage on a wide range of other stock, derivative and synthetic equity transactions. This can undermine the efficacy of the imputation system to reduce/remove double taxation of corporate proﬁts, and hence the introduction of the rules provoked a strong response from investors. Because of the link between the taxation of structured or synthetic and ordinary equity, it is appropriate to elaborate brieﬂy on the economic and ﬁnancial implications of an integrated corporate tax system, particularly in the light of the new view which suggests that integration may not be as important as integrationists maintain.31

The basics of imputation The new view of integration suggests that corporate and personal level investor responses to double taxation can overcome any of the non-neutralities which a classical or double tax system imposes. This means that strategies which might reduce that double tax could be characterized as ‘costless methods of do-it-yourself integration’,32 and would include: the abolition of 16

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dividend payments (relying instead on retention and capitalization of earnings); an increased emphasis on debt ﬁnance (noting the tax deductibility of interest costs); and investor use of alternative business vehicles. In response to the new view of dividends, we can draw some important conclusions relevant to the Australian experience with corporate tax integration. First, the new view of dividends is primarily a US perspective, and although the impost of the classical or double tax system in the US is often wholly or largely removed by the variety of strategies known as ‘self-help integration’,33 the inapplicability of those strategies to Australia renders the policy conclusion of the new view (that double taxation is not necessarily inefﬁcient) impotent in the Australian context. The second aspect of the corporate tax integration literature is the conclusion, expressed in eminent surveys, which supports the traditional policy analysis of the sub-optimal tax policy outcome of classical company tax. The most recent US Treasury analysis of corporate tax integration prefers the traditional critique of classical company tax to the new view, and sets out four compelling tax system design beneﬁts which it accepts as being available under an integrated corporate tax.34 Similar views are expressed by Professor Alvin Warren, in simple terms: ‘conversion of the separate US corporate income tax would reduce economic distortions and troublesome legal distinctions that arise under current law.’35

The Australian imputation ﬂaw The result of the Australian system of imputation is an effective tax levy on corporate profits distributed to non-residents at 30% (that is, the current Australian corporate tax rate). This exceeds the usual level of 15% permitted under international tax treaties, and explains the reluctance of the Australian Government to reduce that rate by an allowance in the imputation system for cash rebates for non-resident shareholders. But this goal is at the expense of an efficient and rational imputation system, a point which has been noticed (with some prescience) by a variety of Australian and international commentators.36 Professor Richard Vann predicted the problem in 1988: It thus seems likely that streaming and sale activities will grow in Australia as companies and shareholders become more accustomed to the imputation system. In turn this will place more pressure on the control mechanisms designed to limit these practices … The difficulties in preventing the many possible avoidance techniques must raise the question whether the attempt is worth the effort, or at least how can a balance be struck between making avoidance difficult without restricting ordinary transactions.37

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This observation is consistent with the analysis of shareholder credit/rebate imputation systems provided by Professor Alvin Warren of the Harvard Law School. In his ‘Reporter’s Study’ on corporate tax integration for the American Legal Institute, Alvin Warren emphasized two critical weaknesses in imputation systems which adopt the model chosen for Australia. The ﬁrst issue relates to the different tax treatment of debt and equity, and the second issue relates to the deliberate exclusion of non-resident shareholders from the tax relief available (only) to Australian taxpayers under the imputation regime: Given that much of the motivation for considering integration … follows from problems caused by the debt-equity distinction under current law, introduction of a shareholder credit for dividends would ideally involve equivalent treatment of debt to avoid a continued distinction between debt and equity ﬁnance.38 If a decision were taken to deny certain beneﬁts of integration to exempt shareholders … additional questions would arise … [for example] whether that effect could be achieved, given the possibility of portfolio shifts by exempt investors in response to integration. For example, if credits were only available to taxable shareholders, exempt organisations might be expected to sell shares to those who could beneﬁt from the credits.39 Exempt investors interested in the investment attributes of stock might then be able to replicate the returns on such investments by using the developing set of derivative instruments that mimic the performance of corporate stock.40

But the problems for tax rules which attempt to stop non-resident taxpayers from investing using derivatives is that these ﬁnancial instruments offer the greatest potential for enhanced investment return out of any contemporary ﬁnancial product or technique. If a corporate tax system denies innovation beneﬁts – because of design weaknesses – then we should be vigorous in our attacks upon it. The introduction of the Australian dividend imputation system in 1988 was correctly hailed as a decisive step towards the introduction of an integrated or conduit approach to the taxation of companies and their shareholders. What is not commonly remembered – although it is clear from a search of the literature – is that imputation has merely returned the Australian tax system to where it was in 1915.41 That is, company tax as it was originally understood in Australia was merely a proxy for the taxation of shareholders – in broad terms, under the Australian tax system which applied at around the time of the start of the First World War, company tax was seen as a type of withholding tax on shareholders, such that they were not also taxed on dividends paid to them.

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Conduits and company tax The economic logic behind the conduit principle of company taxation is that neutrality of tax outcome between the various forms of business organization (for example company, trust, partnership) is required to ensure the efficient operation of the capital market, and identiﬁes that market as the engine for job and wealth creation. It is accepted in many Western tax systems that trusts and partnerships are taxed as relationships, and generally all tax beneﬁts available to them can be passed on to the investors (beneﬁciaries/partners) in accordance with the criteria established by the constituent documents of the structure. In this way, it is possible to describe those entities as conduits for the passage out of tax beneﬁts. Corporate tax integration theory suggests that companies should be treated the same. More speciﬁcally, the policy arguments behind company tax integration include: ■ industrial concentration – tax disincentives on corporate distributions can

lead to concentration in industry, as large corporations grow by retention of earnings, with the collateral reduction of risk capital available to shareholders for investment in emerging industries.42 This is not to suggest that industrial concentration per se is bad, just that it should not be inﬂuenced by the tax system; ■ constrained private savings – to the extent that tax on company income and

distributions is distorted away from a neutral outcome (compared with other forms), equity investment may be discouraged compared with passive and relatively unproductive investment, such as in property. Without full company tax integration, ‘there is a bias towards the acquisition of existing resources rather than the channelling of investment towards active capital formation;’43 ■ capital market efficiency – apart from the earlier analysis of the issue of effic-

iency under the integrated tax approach, we can also note that integration removes a bias towards proﬁt retention by companies, which tends to promote decentralization of investment decisions by encouraging private shareholding levels to rise.44 As indicated above, an overview of the history of company taxation in Australia discloses that the integration or conduit theory was recognized from the inception of the tax system. Thus: provisions that exempt from tax proﬁts distributed by a company which had already paid tax existed in the 1895 NSW Land and Income Tax Assessment Act (s. 27 (v)); the original 1915 Federal Income Tax Assessment Act taxed undistributed company proﬁts but allowed 19

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a deduction for dividends from current income, imposing tax on shareholders but avoiding double tax (s. 16 (i)); in the 1922 successor legislation, a rebate was provided to shareholders in respect of dividends paid out of retained earnings, already taxed to the company (s. 20 (4)); and in the 1922 legislation, the dividend deduction was removed. During this period, integration was identiﬁed as an important conceptual underpinning of the tax system.45 With the commencement of the Second World War, the integration principles were placed under pressure: the dividend rebate was removed from non-residents in 1939 and from resident individuals in 1940. The Treasurer’s 1940–41 budget speech explained the (supposedly) temporary nature of the measures: A good deal could be said in favour of a complete rebate of all company taxation, but considerations of revenue and of administrative difficulties made that out of the question at the present time. It is proposed as a war-time measure to discontinue the rebate with the hope of reconsidering the whole question when the urgencies of war ﬁnance are behind us.46

Full integration lay dormant as a concept in Australia until the Asprey Committee of 1975,47 the ﬁndings of which were largely implemented with the introduction of the Australian imputation system as Part III AA of the Tax Act in 1987. Since that time, various anomalies within the imputation system have been identiﬁed as being inconsistent with the goal of full integration. The practical operation of a system of full imputation was identiﬁed by the Treasury in 1986 as requiring that: there would be no company tax as such on company income but, as a withholding arrangement companies would make a tax payment which was deemed to be a prepayment of personal tax on the share of total company income in which its shareholder had an interest.48

This is precisely the logical framework proposed by Warren in the course of his inquiry into corporate tax integration in the US: The integration proposals [he makes] would convert the separate US corporate income tax into a withholding tax with respect to income ultimately distributed to shareholders.49

Accordingly, we may conclude that the Australian imputation system reﬂects the normative tax policy perspective which favours corporate tax integration, and that failure to accord equity tax beneﬁts of the integrated system to structured or synthetic equity – the conceptual analogue of ordinary equity – may be judged to be inefficient. 20

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Using ﬁnancial analysis to assist tax system design Tax system design literature suggests that the analytical problems posed for the tax administration of structured products can be resolved by the application of ﬁnancial analysis. Derivatives are just as much a creature of ﬁnancial analysis as they are of regulation (and, in fact, arguably they should not be shaped – at least in a ﬁnancial sense – by regulation). Much of the US ﬁnancial product literature displays a fascination with ‘contingent debt’, that is, securities with a debt-like ﬁnancial proﬁle but with returns also linked to the outcome of events contingent to the security, such as the performance of an equity, index or commodity. The US tendency is to package equity exposure as debt, to secure tax deductibility for the ‘interest’ component in the security. This is in order to lower the tax proﬁle of the security below the non-deductible/assessable status of equity, which results from the non-integrated or ‘classical’ corporate tax system prevailing in the US. Because of the tax arbitrage possibilities in the US equity-linked debt market, the US analysis of contingent debt raises similar issues as for structured or synthetic equity in Australia.50

STRUCTURED PRODUCTS AND MARKET COMPLETENESS Financial product innovation is justiﬁed by the efficiency gains delivered, by providing a lower cost of capital at the level of the ﬁrm, and by expanding the range of risk transfer mechanisms available to the market. Concerning the importance of ﬁnancial contract innovation to the expansion of the risk transfer process, ﬁnance theory proposes that innovation ‘completes the market’: In economics terminology, a securities market is complete if, and only if, for each state of the world there is a portfolio that yields a positive amount in that state and zero in all others. Each such portfolio provides insurance against a particular state occurring … the amount paid for an asset with a positive return in one state and zero in all others is equivalent to an insurance premium. The positive yield on that asset if the particular state occurs corresponds to the payment of an insurance claim when an insured event happens. If all states are insurable, it is easy to see why markets are called complete: an individual can protect against any contingency that might occur. Since the ability to pass risks on to those most willing to bear them is an important economic mission for capital markets, completeness is a desirable property.51

Understanding the role of market completeness and the use of derivatives exposes the double-edged sword which tax administrators struggle with in the area of hybrid debt/equity products: a security may display certain equity 21

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characteristics which its designers argue should attract the equity tax beneﬁts (rebate/franking) to it. The security may also be, and typically is, part of a portfolio which is managed so that some or all of that equity risk is transferred elsewhere. Finance theory argues that the use of derivatives to disaggregate and recombine positions to reach an optimal risk/reward portfolio is valid and good. The converse is also true: tax administrators struggle to design a coherent and rational analytical framework, to delineate acceptable market-completing or risk transfer products and structures, from those which are ‘unacceptable’ tax avoidance. Cutting through this task is the difficulty posed by tax arbitrage. Tax arbitrage has been suggested to have three key features; tax deferral; rate conversion; and leverage.52 Professor Strnad provides an elegant description of tax arbitrage which exposes its basic offensive features: Tax arbitrage arises in its purest form when a series of transactions results in no net cash ﬂow but provides tax advantages … it is equivalent, in cash ﬂow terms, to doing nothing, and the usual result for a taxpayer who does not engage in any transactions is that there are no tax consequences.53

To respond to the tax challenge posed by equity derivatives, various analytical frameworks have been proposed. Reasoning by analogy (‘the instrument in question looks like X’) has been criticized, as working well only within a binary categorization framework (for example by allowing analysis of whether an instrument is, for example, equity or debt).54 Reasoning by analogy in the context of equity derivatives is ﬂawed because it focuses only on the disaggregative aspects of derivatives and does not include allowance for their recombination into a new form.55 In another context, that of securities regulation of equity derivatives, this legal tendency for analogous reasoning is similarly ﬂawed.56 Instead of reasoning by analogy, which in the context of hybrids produces a one-sided response to a misguided binary question (for example a debt or equity categorization will never be totally true), it has been suggested that ‘bifurcation’ and ‘integration’ are appropriate.57 Thus: ‘Bifurcation’ decomposes a new ﬁnancial product into a collection of component instruments, each with a known tax treatment. The 1991 version of the Proposed Treasury Regulations for contingent debt apply this approach … [by] dividing the instrument into a non-contingent portion and a contingent portion by subtracting the present value of the non-contingent payments from the issue price of the instrument. … ’Integration’, the logical complement of bifurcation, pools ﬁnancial instruments together rather than splitting them apart. The resulting aggregate cash ﬂow is taxed according to its ‘predominant characteristic’.58 22

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Spanning sets and systemic tax reform Other suggested elements for an improved tax framework are more mathematical and developmental. Because of the differential tax treatment accorded to debt and equity in many Western tax systems, it is difficult to see a simple method of implementation of such models, without fundamental reform. They include concepts known as ‘local pattern taxation’ (which speciﬁes a single generic treatment to all new ﬁnancial products, and is termed ‘local’ to denote application only to new products); ‘global pattern taxation’ which applies the same generic treatment to all ﬁnancial products; and ‘spanning’ theory which identiﬁes the constituent assets of the possible global portfolio and speciﬁes a tax treatment for the spanning set (from which it is possible to derive a tax treatment for individual assets within that set): ’spanning’ provides an ‘atomic theory’ of ﬁnance, in which it is possible to replicate the exact cash ﬂow of any asset or portfolio by a unique combination of the elements from a speciﬁed set of assets. The speciﬁed set of assets thus ‘spans’ the universe of possible ﬁnancial assets and is therefore called a ‘spanning set’ … To ascertain the tax treatment of any asset not in that set, including any new ﬁnancial product, one would determine the unique decomposition of the asset into a weighted sum of spanning set assets and then add up the taxes for that weighted sum. This bifurcation approach would guarantee that the tax system is consistent and universal.59

The challenge for future tax reform is to design an approach which maximizes tax ‘linearity’, and inevitably it seems that this will be the result of reducing or removing differences in tax treatment for different forms of ﬁnancial product. In the meantime, tax system participants will continue to seek a better understanding of the economic fundamentals of ﬁnancial products, and improved coherence in tax rules and their administration.

Notes 1 2

3

4

The complete market can be deﬁned as existing where a transaction can be entered into which will provide for the sale or purchase of any aspect of risk or return. In Australia, the tax authorities recognize the danger for tax administration which the malleability of derivative positions provides. Paragraph 15.27 of the Taxation of Financial Arrangements Issues Paper suggests the equity tax beneﬁts should be denied where ‘a taxpayer enters into an arrangement to substantially remove the opportunities for gain and risk of loss from a share’ (TOFA, 1997, 235). Australia operates an ‘integrated’ corporate and personal tax system, where corporate proﬁts are taxed at the corporate level, with a tax beneﬁt – the franking credit – being provided to the investor to reﬂect the beneﬁt of tax paid at the corporate level. The seminal article by Merton suggests a framework for analysis of the efficiency of ﬁnancial products, and is central to the understanding of the efficiency of structured products 23

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5

6

7 8 9 10 11

12

13 14 15 16 17

18 24

and synthetics which this book develops; see Merton RC: ‘Financial Innovation and Economic Performance’ (1992) 4 Continental Bank Jnl. Applied Corporate Finance 12, 17. This is consistent with the Modigliani–Miller thesis, which acknowledges that a new equity issue can be undervalued, particularly where there is an information asymmetry; see Modigliani F and Miller M, ‘The Cost of Capital, Corporation Finance and the Theory of Investment’ (1958) The American Economic Review 48 at 292: ‘if the owners of a ﬁrm discovered a major investment opportunity which they felt would yield more than p k, they might not prefer to ﬁnance it via common stock at the ruling price, because this price may fail to capitalize the new venture’. Australian tax system design and administration in the area of innovative ﬁnancial contracts oscillates between close consultation between stakeholders and inappropriate position taking both by market participants and regulators. This has in part led to the creation of the new Ministry of the Revenue and the government-appointed Board of Taxation. See Kanigel R: ‘Taylor Made’ The Sciences (1997, Vol. 37, No. 3, New York Academy of Sciences) at p. 18. Ibid. Ibid. p. 19. Bryan L and Farrell D: Markets Unbound – Unleashing Global Capitalism (1996, John Wiley & Sons, New York) p.49 (emphasis added). ‘Simple’ portfolio theory would suggest that the ﬁrm should not manage risk, rather that this is for the investor to manage through the process of construction and re-balancing of the diversiﬁed portfolio. Whilst this may be correct in a perfect world with no limitations on the operation of the market, contemporary ﬁnance theory accepts the managerial risk management function; see for example Miller M and Modigliani F, ‘Dividend Policy, Growth, and the Valuation of Shares’ (1961) The Journal of Business 411 at 431: ‘Each particular ﬁrm would tend to attract to itself a “clientele” consisting of those preferring its particular payout ratio’; and the agency cost literature which accepts a degree of managerial risk aversion as being consistent with a rational investor (that is the manager) who has a non-diversiﬁed portfolio (that is, the ﬁrm) and is thus risk sensitive (for example Easterbrook FH: ‘Two Agency Cost Explanations of Dividends’ (1984) American Economic Review 74 at 652–5). Equity swaps are identiﬁed in the global literature as preferred equity investment vehicles for US and European investment into minor markets. They offer protection from the information asymmetry which can characterize such investment (see for example Bryan and Farrell, op. cit. 104). It is disappointing that the 1997 budget measures, even after the modiﬁcations in Press Release 89, speciﬁcally provide an adverse tax treatment for the Australian provider of equity swaps. That is, the delta of the long stock/short swap position is 0, at least where the stock/swap is perfectly hedged. The case is still being put for recognition that tracking basket swaps do generate equity risk/reward for the Australian hedger. See the analysis of this issue in Chapter 6. Warren, AC: ‘Financial Contract Innovation and Income Tax Policy’ (1993) 107 Harvard Law Review, 460, 460–1. Ibid. Hutchinson DL: ‘Global Trends in Exchange Listed Equity Derivatives’, in Financial Derivatives and Risk Management, Issue 8, December 1996, 9–19, at 39 (emphasis added). Merton RC: ‘Financial Innovation and Economic Performance’, (1992) 4 Continental Bank Jnl. Applied Corporate Finance 12, 17. The TNT CPS was issued with a conversion price of $1.85, with a prevailing ordinary share price of $1.35. The common trade was long CPS/short exchange-traded option (ETO) with a strike of $1.85. The delta of the ETO in that case was approximately 0.5. This is not to indicate that there should be some taxable event when the CPS investor

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19 20

21 22

23 24

25

26 27

28

acquires the security, for example by considering that there is an acquisition of an asset below fair value. The embedded call in the CPS is synthetic – although the CPS holder can hedge a sold call by owning the CPS, the CPS itself does not contain within it an instrument which is separately identiﬁable as a call option. If the CPS holder keeps the full ﬁnancial proﬁle of the CPS, it will receive a certain number of ordinary shares on conversion. If it sells a call option against the CPS, it will receive premium income, and in relation to that premium it will pay tax on realization. If the offsetting sold call is exercised, it will result in the CPS holder delivering the stock it receives on conversion to the call buyer (assuming no mismatch between the maturity or strike of the option and the underlying CPS). The process of risk transfer through CPS and related option trades is subtle, but powerful. Merton, op. cit. 17–18. In contrast, the CPS issued by Westpac Banking Corporation in 1993 had a low delta on issue (and hence low equity value) but rapidly gained in optionality as the underlying Westpac share price rallied – as the market expected. Merton, op. cit. 18. Compare the pro-integration approach of Warren, AC: Reporter’s Study of Corporate Tax Integration (American Law Institute, Philadelphia, 1993) with the US Treasury Department, Report of the Department of the Treasury on Individual and Corporate Tax Systems: Taxing Business Income Once (US Government Printing Office, Washington, January 1992). Part III AA of Tax Act. ‘Corporate tax integration’ describes the view that corporate and shareholder level taxes should be combined to prevent double tax; whilst the concept of ‘integration of stock and derivative positions’ expresses a different idea, that related physical and derivative positions ought be taxed on the basis of the resulting economic substance of those positions. The efficiency beneﬁts of an integrated corporate/shareholder tax had been identiﬁed prior to 1988: see generally Dwyer T and Larkin T: The Taxation of Company and Business Income (1995, Australian Tax Research Foundation); and Treasury Economic Paper (No 9) The Australian Financial System (1981, Canberra, AGPS) (which analysed the impact of a separate corporate level tax on the choice of business vehicle, sources of capital, and the relationship of debt and equity ﬁnance). Once at the corporate level and then again upon receipt as a dividend by the shareholder. The apparent corporate ﬁnance beneﬁts are: dividends signal the ﬁrm’s future prospects; provide a ready method for shareholders to monitor management performance; and provide shareholders a hedge against the future uncertain performance of the corporation: the scope and content of the literature here is encompassed by Kose J and Williams J ‘Dividends, Dilution and Taxes: A Signalling Equilibrium’ (1985) Journal of Finance 40 1053–70; Jensen MC and Meckling WH ‘Theory of the Firm: Managerial Behaviour, Agency Costs, and Capital Structure’ (1977) Journal of Financial Economics 6 305–60; Easterbrook FH ‘Two Agency Cost Explanation of Dividends’ (1984) American Economic Review 74 650–9; Shefrin HM and Statman M ‘Explaining Investor Preferences for Cash Dividends’ (1984) Journal of Financial Economics 13 253–82: see the useful exposition of each in Nadeau SJ and Strauss RP ‘Observations on US Corporate Tax Policy and the 1992 US Treasury Report on Integration’ in Head JG and Krever R (eds) Company Tax Systems (1997, Australian Tax Research Foundation, Sydney). The self-help integration strategies are observable in the US which retains the classical system of company tax. There, rather than making a dividend distribution, many top corporates reinvest earnings; the capitalized earnings are ultimately received tax free via a share repurchase programme or at the low tax levels applicable to many shareholders subject to US capital gains tax (after the US Taxpayer Relief Act 1997, sometimes as low 25

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29

30 31 32 33 34

35 36 37 38 39 40 41 42

43 44

45 46 47 48 49 50

26

as 18%). The essence of the new view stems from the work of Modigliani F and Miller MH ‘The Cost of Capital, Corporation Finance and the Theory of Investment’ (1958) American Economic Review 48 261–97; the new view and its fundamentals are revisited in Head JG ‘Company Tax from Theory to Policy’ in Head JG and Krever R (eds), Company Tax Systems (1997, ATRF, Sydney). See the description of prototypical franking credit transfer devices provided by Prof. Richard Vann in the ‘Prologue’ to Vann R (ed.): Company Tax Reform (Law Book Co., Sydney, 1988) at p. lvi. The measures were announced in Treasurer’s Press Releases 46 and 47 dated 13 May 1997, Press Release 89 dated 8 August 1997. The competing views are covered in Head J ‘Company Tax from Theory to Policy’ in Head J and Krever R, op. cit. at p. 9 ff. Head J, op. cit. p. 6. Ibid. US Treasury Department: Report of the Department of the Treasury on Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (1992, US Government Printing Office, Washington) 13. Warren AC: Reporter’s Study of Corporate Tax Integration (1993, American Law Institute, Philadelphia) at p. 12. The interface of the Australian domestic imputation system with the international tax system is the subject of a review by the Australian Government’s Board of Taxation. Vann R, op. cit. at p. lviii. Warren AC: Reporter’s Study of Corporate Tax Integration (1993, American Law Institute, Philadelphia) at 90. Ibid. 162. Ibid. 166 (emphasis added). See for example the survey of corporate tax integration in Australia in Dwyer T and Larkin T: op. cit. at 7. The retention of earnings point is susceptible to differing viewpoints depending on factors speciﬁc to individual companies and shareholders. Warren notes that ‘Whether the classical system encourages retention or distribution of corporate earnings depends on the rate relationships among corporate, shareholder, and capital gains rates, as well as assumptions about the operation of the capital markets’ (Warren, AC: Reporter’s Study of Corporate Tax Integration (1993) American Law Institute, Philadelphia, 3). Dwyer T and Larkin T, op. cit. 38. Dwyer T and Larkin T, op. cit. 39. The point is also made by Warren: ‘In general, the classical system can … discourage individual investors from investing in new corporate equity’ (Warren AC, op. cit. 3). The M–M thesis observes that investors can use external leverage to ‘release’ the value of retained earnings: the practical reality for small investors is probably not quite so. See for example the 1921 Warren Kerr Royal Commission, cited in Dwyer T and Larkin T, op. cit. 19. Treasury Taxation Paper No. 9 (1974, Canberra, AGPS) at p. 41, cited in Dwyer T and Larkin T, op. cit. 22. Taxation Review Committee: Full Report (1975, Canberra, AGPS) at p. 233 ff. Treasury, 1986: 47, cited in Dwyer T and Larkin T, op. cit. 58. Warren AC, op. cit. 1. Just as this book makes the case for a facilitative tax treatment for ‘bona ﬁde’ synthetic equity securities in Australia, it appears that many US synthetic securities are properly facilitated by US tax laws. The Taxpayer Relief Act of 1997, which was notable for the deep capital gains cuts it provided, attacked many quasi-debt securities: interest deductibility is now denied for debt with a tenor of greater than 40 years, and for mandatorily convertible corporate issues. The new measures have been reported,

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51 52

53 54 55

56 57 58 59

however, as not extending to ‘DECS, ACES, PRIDES, and similar collateralized forward contracts … not involving the sale of stock of the issuer or a related party’ (see Cleary Gottlieb Steen and Hamilton, ‘Selected Corporate Finance Provisions of The Taxpayer Relief Act of 1997’, New York, 1 August 1997, at p. 5). Strnad J: ‘Taxing New Financial Products – A Conceptual Framework’, Stanford Law Review (1994) 48, 569, 578. See for example Cooper, GS: ‘The Taming of the Shrewd: Identifying and Controlling Income Tax Avoidance’ (1985) Columbia Law Review 657,667; Dixon, D and Vann, R: ‘How Business Tax Planning Operates: Arbitrage, Imputation and International Investment’ (1988, n.p, paper on ﬁle University of Sydney Law School, at p. 6); and Rumble, T: ‘Tax Arbitrage – A Regulatory Model’ (1990) 24 Taxation in Australia 874, 878–9. Strnad, op. cit. 573. Kleinbard, ED, ‘Equity Derivative Products: Financial Innovations Newest Challenge to the Tax System’ (1991) 69 Texas Law Review 1319, 1355. The question posed for comment in TOFA, op. cit. p. 82, (as to whether bifurcation should be part of the proposed new Australian accruals regime) should be answered in the negative, unless it is part of an integrated analysis. See Rumble, T: ‘Nobody Wants a Preying PacMan’ Australian Financial Review 1 April 1996, at p. 13. Kleinbard, op. cit. 1356–7; Strnad, op. cit. 570–1. Strnad, op. cit. 571. Strnad, op. cit. 574–5.

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CHAPTER 2

PERSONAL INVESTMENTS AND FINANCIAL INNOVATION

THE ECONOMICS OF SAVING We begin this chapter by looking in more detail at the ﬁnancial efficiency of structured and synthetic products, from the perspective of the savings market, after which we examine the use of derivatives in the modern investment market; and ﬁnally turn to some case studies of leading examples of structured products in the United States, the United Kingdom and Australia. Structured and synthetic products were ﬁrst mentioned in the literature in the August 1990 edition of the US magazine Institutional Investor, where an article appeared under the byline of Saul Hansell, entitled ‘Is the World Ready for Synthetic Equity?’ In a fascinating analysis, Hansell described the drivers behind this new structuring approach, but not perhaps as some market participants would have hoped: Both investors and dealers are impressed by the advantages of derivatives. But there are potential problems for both sides and the equity markets themselves. For investors, synthetics can be overlaid on a portfolio of stocks to guard against market declines … or to hedge currency exposure or to boost income. And they can even take the place of stock holdings to increase leverage or reduce transaction costs … But the complexity of the structures and the vagaries of pricing make it difficult to 28

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predict whether the better control offered by these custom-tailored investments will always justify the cost … In fact, these new instruments challenge a government’s regulatory control over its national equity markets. The business is global and entirely unregulated … many of the synthetics are sold speciﬁcally to circumvent local taxes, investment restrictions and margin requirements. And they may also provide opportunities for front-running and insider trading.1

This statement has proven to be remarkably prescient – many structured product market participants will have seen these products used in every one of the offensive aspects referred to by Hansell (albeit infrequently). Structured and synthetic equity products present significant arbitrage opportunities, both ﬁnancial and regulatory. Given this propensity for regulatory avoidance, they intuitively strike most observers as something to be discouraged: but is this the appropriate response, and if we are troubled by the issue, how do we analyse it?

Some benchmarks for measuring the utility of ﬁnancial contract innovation The 1997 Nobel Prize for Economics was awarded to Robert Merton of the Harvard Business School. The award was attributed to his work on option pricing, but as is often the case with multifaceted ﬁnance academics, Merton has also made a signiﬁcant contribution to the world of synthetic equity. In a seminal article on the utility of synthetics, Merton made the striking observation that: There are some in the academic, ﬁnancial, and regulatory communities who see all this innovation as nothing more than a giant fad, driven by institutional investors and corporate issuers with wholly unrealistic expectations of greater expected returns with less risk, and fuelled by financial services firms and organized exchanges that see huge proﬁts from this vast activity. From this viewpoint, opportunists develop innovations that have no function other than to differentiate their products superﬁcially … One widely accepted theory is that cost reduction or otherwise lessening the constraints of regulation including taxes … is a driving force behind ﬁnancial innovations.2

Needless to say, Merton goes on to question the validity of this style of analysis. The tools he deploys rely on the consideration of the ﬁnancial attributes of the new products. He focuses on their propensity to enhance risk management, and concludes that, despite their detractors:

29

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[Financial] innovations have greatly improved the opportunities for households to construct portfolios with more efficient risk-return tradeoffs and payoffs tailored more closely to changing needs throughout an investor’s life-cycle. [It] is possible to have an innovation motivated entirely by regulation that nevertheless reduces the social cost of achieving the intended objectives of the regulation.3

To understand and evaluate the new ﬁnancial products, we need to understand the ﬁnancial attributes which, it is argued by their promoters, make them commercially attractive. Like many Western markets, the Australian stockmarket has retracted from record high levels, and the majority of companies have sharply revised their earnings estimates downwards. The rising market may have largely been attributed to the weight of money behind it: savings and investment contributions worth billions of dollars per annum provide a strong lifeline for even the weakest performers in the corporate sector. Low interest rates will have helped the market along, too. Whether the cause of Australian economic problems is so simple (and so dramatic) as someone like Lester Thurow4 would have is uncertain. Thurow’s analysis of recent economic volatility is that it is driven by economic transformation to a postindustrial society. His thesis suggests that there are signs of a growing dysfunction in market-based economies, thriving on competition but at the same time shedding labour as lower cost technology proliferates. His predictions are chilling for those who will suffer retrenchment, but are equally concerning for those approaching retirement age – and even those in the generations behind them. Increasing productivity gains are shared unequally, with the unemployed being denied any practical access to the beneﬁts, other than through lower cost consumer goods. This stresses both welfare systems and tax revenue collection: Already the needs and demands of the elderly have shaken the social welfare state to its foundations, causing it for all practical purposes to go broke. If one adds payments to the elderly to interest on the national debt, remembering that today’s budgets are being produced by our unwillingness to pay for today’s expenditures on the elderly, interest plus entitlements are swallowing government budgets. Project the numbers forward and government simply goes broke. It will have promised its elderly more than it can collect in taxes from those who are working.5

The accuracy of this chilling statement (made in the context primarily of the US situation) to Australia is conﬁrmed in the Report of the National Commission of Audit and the recent Intergenerational Report:

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The Commission concludes that the main expenditure areas generating pressure on the budget are health and aged care, family support payments (such as childcare) and age pension expenditures. Action will be necessary to moderate expectations about what support the Commonwealth Government can reasonably be expected to provide in future and to strengthen incentives for self help by those who can afford it.6

The rational response by income earners is to increase provision for selffunded retirement. This will no doubt explain the surge in ‘do-it-yourself’ superannuation in Australia (now the fastest growing class of personal savings, accounting for over $96 billion invested). But this simple approach actually reﬂects an intergenerational inequity, which has been starkly recognized by Thurow in the US context: While more saving for retirement should be encouraged, such actions cannot solve the current problem. They in fact compound it. If today’s workers are essentially forced (‘encouraged’) to save for their own old age, but if nothing is done to cut the costs of the current system for those who already are elderly, today’s workers must simultaneously ﬁnance both today’s elderly and their own age. They have their economic burdens essentially doubled.7

The National Commission of Audit addresses the point, but avoids the intergenerational concern: Better targeting and delivery of Government beneﬁts are an important means of containing the burden on future taxpayers in a society where the proportion of aged people is increasing. Another strategy is to address the level of community reliance on government assistance in retirement. This can be done by encouraging higher rates of personal saving.8

One vital reaction to the growing importance of personal savings is the maintenance of a sound, cheap and efficient domestic capital market. At the heart of a market displaying these features is a robust savings base.9 To attract investors to a volatile equity market, money managers can either promote themselves as efficient investors who will attempt to achieve returns based on the exercise of their discretion, or they can offer tailor-made investment products which in many cases offer some capital protection.

PORTFOLIO THEORY AND INNOVATIVE FINANCIAL PRODUCTS Unfortunately for traditional superannuation fund managers, the main category of ‘discretionary’ investment managers, their recent performance has 31

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often produced returns below simple government bond rates. Even in the midst of the bull markets of the 1990s this phenomenon prompted negative publicity. A 1997 article in the Sun-Herald, a popular tabloid newspaper, reported that: The return from the average superannuation fund was less than from cash investments over the past 10 years, a survey by independent consultants InTech has shown. Even more embarrassing for the super funds is that the period covered was long enough to iron out market ﬂuctuations. The survey suggests most working Australians would have been better ﬁnancing their own retirement, or investing in government bonds.10

Similar investment surveys confirm that the underperformance trend continued during the 1990s, with drastic implications for investors in traditional superannuation funds: The InTech Asset Allocation Report shows that the median manager over the year to March [1998] subtracted signiﬁcant value through tactical asset allocation.11

That survey also disclosed that over the last ten-year period, the median fund manager has returned 10.8% pa, in comparison with the return from Australian government bonds of 12.0%.12 In similar vein, the Australian Financial Review of 22 May 2002 reported that ‘investors suffered again in April with the 56 Australian share managers returning negative ﬁgures for the month’.13 This trend of underperformance by asset managers adopting the ‘traditional’ active approach had been noticed in the US market as early as the 1970s. Writing in the American Bar Association Journal, the eminent ‘law and economics’ scholar Richard Posner wrote of the implications for trustees’ compliance with its ﬁduciary investment duty if it did not adapt to new investment management technology: Trustees’ conventional investment practices may be producing inadequate results in view of the growing body of evidence that stock picking and mutual funds are not outperforming, and perhaps may be underperforming, the market. The new learning has resulted in the ‘market fund,’ which should receive judicial approval for prudent investment standards. Thereafter trustees may be running the risk of surcharge in continuing to use the old methods.14

This simple reality of underperformance explains why modern Australian retail investors are ﬂocking to structured and synthetic equity products, such as converting preference shares, warrants, Instalment warrants and geared

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equity products.15 It is also sufficient reason to consider the role of structured and synthetic equity products in the modern investment portfolio. We have seen that demographics are driving the trend to increased public sector savings (by a process of reducing expenditure and ‘dis-saving’): changes in developed countries since the Second World War have produced growing demands on state welfare systems, particularly in the areas of health care and pensions. Since the tax revenue collected from an ageing population dwindles because income levels and consumption patterns decline with age, the growing demand on state welfare from these groups has typically been funded in developed countries by increasing levels of government debt or tax revenue collection.16 The negative socioeconomic impact of increasing tax revenue collections is partly offset in countries with a broad tax base, including countries such as Australia which recently introduced a goods and services tax (GST) to reduce the emphasis on income as the tax base. Nevertheless, the rapid expansion of government deﬁcits produced by these demographic changes is so clear in most developed countries that comments such as the following are normal: The political pressures on the leaders of national governments to continue borrowing to fund social expenditures are enormous. Citizens have come to expect these expenditures to continue as entitlements … Current policies are unsustainable into the next century. However, it will take pressures of at least equal strength to counterbalance the political pressures and get leaders to act.17

The trend which has existed in Australia since at least the start of the 1980s, a pattern of public and private consumption and expenditure in place of savings, parallels these comments. This was recognized by the National Commission of Audit, and continues to pose serious concerns for Australian social and economic life.18 The trend in developed countries to ﬁnance the growing gap between outlays and revenue collections has coincided with the global deregulation of credit markets. But the global credit markets operate with the ‘unseen hand’ of supply and demand as a price-ﬁxing mechanism and allocational tool: at the extreme, it is argued that high levels of government debt leads to expensive capital costs and ultimately to capital shortages: the global capital market [will] act as a powerful check on the tendency of governments in the developed world to issue debt. By the straightforward act of making that debt increasingly costly, the market may be able to force the recognition and correction of ﬁscal policies that … are unsustainable in the long run.19

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The emphasis on budget deﬁcit reduction in developed countries is restoring individual responsibility for welfare, or the ‘self-help’ referred to by the National Commission of Audit. This is producing a need for households to increase savings levels, and also to demand better levels of security and yield in respect of those savings. The private sector demand for better and more efficient savings products parallels the need for government to remove inefficiencies in the market. Without a streamlined public sector: ‘the capital demand by Government, however, will be used for consumption, or dissaving, rather than investment.’20 Accordingly, it is clear that a tax policy which facilitates synthetic equity is a vital tool in order to allow market forces to boost national savings as well as improve market efficiency.

National savings and tax incentives The arguments about tax incentives for national savings are, by now, well rehearsed.21 One leading ‘anti-savings tax incentives’ contribution has been from an Australian Treasury economist, Michael Carnahan, who questions the econometric basis of claims that a linkage exists between savings and economic growth. His critique is strong in the area of the link between tax incentives, savings and economic growth. He is ultimately moved to conclude, however, that: While the evidence of a link from higher saving to higher growth is weak, the results do not, of course, imply that domestic saving is not important in its own right. The rate of wealth accumulation in a society depends on the rate of saving. Therefore a society’s ability to provide for an ageing population, amongst other things, will depend on the rate of saving. The rate of domestic saving may also be an important inﬂuence on the size of any risk premium attached to the domestic interest rate structure.22

If we accept even this mild praise for the role of national savings, we can do well also to accept Dr Vince Fitzgerald’s synthesis of the debate: Both perspectives point to essentially the same, or to complementary, national imperatives. Creating a climate strongly conducive to productive investment, and encouraging a flow of domestic saving to finance it, involves not just providing a non-distorting taxation and low inﬂation environment but addressing a range of supply side factors. These include ﬂexibility in the labour force, efficiently provided infrastructure, and so on.23

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Restoring neutrality and efficiency to the tax treatment of synthetic equity will provide an important facilitation to household savings. But by targeting the efficiency gain directly at the corporate capital-raising vehicle, rather than implementing a general tax incentive-based pro-savings policy, a facilitative regulatory strategy for innovative financial contracts will enhance and underpin national competitiveness.

Money supply and the investment shortfall Several points of conclusion can thus be reached from this brief overview of the changing social and economic circumstances being experienced by Australia, in common with many Western economies. In one view, low public and private savings levels increase the national cost of capital, and may even be a signiﬁcant cause of low national competitiveness. However, if we accept that direct tax concessions may not increase competitiveness, investor use of structured and synthetic equity products – as a reduced-risk and yieldenhanced savings tool – will facilitate savings, and more directly encourage investment in productive capacity. Enhancing efficiency in the savings and investment market, in particular by facilitating the use by investors of contemporary risk management techniques made available by derivative products (including structured products), is a vital response to the rapidly changing global and national marketplace. This approach will allow these products to deliver their two key beneﬁts: enhanced

35

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investment returns (which will support increased savings); and cheaper capital for corporates (boosting productivity, growth and employment).

ACTIVE ASSET ALLOCATION V. PASSIVE INDEX REPLICATION As we deepen our understanding of the utility of structured and synthetic products, we can move to a more precise consideration of their role in investment management. In Chapter 1, we examined the efficiency enhancements available at the level of the ﬁrm which deployed a structured product issuance programme; here, we consider in more detail the beneﬁts of synthetics at the investor level. Contemporary asset allocation models guide the optimal mixture of investments between equity, debt and other asset classes. Active asset allocation models take account of variable market conditions (changing prices, market volatility, revised economic forecasts and so on) and update the investment mix continuously. These models act to counter the ﬁnancial risk of each of these asset classes, whilst retaining the possibility of economic gain. Assets which display high-growth and high-risk prospects relative to other assets in the target group, such as shares of ordinary stock in industrial companies, are balanced with more stable investment in, for example, interest-bearing bonds and cash: Under these strategies the required returns on their portfolios is sought [by investors] through identiﬁcation of particular asset classes/markets in which to invest. The emphasis is on relative value of the asset or market as distinct from speciﬁc security selection.24

The more sophisticated investor models include allowance for the market impact on the portfolio which an investment reweighting causes. For example, an indication to buy a particular share, basket or index at a particular price may not actually be capable of being efficiently executed: if the model indicates that a large number of those shares (relative to usual market turnover) be purchased, the available price may be greater than the price parameters speciﬁed by the model.25 One of the common views concerning the observed underperformance in the Australian market of the active asset allocation approach when compared to bond yields is the market impact factor (a function of relative liquidity and investor size), and another is the internal cost structure of Australian fund managers.26 In a recent survey of the performance of Australian active investment managers, State Street Global Investors identiﬁed a number of areas where those managers did not achieve the performance returns which they had targeted.27 36

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The data used in the analysis was the Australian Equities Sector Specialist universe as compiled and maintained by William M Mercer. This dataset was selected in part because it includes discontinued managers and products and hence ‘survivorship bias’ was not a concern. Data to 31 March 2002 was used in the analysis, being the latest quarter end data available at the time. For convenience, a common benchmark of ASX/S&P 200 Accumulation Index was assumed for all past and present participants in the universe. In the charts that follow, an index ‘threshold’ of 2.10% pa has been adopted. This reﬂects the fact that the data is gross of investment management fees and tax. However, when considering the merits of active versus passive management, allowance needs to be made for higher management fees and realization of capital gains associated with active management. The threshold of 2.1% pa is designed to compensate for typical costs incurred by a retail investor.

Year on year survey results Figure 2.1 shows the year on year results for the full survey. The dark bars above the horizontal axis indicate the number of managers who exceeded the

10.0%

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Surveyed Manager Results versus Index - Threshold of 2.1% pa 50

-8.0% 1990

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12 months ended 31 March Data Source:William M Mercer Specialist Australian Shares

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Figure 2.1 Surveyed manager results versus index – threshold of 2.1% 37

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index (plus 2.10% pa) for that year to 31 March. The light bars indicate the number of managers who fell below the index. The clear triangles indicate the median performance of the managers then appearing in the survey. The chart indicates that there have been periods where managers as a whole have outperformed (2001 in particular) the index plus 2.1% pa and periods where managers as a whole have underperformed.

Performance persistence While Figure 2.1 does indicate that managers as a whole have at times moved above and below the index, it does not trace persistence – in other words have the same managers been above index each year? In Figure 2.2 results are grouped from different time periods in order to try to gauge the overall persistence of managers in adding value. The clear triangles indicate the number of observations included in the assessment. For the one-year analysis, there were 177 instances where a manager recorded a result that was above index plus 2.1%; 54% of those managers achieved index plus 2.1% again, 46% failed to achieve index plus 2.1% and 1% no longer appeared in the survey.28 The three-year figure is of particular interest, given that this is often cited as a minimum period for assessing past performance. Of the 33 instances

Performance of Above Index Managers in Subsequent Period - Threshold of 2.1% pa

70% 62%

180

58%

60%

160

53% 47%

46%

140 42%

120

38%

40%

33%

100

30%

80

64

60

20% 33

40

Number of Above Index Observations

54%

50%

200

67% 177

21

10%

20

9 1%

0%

0% 1 yr Data Source:William M Mercer Specialist Australian Shares

2 yrs

0%

0%

3 yrs

4 yrs

0%

0

5 yrs

Survey Measurement Period Above Index

Below Index

Exited

Number

Figure 2.2 Performance of above index managers – threshold of 2.1% 38

PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

where a manager was successful in achieving index plus 2.1% over a threeyear period, only 42% duplicated their success while 58% failed to achieve index plus 2.1%.

Average value added across all managers There is more than one way that average value added can be gauged. Traditional surveys do not provide a good guide to average value added as they include survivorship bias, plus they only provide results over set periods (one year, three years, ﬁve years and so on). Any manager who did not have a track record for the entire period selected is excluded. An alternate approach is to calculate for each manager: ■ total performance from inception to the end of the track record; and ■ total performance of the index plus 2.1% pa over the same period.

In the State Street survey, the geometric average across all managers of (i) and of (ii) was calculated. Note that this approach includes the full track record of every manager and, by using total performance, it also gives greater weight to managers with a longer track record. The result was an underperformance of 0.1% pa across the survey universe.29

Growth Movements in the ASX All Ordinaries share price index 1980–2000

points 3500

3000

2500

2000

1500

1000

Dec-00

Jun-99

Mar-00

Sep-98

Dec-97

Jun-96

Mar-97

Sep-95

Dec-94

Jun-93

Mar-94

Sep-92

Dec-91

Jun-90

Mar-91

Sep-89

Dec-88

Jun-87

Mar-88

Sep-86

Dec-85

Jun-84

Mar-85

Sep-83

Dec-82

Jun-81

Mar-82

Dec-79

0

Sep-80

500

end of quarter index values

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TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

Synthetics and alteration of the risk/return calculus Although asset allocation models normally operate satisfactorily in ‘usual’ market conditions, they are disrupted by cycle-changing market events, such as the October 1987 stock market crash. Modern portfolio theory is preoccupied with tailoring asset allocation models to take into account asset price volatility, and one avenue currently being used is to overlay derivative protection strategies (for example the use of put options structured to suit investor’s particular requirements). If the risk/reward calculus is favourable, investors may also sell call options against their portfolio to help pay for the protective put strategy. The derivative overlay is also a strategy deployed by active fund managers seeking to move their risk/return performance into more attractive quartiles, particularly in response to the prevailing underperformance levels. Another rapidly increasing trend is the use by investors of structured products, which often forgo an element of equity upside in return for some capital protection, or increased yield. The more sophisticated structured products are based on the probability analysis of future market expectations. Accordingly, if an investment model forecasts that a given share or index price is not likely to appreciate more than a certain amount, but that there is also the likelihood of a drop in price, it may often be cheaper to invest in a synthetic security. This is because the synthetic security is an arbitrage vehicle: the issuer of the synthetic will take a view contrary to the investor, for example that the downside risk potential is less, or the upside proﬁt potential is more, than the level expected by the investor. These products also offer scope for the reduction of market impact, which may otherwise harm an effective asset allocation. For example, the issuer of the synthetic equity product may ‘sell’ the equity exposure at market prices, not at the premium to market which a physical purchase of large volumes of the speciﬁed shares, basket or index might entail. This is because the issuer of the synthetic product may do so ‘unhedged’, that is, it will cover its exposure gradually and, subsequently, perhaps at a proﬁt to it. Accordingly, synthetic equity offers the risk transfer potential which is the key value driver of all arbitrage transactions. These trends have been identified as the key features in the development of the synthetic equity market. Commenting on the use of synthetic equity in contemporary portfolios (particularly in the case of the US), it has been noted that: In relation to the equity market, the investment strategy of these investors is focused on purchasing shares in order to create a portfolio that replicates the return on an

40

PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

index. The trend towards index replication is also enhanced by the process of investment performance evaluation whereby investment returns are measured relative to the performance of the benchmark index. [Synthetic equity instruments] are particularly suitable for this type of investment strategy as they facilitate the purchase of an entire index with a single transaction.30

Synthetics in the retail market If these remarks are valid at the wholesale level, they are also becoming true for retail investors. An emerging trend is for retail investors to take a more active role in the construction of their personal investment portfolio.31 This trend is very noticeable in the widespread popularity of speciﬁc purpose ‘mutual funds’ in the US retail market. In Australia, the self-help approach is driven largely by the observed underperformance of many of the balanced or managed superannuation funds, compared to the industry benchmark (the All Ordinaries Index). The rapid growth of the Australian warrant market (which now includes structured warrants such as Instalment warrants) and the popularity of protected or geared equity lending structures is evidence of the emerging trend for self-control of investment decisions by the retail market. Retail investors use synthetic equity products for many of the same reasons as their wholesale counterparts: A major factor underpinning the development of these types of transactions in equity markets is the capacity to customise the pattern of returns from the relevant investment. [Investors] can utilise these specially tailored structures to position portfolios to proﬁt from anticipated moves in equity market values.32

As we have seen,33 corporate issuers of synthetic equity products also avail themselves of the cheaper cost of capital offered by these instruments. This trend has been documented in the context of the popularity in the US market of so-called ‘interstitial securities’.34 These instruments are really synthetic equity products which offer a customized risk/reward profile to investors. In the US market, there was in excess of US $23 billion worth of synthetic equity issues by corporations between 1991 and 1997. In Australia, the leading example of corporate issued synthetic equity is the converting preference share (CPS). Since 1990 there has been in excess of $10 billion worth of converting preference share issues in Australia, from leading corporates such as Westpac, CBA, News Ltd, ANZ, Coles Myer and TNT.

41

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

CAPITAL PROTECTION, INCOME ENHANCEMENT AND FINANCIAL PRODUCTS Investment is all about the purchase of risk at a price which investors feel is both fair and suitable for their needs. This concept is important on several levels. First, it acknowledges that in a certain world, that is, a world without risk, profit possibilities derived from risk taking do not exist.35 This explains the absence in such a world of demand for and supply of debt finance, since lenders and investors do not enjoy additional risk-based returns and hence finance investments through direct (that is, equity) mechanisms. Absence of risk would coincide with an abundance of resources, so that citizens desiring access to one resource would sell or barter resources to which they have ready access, in order to provide funds for the purchase of those other resources which they desire. The corollary of this position is that a world in which debt finance exists is a risky world: the management of that risk is precisely the rational response to the human condition which, in the field of financial innovation, drives the arbitrage market: The recognition of risk management as a practical art rests on a simple cliché with the most profound consequences: when our world was created, nobody remembered to include certainty. We are never certain; we are always ignorant to some degree … the essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between cause and effect is hidden from us.36

Investment policy which fails to accommodate the taking and minimizing of risk will accordingly be adrift from the actual manner in which society orders itself and conducts its affairs: it will be truly irrational and incoherent. This has vital implications for the investment appraisal of structured and synthetic equity positions, as well as for the broader construction of contemporary investment portfolios.

CASE STUDY: INSTALMENT WARRANTS Instalments are the fastest growing structured product on the Australian Stock Exchange (ASX). Instalments can be used simply to increase leverage within portfolios, but for a risk-averse investor, they can also be used to increase the yield and reduce the tax payable within a wide range of investment vehicles, including complying superannuation funds. This case study describes Instal-

42

PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

ments in more detail and describes some interesting strategies which investors can use in their client portfolios. Chapter 6 provides a detailed analysis of the tax and regulatory issues which Instalments raise.

What is an Instalment? Instalment warrants are simply packaged loans over shares, baskets and indices. When you buy an Instalment, the issuer includes a loan which is used to ﬁnance the purchase of the underlying assets. When you pay the ‘ﬁnal Instalment’, you are actually repaying that loan. The ﬁrst Instalments were used by the Commonwealth Government as part of the privatization of the Commonwealth Bank of Australia and Telstra. Instalments are listed and traded on the ASX. Instalments are issued by most major Australian and international banks and each year many hundreds of new Instalments are created. The key valuation issue for Instalments is driven by the interest rate and degree of leverage on the loan within the Instalment. Most Instalment issuers now offer interest rates and leverage which is competitive with more traditional margin loans. Instalments are a classic example of a structured product, which can be used in a wide range of situations to add value and reduce risk to investment portfolios. Synthetic products provide ‘deﬁned-outcome’ investment proﬁles. By combining a number of ﬁnancial building blocks, Instalments allow investors the opportunity to obtain equity market exposure plus various levels of capital protection, as well as providing yield enhancement and strong tax beneﬁts. Unlike margin loans, Instalments do not involve margin calls, and they are eligible for use within complying superannuation funds. Of course, structured products are often difficult to understand, price and implement. To illustrate the beneﬁts of these products, in this case study we will take a close look at two strategies that were extremely successful after the terrible events of 11 September 2001. Both strategies involve Instalments as the underlying investment. Instalments are as liquid as the shares themselves: once you repay the loan, the full title to the shares is transferred to the investor. Instalments now account for between 25 and 50% of all new products listed on the ASX warrant market, making this multi-billion dollar market vital for investors to understand.

43

44

Instalment trend 600

$180,000,000 $160,000,000

500

400

$100,000,000 300 $80,000,000 200

$60,000,000 $40,000,000

100 $20,000,000

MONTH Value

Jan-02

Jul-01

Oct-01

Apr-01

Jan-01

Oct-00

Jul-00

Apr-00

Jan-00

Oct-99

Jul-99

Apr-99

Jan-99

Oct-98

Jul-98

Apr-98

Jan-98

Oct-97

Jul-97

0 Apr-97

$0

Jan-97

VALUE

$120,000,000

TOTAL ON ISSUE

$140,000,000

PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

Instalments explained Buying Instalments involves the investor making: ■ a down payment (the ‘ﬁrst Instalment’) ■ a payment of interest (normally in advance but some Instalments involve

interest in arrears). In return the investor receives: ■ a loan from the Instalment warrant issuer (which is repayable at the Instal-

ment holders’ election, by paying the ﬁnal Instalment) ■ the beneﬁcial interest in the underlying share/s, which is held in a bare trust

pending payment of the ﬁnal Instalment ■ the evidence of the transaction (represented by the Instalment).

All dividends and franking credits paid on the shares held within the Instalment are distributed to the investor during the life of the Instalment. For capital gains tax (CGT) purposes, owning an Instalment is the same as owning the underlying share/s, and hence when you pay the ﬁnal Instalment, it is the same as repaying a margin loan: no CGT is triggered. The loan which may be repaid by paying the ﬁnal Instalment is limited in recourse to the underlying share/s (the ‘underlying parcel’) and it is this

45

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

feature that gives the product its ‘optionality’ (since the payment of the ﬁnal Instalment is at the election of the investor). Since repayment of the loan is optional, the risk of loss in an Instalment is signiﬁcantly lower than an investment in direct shares. In legal terms, the Instalment is the combination of a loan and the beneﬁcial interest in the underlying parcel: Instalments warrants are ‘fully covered’, that is, the underlying shares must be held by a security trustee pending repayment of the embedded loan and release of the security over the shares granted by the investor. This means there is no performance risk when the second Instalment is paid: the underlying parcel is held for the beneﬁt of the Instalment holder and is transferred to it when the ﬁnal Instalment is paid.

Shareholder applications As an alternative to the simple cash application described above, some Instalment issuers allow for shareholder applications where a pre-existing shareholding is used, as security for a loan which is advanced to the investor, and which is repayable by that investor making a payment of the second Instalment. Shareholder applications involve payment of an interest amount, but do not require a ﬁrst Instalment payment. Instead, an existing shareholder wishing to borrow money against its shares can deposit them into an Instalment programme. This process involves the shareholder applicant transferring legal title to its existing underlying parcel to the security trustee established by the Instalment issuer. That underlying parcel is then held subject to an equitable mortgage. In return, shareholder applicants will then receive a limited recourse loan and an Instalment. If an Instalment holder sells the Instalment prior to maturity, the ﬁrst loan (including any prepaid but non-accrued interest) is typically repaid automatically and a new loan is advanced to the incoming investor. This incoming investor – called the transferee – will have an outstanding loan obligation to the issuer in respect of the interest accrued from the period of the acquisition of the Instalment until the date of transfer. Accordingly, Instalment investors can typically claim interest deductions for the interest component in the purchase price of the Instalment. Each holder of an Instalment warrant has the right (but not an obligation) to make the ﬁnal Instalment at or prior to the exercise date. Upon that payment being made, the holder will obtain legal title to the underlying parcel as a result of satisfying the loan from the issuer and discharging the equitable mortgage given to the issuer.

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What happens if the ﬁnal Instalment isn’t made? If the Instalment holder does not choose to pay the ﬁnal Instalment, the Instalment issuer will take over the underlying parcel, and sell it to recoup its loan. If the proceeds of sale are greater than the loan, the issuer will normally rebate any excess to the Instalment holder.

Two smart strategies using Instalments Synthetic products like Instalments can be used to generate enhanced yields as well as providing a low-risk, leveraged equity investment. In this section we illustrate how to include Instalments as a low-risk, high-yield component of typical investment portfolios. In volatile market conditions, the prudent investor is faced with an almost impossible task: reducing risk of loss of capital, while maintaining portfolio exposure to growth assets (such as shares). When equity markets suffer volatility, the usual defensive strategy relies on increasing exposure to cash and ﬁxed interest returns. This approach often involves selling shares into a weakening market and typically coincides with cash and ﬁxed interest investments which offer very low interest rates (since low interest rates and cash returns are used in such market conditions to stimulate the market). In short, in volatile markets, the orthodox investment strategy is often an imperfect and underperforming measure. In these situations, judicious use of structured and synthetic products can provide outperformance as well as signiﬁcant capital risk reduction.

Strategy 1: Instalments as enhanced yield products To recap, Instalments involve two simple building blocks: exposure to the equity market (Instalments now cover single stocks, baskets and indices such as the ASX 200), coupled with a loan from the product issuer to provide leverage. The loan is repayable at the option of the investor, and this repayment occurs when and if the investor pays the ﬁnal Instalment. Since the loan embedded in all Instalments is limited in recourse to the underlying shares, if the shares drop in value below the amount of the loan, the investor can ‘walk away’ from the Instalment. Compared with outright purchase of the shares held in the Instalment, which exposes the investor to full risk of capital loss, Instalments provide signiﬁcant capital protection. (With a disciplined approach, the cost of the protection provided by Instal-

47

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

ments can be reduced to insigniﬁcant levels. Put simply, when you look for good value Instalments, measure the interest rates and fees charged by Instalment issuers. SavingsFactory provides a free online valuation tool to help investors value Instalments: www.savingsfactory.com.) In the wake of 11 September, many Australian shares declined by 15–20% in value. Despite this slide, a wide range of those shares displayed strong and maintainable earnings, with yields on many blue-chip shares ranging above 5%, with franking credits attached. When considering investing in Instalments, investors need to be comfortable with the capacity of the underlying company to pay dividends and grow at a reasonable rate over the life of the Instalment. Matching solid dividendpaying stocks with Instalments which offer low interest rates is simply a matter of basic investment analysis. After 11 September, when considering the future dividend-paying capacity of Australian shares, it was obvious that many shares offered valuable yields, even if one made a worst-case assumption that the company could reduce dividends by (say) 25%. Stress testing the dividend assumption in this way is a good guide to the strength of the company: since most major blue-chip stocks with good dividend yields have high levels of retained earnings, it will typically be seen that they have a high prospect of maintaining or even increasing dividend yields over time: but even if they cut yields, a well-structured investment can outperform the simple alternatives of cash or ﬁxed interest. These high cash yields provide cash ﬂow sufficient to cover the interest costs in the case of many Instalments, with the reduced risk of capital loss generated by the limited recourse feature of the embedded loan. Franking credits on the dividends enhance the value of Instalments as an investment, since the franking can be used to reduce tax in super funds. In many cases after 11 September, Instalments offered an after-tax yield in excess of 20% per annum, with full upside exposure to the equity market and reduced capital risk. As a credible alternative or supplement to the more traditional ‘ﬂight to cash’ approach, Instalments provide a powerful enhanced cash investment proﬁle. This ‘enhanced cash’ approach does require the investor to be comfortable with the (reduced) risk of loss which the Instalment generates: where the investor has a long-term investment horizon, the short-term yield enhancement will pay the investor to wait as capital growth occurs. Consider the following (real-life) example which used Instalments over CBA (Commonwealth Bank of Australia) shares. The initial investment was made on 20 September 2001 and has since produced a positive return of 25.66% per annum (as at 11 October 2002):

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PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

CBA share price:

$25.55

Instalment maturity:

19 May 2006

Total premium:37 Interest and fees:38

Exercise price (that is, loan amount):39

$9.96 $0.91 $16.50

Leverage:

61.4%

Actual cash dividends 2001:

$1.36, fully franked

Dividend yield:

5.32% pa

Franking value: After-tax yield (ungeared):

2.28% pa (that is, 5.32% × 3/7) 7.6%

Geared yield: Geared franking value:

13.65% (that is, $1.36/$9.96) 5.84% (that is, 13.62% × 3/7

Instalment after-tax yield:

19.45%

Tax deduction for cost of Instalment paid:

$0.91

Thus after-tax cost (assume 15% tax rate):

$0.77

Looked at in another way, for an after-tax cash outlay of $0.77, the investor will receive full upside exposure to CBA shares, with downside risk limited to $9.96,40 and a year-one payback of $1.94 (that is, the cash dividends plus franking credits). The investment is self-funding in this scenario after less than one year. While this type of return will not always be available, this example illustrates the power of Instalments as both an enhanced cash product, as well as a way of obtaining low-cost exposure to the equity market.

Strategy 2: Extracting cash without selling shares Instalments can also be used to raise cash against a shareholding without selling those shares. Since Instalments involve a loan from the issuer to the investor, most Instalments offer the shareholder application facility described above, which involves the shares being deposited in an Instalment as security for the loan from the issuer. This strategy does not involve a disposal of shares for CGT purposes, and hence allows investors to monetize shareholdings and use the cash raised for diversiﬁcation into other assets. Two investment approaches can be used in volatile markets as part of a cash extraction strategy. The ﬁrst approach is like a pre-emptive strike – where the share market is trading at levels which analysts think is too high compared to real values, cash extraction can be used to raise cash at those levels while retaining exposure to the underlying shares. This effectively removes the diffi-

49

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

cult issue of market timing from the investment decision: one of the worst outcomes for many investors is selling shares which are considered to be trading at high levels, only to see them continue to appreciate in value. The cash extraction approach allows the investor to retain exposure to the upside growth potential in their shares. Secondly, after a market shock has been experienced, investors who would like to increase their exposure to cash or ﬁxed interest can simply deposit shares in an Instalment and redeploy the released cash in alternative investments such as cash at bank or a cash management account. Once the market stabilizes this cash can be reinvested in the equity market, and even in the same shares that are held in the Instalment (for example the Instalment can be repaid). A powerful way to diversify equity investments is to use the cash released by a cash extraction strategy to invest in other equities or markets. This reinvestment can be used to widen a portfolio and is especially useful where the investor is overweight in single stocks. Good investment choices diversify risk and provide balanced exposure to growth assets. Equity markets provide good long-term growth prospects but often suffer from short-term volatility. More traditional investment management techniques use active asset allocation tools to minimize risk but often suffer from high transaction costs and internal management to expense ratios. As a supplement to the typical investment portfolio, Instalments provide a powerful way to generate high yields with capital protection. Instalments offering long-dated maturities (often now up to ﬁve years), and interest rates which are comparable with margin loans are increasingly used by many investors as a way to diversify portfolios while maintaining exposure to the equity market. Instalments have traditionally been issued over single stocks with moderate levels of gearing. In the past 18 months, as demand for Instalments has risen, issuers have extended their range to include Instalments over a range of assets, including listed property trusts and exchange-traded funds, as well as increased levels of gearing. It is interesting to compare two recent products which provide investors with signiﬁcant variety compared to traditional single stock Instalments.

BNP Paribas ‘streetTRACKS’ ASX 200 Instalments One of the frequent criticisms of direct share investing is that it is more risky than ownership of a diversiﬁed portfolio of stocks. The traditional vehicle for holding a diversified equity portfolio is the managed fund; but given the under-

50

PERSONAL INVESTMENTS AND F I N A N C I A L I N N O VAT I O N

performance of many active fund managers, the introduction of low-cost passive funds has provided a serious alternative investment product. An interesting example of the use of Instalment technology can be seen in the recently launched streetTRACKS ASX 200 Instalments, issued in Australia by BNP Paribas. This Instalment provides a geared exposure to the streetTRACKS ASX 200 passive fund, justiﬁable for those investors who are inadequately provisioned for their retirement needs. The Instalment allows for the use of a low-cost, ‘passive’ index replication fund as the core of an investment portfolio, in combination with a range of ‘satellite’ ﬁnancial products, blended to produce a risk/return proﬁle to suit individual investor needs. Products like the streetTRACKS ASX 200 fund represent the new wave of low-cost, passive index replication products. This fund is listed on the ASX (hence the acronym used to describe them, ETFs – exchange-traded funds), and is guaranteed to match the performance of the ASX 200 Index. Unlike traditional active funds which charge management fees of between 1 and 2% pa, the streetTRACKS ASX 200 ETF involves a management fee of 0.286% pa. A number of ﬁnancial product issuers have created Instalments over ETFs, the most recent being launched in mid-2002 by BNP Paribas (ASX code STWIPA). This Instalment provides conservative gearing and is suitable for investors who expect the underlying index to appreciate by at least the aftertax cost of the Instalment. For investors who wish to obtain geared exposure to this innovative ETF, this product may provide interesting beneﬁts, particularly as an alternative to traditional managed funds.

Product structure Like all Instalments, BNP Paribas streetTRACKS Instalments are simply the combination of a loan and the associated purchase of the streetTRACKS ASX 200 ETF, which is held by a security trustee until the repayment of the loan. The Instalment investor pays interest on the loan and gets all dividends and attached franking credits on the shares which are contained in the ETF. In the case of the BNP Instalment, investors are required mandatorily to reapply all dividends to reduce the balance of the loan contained within the Instalment, and although the total dividend yield on the shares within the ASX 200 is relatively low, this may not be an efficient approach for some investors.

Financial performance, risks, fees and charges The BNP Instalment is conservatively geared, with an embedded loan of $20, repayable on 30 June 2003. This represents a loan to value ratio of 57.95%. Like 51

TA X AT I O N O F E Q U I T Y D E R I VAT I V E S AND STRUCTURED PRODUCTS

all geared investments, the risk is that the underlying asset needs to appreciate by at least the after-tax cost of the gearing before the investor receives a positive return. This can be analysed in the case of this Instalment by analysis of the performance of the streetTRACKS ETF, and by comparison of this performance with that offered by traditional managed funds. The streetTRACKS ASX 200 ETF is manufactured by State Street Global Advisers, a global fund manager and asset consultant. As we saw above State Street has undertaken a detailed survey of Australian fund managers and concludes that after taking account of management fees and tax costs (which they model as an average 2.1% pa for retail investors): ■ the median Australian active fund manager underperformed the ASX 200

Index by more than 2% in 2000 and by nearly 2% in 2002 (year to date); ■ in 2002, more than 40 fund managers have underperformed the ASX 200

Index while only 22 have outperformed the index; ■ less than half the active managers who outperformed the ASX 200 Index for

three consecutive years repeated that performance for the next three years; ■ the average total returns of all Australian active fund managers since 1990

have underperformed the ASX 200 Index by 0.1%. While it is clear from this analysis that active fund managers do not consistently beat their benchmark and that low-cost funds which replicate that benchmark are at least as efficient as an investment tool, how do we measure the prospect of successful geared investing into these new funds? The net effective cost of the geared investment made via the STWIPA Instalment represents an interest cost of 9.1% (after tax @ 15% = 7.735%) for the BNP Paribas Instalment at the time of writing. While non-recourse ﬁnance of the type which an Instalment contains involves a premium interest rate compared to secured ﬁnance, this rate imposes a high hurdle rate of return for the underlying asset for the Instalment to be economic. The BNP Instalment over the streetTRACKS 200 ETF represents an innovative way to gear into this ETF, and for those investors who expect the ETF to appreciate by at least the cost of the Instalment it will be a useful tool for a contemporary investment portfolio.

‘Hot’ Instalments

Since their inception in the mid-1990s, many investors have used simple Instalments to obtain leveraged exposure to stocks and baskets of shares.

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Simple Instalments offer relatively conservative levels of gearing (typically between 50–65%) and have proliferated as mainstream investment products. As investor demand and issuer capacity grows, an increasing number of Instalment issuers are now competing through service levels as well as product innovation. A number of ﬁnancial product issuers now offer Instalments with high levels of gearing, often up to (or exceeding) 100% of prevailing share prices. As with any geared share product, these ﬁnancial beneﬁts are only available at a cost, and the appraisal of highly leveraged Instalments needs to consider fully the risks and costs they contain. The new highly geared Instalments provide some interesting investment opportunities and are particularly attractive to investors wishing to enhance yield and franking credits within DIY superannuation funds. Day traders are also ﬁnding that these highly geared Instalments offer additional trading opportunities as a surrogate for simple call warrants.

Product structure The simplicity of Instalments is supplemented by the lower level of risk contained within the Instalment compared to traditional share-lending products, like margin loans. In the case of Instalments, the repayment of the loan by the investor is entirely optional, with the product issuer protected by security over the shares and also by its own internal hedging programme. In other words, apart from the investor’s initial cash outlay (which will combine a capital contribution, a payment of interest and payment for fees and charges), the investor has no share price risk. If the shares go up during the term of the Instalment, the investor can repay the loan and either hold the underlying shares or sell them at a proﬁt. If the shares decline in value, the investor can simply walk away from the investment with no further payment required. High levels of gearing involve very low initial cash outlays by the investor, and full gearing involves payment only for the cost of interest for the loan and the associated fees and charges.

Financial performance, risks, fees and charges The product issuer passes on the costs of its hedging to the Instalment investor through the Instalment fee structure. Simple Instalments with low levels of gearing involve very little extra cost associated with this hedging, since the product issuer assumes that the risk of a share price halving during the life of

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the Instalment is insigniﬁcant. (Expressed in another way, the cost of a put option over the asset underlying an Instalment with a strike price around 50% of spot is relatively insigniﬁcant.) Of course, the risk for a product issuer who lends 100% of the prevailing share price is signiﬁcantly higher, and this translates into much higher fees and charges than for low-geared Instalments. The trade-off is in the levels of initial cash outlay, with the initial cash outlay for a highly geared Instalment being signiﬁcantly lower than for a lesser geared Instalment (which requires some capital contribution). A simple view of highly geared Instalments is that they allow for higher leverage than ungeared or low-geared products. In this view, high-geared Instalments can be used for speculation on stocks which are expected to rise. The financial performance of highly geared portfolios can be spectacular where the underlying share price rises, but the levels of risk involved in this type of investment are not for the faint-hearted. Not only does the cost of gearing need to be recovered through share price appreciation, but downside risk is strongly magniﬁed with this type of leveraged approach (if a portfolio is geared ten times by leverage then every $1 loss on the underlying share will produce a $10 loss on the portfolio). For this reason, highly leveraged portfolios are not usually recommended for unsophisticated investors. However, a far more interesting approach to using highly geared Instalments has begun to emerge. As a result of the mathematical theorem known as ‘put/call parity’, in normal market conditions the cost of a fully geared Instalment, less the value of dividends and franking credits received on it, will be equal to the cost of a simple ‘at the money’ call warrant over the same stock. In other words, highly geared Instalments behave like dividend-paying call warrants. (Investors who are familiar with simple call warrants will know that they do not pass dividends through to the investor, who is compensated for these foregone dividends through the price of the call warrant.) This is particularly attractive for those investors who wish to pursue aggressive derivative trading strategies but who also value the tax beneﬁts available from fully franked dividends.

Verdict Highly geared Instalments are traditionally considered as high-risk/reward instruments, suitable primarily for speculative investors wishing to magnify proﬁts in a rising share market. When used in this fashion, they can provide signiﬁcant returns but are also capable of generating signiﬁcant losses in market downturns. A more progressive approach is to use the highly geared Instalment as a surrogate for a simple call warrant, and in this capacity to use 54

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the dividends and franking credits to increase yields and enhance the tax proﬁle within the overall investment portfolio.

Notes 1 Hansell S: ‘Is the World Ready for Synthetic Equity?’ (1990) Institutional Investor, August 54, 55–6. 2 Merton RC: ‘Financial Innovation and Economic Performance’ (1992) Continental Bank Journal Appl Corp Fin. 12, 14–15. 3 Ibid. 16. 4 Thurow L: The Future of Capitalism, (1996, Allen & Unwin, New York). 5 Ibid. p. 97. 6 National Commission of Audit: Report to the Commonwealth Government (1996, Canberra, AGPS) p. xv (emphasis added). 7 Thurow L, op. cit. at p. 109 (emphasis added). 8 National Commission of Audit Report, op. cit. at p. 147 (emphasis added). 9 The low level of personal savings in Australia has long been of concern. The National Commission of Audit Report noted that Australia’s gross savings ratio of 16–18% ‘compares poorly with the average of around 22% for member countries of the OECD’ (ibid. p. 147). 10 The Sun-Herald, 23 March 1997, p. 77. 11 InTech Performance Survey, Superannuation Pooled Funds, ‘Tactical Asset Allocation’ (InTech Asset Consulting Pty. Ltd, Sydney, Vol. 9 No. 98, 30 April 1998), p.1 . 12 Ibid. p.3. 13 ‘Managers Post Woeful Figures,’ Australian Financial Review, 22 May 2002, at p. 50. 14 Langbein JH and Posner RA: ‘The Revolution in Trust Investment Law’ (1976) 62 American Bar Association Journal 887–91. The example given in the excerpt does not involve derivatives, but the modern approach to index funds often uses a derivative overlay to provide tactical asset allocation performance enhancement. 15 The ‘mini crash’ in Australasian stock markets during the week 19–24 October 1997 prompted the highest turnover in the ASX warrant market, with the turnover on 23 October topping 37 million warrants (‘Record In Warrants Trade,’ Australian Financial Review, 24 October 1997, p. 81). 16 See for example the National Commission of Audit: Report of the Commonwealth Government (1996, AGPS, Canberra) at Chapter 6, pp. 121–54. 17 Bryan L and Farrell D, Market Unbound – Unleashing Global Capitalism (1996, John Wiley & Sons, New York) at 135. 18 National Commission of Audit:Report, at p. xv. 19 Bryan and Farrell, op. cit. at 116. 20 Ibid. 21 In an earlier paper I canvassed the competing views: see Rumble T: ‘Developing Arbitrage Products – Exchangeable Shares’ in Ch. 1, Innovative Financial Products (1996, Prospect Publishing, Sydney). 22 Carnahan M: ‘The Link between Saving and Economic Growth: A Review of the Evidence,’ (n.p 1996, paper presented to the Conference Of Economists, at p. 11). 23 Fitzgerald VW: Report on the Australian National Savings Policy (1993, Canberra, AGPS) p. 15 (emphasis added). 24 ‘Editor’s Note’ in Financial Derivatives and Risk Management, at p. 3 (emphasis in original). 25 This view is also evident in Posner’s comments on the ‘new’ ﬁduciary investment management approach: ‘Why have the ﬁnancial experts and analysts been unable to turn their research skills to the advantage of their clients’ portfolios? The answer, it seems 55

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26 27 28 29

30 31

32 33 34

35

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clear, is that the experts have cancelled out each other’ (Langbein JH and Posner RA: ‘The Revolution in Trust Investment Law’ (1976) 62 American Bar Association Journal 887–91, at 887). One of the features of the passive index replication funds is the low cost ‘management to expense ratio’ (MER). The following analysis was provided by State Street and is reproduced with thanks. Possible reasons include discontinued products, withdrawal from the Australian market for overseas managers and mergers or takeovers. The data used in the charts was sourced from the William M Mercer Performance Analytics software. This data set includes 84 managers and/or products with some performance histories dating back to 1981. The following comments about the data can be made: (a) Given that the data includes managers and/or products that no longer appear in the survey, ‘survivorship bias’ is minimal; (b) No attempt has been made to remove apparent duplication where more than one performance series appears in respect of a single manager. This can occur for a number of reasons; for example some managers offer products with different risk proﬁles, in some cases a manager has ‘inherited’ a second track record via a merger or takeover and so on. In any event, the data reﬂects the published William M Mercer Survey and the level of genuine duplication is probably minimal; (c) Effective April 1999, William M Mercer do not allow new managers entering the survey to include extensive past histories of performance. This is to ensure that the snapshot of managers included at any particular date is reasonably representative of managers who were actively promoting their services at that time. It is possible that there might be biases in some of the early data periods relating to inclusion of back histories for new managers; (d) The analysis has been conducted assuming a benchmark of ASX/S&P 200 Accumulation Index for all managers. While a number of survey participants benchmark against ASX/S&P 300 Accumulation Index, both these indices only commenced in April 2000 and the performance difference since that date has only been 0.1% pa. Editor’s Note in Financial Derivatives and Risk Management, at p. 3 (emphasis in original). For example, see the comments attributed to George Russell, the global Chairman of consulting actuaries Frank Russell & Co, in the Australian Financial Review of 7 March 1997 at p. 42: ‘The major demographic changes in the Western world are driving a universal need to save and producing an inﬂow of retirement savings. This is creating a need for new areas of higher yielding investments for the superannuation and pension funds … Most people in the Western world will soon be responsible for their own retirement income and for the decisions driving their investment, because of the major demographic changes’ (emphases added). Editor’s Note’ in Financial Derivatives and Risk Management, at p. 4. Chapter 2, above. See, for example, Prof. Henry TC Hu: ‘New Financial Products, the Modern Process of Financial Innovation, and the Puzzle of Shareholder Welfare’, in Texas Law Review, Vol. 69, No. 6, May 1991, at 1273. Compare this proposition concerning the role of risk with the analysis of the Japanese malaise which Professor Paul Krugman provides: ‘Thanks to a declining birth rate and negligible immigration, (Japan) faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the country should save heavily to make provision for its future – and it does. But investment opportunities in Japan are limited, so that business will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession. If this is the problem, there is in principle a simple, if unsettling solution: what Japan needs to do is promise borrowers that there will be inﬂation in the future! If it can do that, then the effective ‘real’ interest rate on the borrowing will be negative:

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36 37 38 39 40

borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs’ (Krugman P: ‘Can Japan Be Saved’ (1998) Sydney Morning Herald 33–6, at p. 36. Bernstein P: Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, New York, 1996) at pp. 197–206 (emphasis added). Total premium includes interest and other fees, as well as ﬁrst Instalment (that is, investor’s equity contribution). Interest and fees of $0.91 implies ﬁrst Instalment amount of $9.05. Loan amount is repayable via ﬁnal Instalment. Unlike an investment in CBA shares directly, where the investor is fully exposed to the risk of capital loss, in this Instalment example the investor will only stand to lose the premium invested, that is, $9.96.

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CHAPTER 3

MODERN CAPITAL MANAGEMENT TECHNIQUES AND FINANCIAL INNOVATION

THEORIES OF CAPITAL STRUCTURE (THAT IS, WHEN DOES CAPITAL STRUCTURE MATTER?) One of the most vexed topics in the ﬁeld of corporate ﬁnance is the valuation of a company’s wealth, both in the context of analysis of the cash ﬂows which the company generates, as well as in relation to the market’s perception of that wealth. The link between the composition of the ﬁrm’s balance sheet, the value of its income-producing assets, and the price investors will pay for the risks and returns available from the company are complex and still not fully understood. Nevertheless, there is an emerging consensus that a balance sheet can be constructed in such as way as to maximize the attractiveness of the ordinary equity of the company. This perspective has led to the use of innovative ﬁnancial contracts as tools to improve shareholder value. The seminal contribution by Modigliani and Miller in their 1958 article1 and the various revisions of it 2 highlight a number of crucial matters relevant to a consideration of the role of capital structure in the determination of a ﬁrm’s wealth. If the promoter of a structured product issuance programme suggests 58

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that it will be efficient for the company to follow that strategy, how is the company to verify whether the efficiency beneﬁts actually exist and, if so, to quantify their value? In their ﬁrst article, Modigliani and Miller make the seminal assertion that: The market value of any ﬁrm is independent of its capital structure and is given by capitalising its expected return at the rate pk appropriate to its class.3

They verify this perspective mathematically, using the following logic: Levered companies cannot command a premium over unlevered companies because investors have the opportunity of putting the equivalent leverage into their portfolio directly by borrowing on personal account.4

Although the M–M thesis indicates that the cost of capital and the debt/equity mix will not essentially alter the value of the ﬁrm in equilibrium, they do acknowledge the value of capital management in conditions of information asymmetry: In general, except for something like a widely publicised oil strike, we would expect the market to place very heavy weight on current and past earnings in forming expectations as to future returns. Hence, if the owners of a ﬁrm discovered a major investment opportunity which they felt would yield much more than pk they might well prefer not to ﬁnance it via common stock at the ruling price, because this price may fail to capitalise the new venture. A better course would be a pre-emptive issue of stock. Another possibility would be to ﬁnance the project initially with debt. Once the project had reﬂected itself in increased actual earnings, the debt could be retired either with an equity issue at much better prices or through retained earnings. Still another possibility along the same lines might be to combine the two steps by means of a convertible debenture or preferred stock, perhaps with a progressively declining conversion rate.5

Structured products such as converting preference shares offer precisely this capital cost beneﬁt, by issuing at a premium to the current stock price, and involving a declining conversion ratio and ﬁxed dividend yield. The central observation of the M–M thesis is that, apart from taxes, debt and equity are essentially fungible, in that they perform the same core function of providing ﬁnance to the ﬁrm: The cost of capital is equal to the rate of interest on bonds, regardless of whether the funds are acquired through debt instruments or through new issues of common stock. Indeed, in a world of sure returns, the distinction between debt and equity funds reduces largely to one of terminology.6 59

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This initial assertion ignored the consequences of taxes. The initial M–M formulation considered the role of tax thus: The deduction of interest in computing taxable corporate proﬁts will prevent the arbitrage process from making the value of all ﬁrms in a given class proportional to the expected returns generated by their physical assets. Instead, it can be shown … that the market values of ﬁrms in each class must be proportional in equilibrium to their expected returns net of taxes.7

In their 1959 ‘Correction’, they restated the position thus: The statement in italics, unfortunately, is wrong … one ﬁrm may have an expected return after taxes twice that of another ﬁrm in the same risk equivalent class [but] it will not be the case that the actual return after taxes of the ﬁrst ﬁrm will always be twice that of the second, if the two ﬁrms have different degrees of leverage … values within any class are a function not only of expected after tax returns, but of the tax rate and the degree of leverage … the tax advantages of debt ﬁnancing are somewhat greater than we originally suggested.8

In the context of an integrated corporate tax system, a checklist of the issues which a company will typically consider when deciding what type of capital structure it should have will include: ■ Taxes, that is, is the company paying tax and what is the tax position of its

clientele (that is, shareholder base)? If the company is not paying tax, a deductible interest payment will have no present value and vice versa. If the company is paying tax, it will typically generate franking credits and hence the company will be neutral as to the choice between debt and equity ﬁnance, assuming its investors are resident taxpayers and have the same rate of tax as the company. ■ Agency costs, that is, the cost of paying external investors to compensate

them for the different risks they assume by making investment/s in the company. Shareholders bear the ultimate risk of loss if the company’s management chooses the wrong debt proﬁle, and will hence demand higher returns to compensate for that risk. This can be illustrated practically by looking at the risk involved if a company is either under- or overgeared. ◆

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Overgearing can mean the company is ﬁnancially overcommitted and cannot take advantage of commercial opportunities which may be proﬁtable. Optimal gearing levels are linked to the type and maturity of business activity which the company engages in: companies with variable

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cash ﬂows will tend to support lower gearing levels than mature and stable cash ﬂow generating companies. ◆

Too little debt can mean that companies ﬁnance existing or new business with retained earnings, and without key performance indicators which guide the investment decision, this may be destructive of shareholder value. This concept is similar to the ‘bird in the hand’ approach, which suggests that shareholders should receive a full payout of retained earnings to minimize agency costs associated with management retaining control of them. Increased dividend payout ratios and debt-funded share buybacks are two ways of distributing excess capital.

■ Information costs: company management is inherently favourably biased

towards its own ends, and the market discounts management information unless the cost associated with information disclosure is high. Issuing debt securities obligates the company to a ﬁxed cost of capital, and hence a debt issue is a credible signal to the market that the company’s management is conﬁdent in its future cash ﬂow prospects. Efficient ﬁnancial engineering creates structured products that combine multiple features providing a tailored package of beneﬁts for the issuer and investors. Sophisticated derivative pricing models allow for the incorporation of ‘multiple options’ in structured products and enable precise pricing of the resulting instrument. It is not surprising that contemporary corporate structured products target the three key corporate ﬁnance issues (agency costs, information costs and taxes) and seek to maximize shareholder value by combining: ■ higher levels of ﬁxed cost capital and reduced levels of ﬂoating cost capital

(that is, by increasing gearing, by using hybrids with a ﬁnancial proﬁle similar to the proﬁle of a debt security), which allows the company to increase returns to ordinary shareholders; ■ an accounting and ﬁnancial proﬁle for the new security which contains

features of equity, that is, the cash ﬂow of the new security is linked to the proﬁtability of the company. This combination of debt and equity features seeks to reduce agency costs by increasing the returns to equity investors without increasing the risk of loss to them. Careful attention to the levels and pricing of the new security issue is needed to ensure that debt investors to the company do not feel exposed to higher risk; ■ the ﬁxed capital cost of the new security is a signal to the market that the

management sees an optimistic future for the company, expressed through its commitment to make ﬁxed payments to new investors and through the

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judicious use of non-dilutive ﬁnance to fund future activity (avoiding dilution is a signal of future ﬁnancial strength); ■ optimal tax outcomes available by funding domestic operations through

frankable equity and offshore operations through deductible equity. Changing corporate gearing levels using structured products requires ﬁne attention to detail in terms of structure and pricing to avoid ﬁnancial imbalance. For example, increasing gearing levels may reduce dilution of corporate earnings but can also expose the company to higher bankruptcy risk, hence increasing the yield required by lenders to compensate for the risk that they will not be repaid. The ﬁnancial interrelationship between ordinary shareholders and lenders is equivalent to a put option which is granted by the lenders to the shareholders. Stockholders ultimately control management and management gets to choose how much to gear. Stockholders may want to gear in order to expand corporate opportunity and minimize the dilution of proﬁts. But a decision to gear the company up – and assume higher levels of ﬁxed capital costs – may ultimately prove to be beyond the means of the company to continue servicing the new capital. The resulting default on the new capital effectively means that the stockholders have the ability to ‘put’ the company to the lenders, who take over the assets of the company by enforcing their security: stockholders gain at the expense of bondholders by increasing the value of their right to default on the bonds. Bondholders, in effect, sell to stockholders a put option, an option to sell the ﬁrm to the bondholders for the face amount of the debt. The value of this option increases by investing in projects that increase cash ﬂow risks or by replacing equities with additional liabilities of equal or greater priority than those already outstanding.9

Investors do not typically create options in favour of other market participants without receiving compensation for it. In the case of the put option which creditors sell shareholders, the fee is in the form of the higher interest rate which a creditor to a highly leveraged company will want. This reality means that there are practical limits on the size and pricing of hybrid securities issues.

OPTIMAL CAPITAL STRUCTURE AND STRUCTURED PRODUCTS AS SHAREHOLDER VALUE DRIVERS Converting/convertible preference shares (CPS) are one of the most successful Australian ﬁnancial market innovations. This bold statement reﬂects not only the size of the market but also that CPSs have penetrated each of the three tiers 62

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of the market: wholesale, retail and offshore. These securities have increasingly been used by Australian companies as part of capital management programmes. It will be seen that the key value drivers to both CPS issuers and investors centre on the ﬁnancial beneﬁts offered by the conversion mechanism and the yield.

Analysis 1 First, a brief examination of the essential features of the CPS: ■ the CPS has a ﬁxed term, after which it converts mandatorily into one or

more ordinary shares of the issuer; ■ during the CPS term, a fixed dividend is specified as being payable

(although as a matter of company law, the dividend can only be paid if the issuer has sufficient distributable proﬁts and the directors so resolve); ■ the dividend is normally franked; ■ at conversion, the number of ordinary shares obtained by the CPS investor

is deﬁned by the application of a conversion formula, by which ordinary shares are issued at a discount to the prevailing ordinary share price of the issuer (normally 5–10%), with the number of ordinary shares obtaining being a function of that ordinary share price; ■ in practice, the conversion formula uses the issuer’s ordinary share price

during a period after the conversion trigger date (the ‘reference price’), allowing a CPS investor wishing to exit its holding to sell short ordinary shares (obtaining a price equal or very close to the reference price) and cover its short position by the resulting ordinary shares it receives on conversion; ■ alternatively, a CPS investor may elect to retain the resulting ordinary

shares but in either case will be issued ordinary shares at a discount to the reference price (in practice, resulting in more ordinary shares being issued).

Analysis 2 The accepted valuation methodology of a CPS is to break the product into three separate financial components, each value driven by the features described:

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■ equity option value, a function of the strike price of the embedded long call

option contained within the conversion mechanism (but discounted by subtracting the value of the embedded short put option represented by the par value of the ordinary shares); ■ yield value, a function of the CPS dividend, normally measured by instit-

utional investors as a comparison to benchmark debt securities, by ‘grossing up’ the notional yield to represent a ‘pre-tax equivalent bond yield’ (the gross up being simply a multiplication of the notional yield by the s.160 AQT Tax Act 1936 amount, obviously applying only to a franked CPS); ■ discount value, being simply a yield-enhancement analysis of the value

added to the CPS yield, assuming the additional shares issued at conversion to satisfy the discount feature are sold; ■ each of the three values are then net present valued by assuming that (i) the

equity option value is realized at the time of CPS purchase, and the cash placed on deposit at compounding interest rates, (ii) each CPS dividend is placed on deposit when received and similarly compounded, and (iii) the conversion discount is received at the conversion date in cash (derived by arbitraging the conversion process) and that cash amount is discounted back using the same interest rate as in calculation (i) and (ii). Having described brieﬂy the key features of the CPS, the ﬁnancial beneﬁts of the CPS both to corporate issuer and investor will be examined by adopting the following hypothetical CPS terms.

Analysis 3 Issuer:

Another Bank Ltd

Instrument:

Fully paid, non-cumulative, nonredeemable, mandatory CPS

Issue size:

$150m

CPS price A:

$4.00 ($1.00 par, premium $3.00)

CPS price B:

$3.00 ($1.00 par, premium $2.00)

No. of CPSs:

A: 37.5m; B: 50.0m

CPS term:

5 years (issuer may convert after 4 years)

Base dividend A:

8.5% fully franked

Base dividend B:

6.0% fully franked

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Conversion discount:

10%

Conversion price calculation period:

20 ASX trading days prior to conversion date

Current ordinary share price:

$1.85

You will notice that these hypothetical terms contemplate two alternative CPS issue prices, CPS issue price A being $4.00 and CPS issue price B being $3.00. These prices illustrate the two common CPS issue strategies: CPS A representing an investment which is primarily yield-driven, (but which offers a future equity upside as well as a resulting entry into ordinary shares) and CPS B representing an investment which is also yield-driven but which can be a present ﬁnancial surrogate to direct investment in the ordinary equity of Another Bank Ltd. The ﬁrst strategy has low optionality or delta at issue, but growing over time; the second has real optionality and delta at issue, as well as growth prospects over time.

Applying the CPS valuation methodology outlined in Analysis 2, it is possible to value the two proposed CPSs as follows: 65

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Analysis 4 Yield value Option value Discount value Total value Option delta Assumptions:

CPS A 13.28% –0.17% 1.289% 14.399% 0.037

CPS B 9.375% 0.375% 1.289% 11.039% 0.2

Ordinary share dividend yield: 5-year swap rate: Ordinary share volatility:

12.5% 9.0% 20%

It can be seen from this valuation that from the perspective of investors both proposed CPSs are attractive. CPS A has a total theoretical value which exceeds the rate which could be earned by investing in comparable maturity ﬁxed interest securities. Although the CPS value has a relatively low correlation to positive price movements in the underlying ordinary equity of Another Bank Ltd (reﬂected by the delta of 0.037), that correlation may well increase over the life of the CPS if the ordinary share price rises, that is, as the delta of the CPS increases. A classic example of this increasing correlation over the life of a CPS exists for the CPS issued by Westpac: the CPS issue price of $7.50 had a low delta at issue (with the ordinary share price at $3.50) but had a high delta at the time of conversion (the Westpac CPS delta at conversion was 1 with the ordinary share price around the $10.00 level).

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CPS B also has a total theoretical value which exceeds the rate which could be earned by investing in comparable maturity fixed interest securities. However, the value of CPS B has a high present correlation to positive price movements in the underlying ordinary equity of Another Bank Ltd. Accordingly, the proposed CPS B may well be attractive as a surrogate to direct investment in the ordinary equity of Another Bank Ltd. It should also be noted that both CPS A and CPS B offer downside investment protection, through the conversion mechanism. This mechanism operates to issue sufficient ordinary shares to the holder at conversion to provide a return in value of the initial CPS investment, plus an additional amount reﬂecting the conversion discount.

Analysis 5 Thus, if the example of the proposed CPS A is considered, and we assume that at the time of CPS conversion the ordinary share price for Another Bank Ltd is (i) $2.00 or (ii) $4.44, it can be seen that the number of ordinary shares obtained on CPS conversion will be 2.22 in case (i), and 1 in case (ii). Accordingly, although both CPS A and CPS B offer a total theoretical value which is attractive and operate as surrogates for ordinary equity investment in Another Bank Ltd (correlation varying according to the premium at which the CPS is issued), both A and B are value-protected through the operation of the conversion mechanism. If we assume that there is demand for either of the proposed CPS issues, by what criteria should Another Bank Ltd evaluate the proposed pricing? Put another way, by what criteria does Another Bank Ltd determine whether the proposals are mispriced? The accepted valuation criteria examines the cost of capital of Another Bank Ltd, and in particular the impact of the proposals on the earnings per share of Another Bank Ltd. This analysis highlights that an appropriately priced CPS will be successful because it facilitates a risk transfer from the investor to the corporate issuer: the downside protection embedded in the conversion mechanism may represent an expensive and earnings per share dilutive feature of the CPS if it is triggered. If the downside protection is not triggered, the CPS conversion mechanism will represent an issue of ordinary equity at a premium to the current share price, and this is normally an attractive feature for a company considering an equity issue. The evaluation by a company considering a CPS issue will determine whether an acceptance by it of a risk transfer from the investment market is rational.

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Analysis 6 The ﬁrst level of capital cost analysis compares the proposed CPS issue against the benchmark cost of an ordinary equity issue to raise the same amount of capital. In this analysis, it is assumed that the capital ratios of Another Bank Ltd will not accommodate a debt issue, and that the discount required to clear a rights issue or placement of ordinary stock is 20%. The following analysis shows that both CPS A and CPS B are earnings per share positive compared to the benchmark discounted rights issue. The results conclusively demonstrate that CPS issues can involve a lower cost of capital at issue than a comparable issue of ordinary equity. Assume: ■ ■ ■ ■ ■

Another Bank Ltd has $100m in earnings 1996–97 435.7m ordinaries on issue P/E multiple of 8 × ordinary share price $1.85 earnings per share (EPS): $0.23

Scenario 1 ■ rights issue to raise $150m ■ discount 20% ■ rights issue price $1.48 ■ 101.35m additional ordinaries ■ EPS post-issue: $0.18 Scenario 2 ■ CPS issue to raise $150m ■ CPS A: $4.00 @ 8.5% dividend, franked ■ CPS B: $3.00 @ 6.0% dividend, franked ■ no. of CPS issued: A = 37.5m CPS; B = 50m CPS ■ earned for CPS: A = $0.34 × 37.5m = $12.75m B = $0.18 × 50m = $9.0m ■ earned for ordinaries: after CPS A = $87.25m/ after CPS B = $91.0m ■ EPS post-issue: scenario A = $87.25m/435.7m = $0.20 scenario B = $91.0m/435.7m = $0.208 This analysis shows that CPS A produces a 7% lower cost of capital than the benchmark ordinary equity issue; and CPS B produces a 10.6% lower cost of capital (both measured at issue).

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The ﬁnal level of the cost of capital analysis examines the EPS dilution of a CPS issue at conversion. Although it is notoriously difficult for analysts to estimate forward earnings, companies privately compile these estimates and it is relevant for their consideration in these situations. This analysis will show that where the return on equity at the ﬁrm level is higher than the CPS dividend, the CPS will produce a dynamic leverage effect on the underlying ordinary share price. This is because the CPS dividend is ﬁxed, and if we assume rising earnings and a constant P/E ratio, the organic growth in earnings will all be diverted to the beneﬁt of the ordinary shareholders. That is, in an earnings growth environment where return on equity is higher than the CPS dividend, a CPS issue will drive the ordinary share price up harder than if fresh equity is raised through an ordinary issue.

Analysis 7

Earnings

1997 $ 100m

Earned for ord.: after CPS A 88.25m EPOS (A)

0.202

Earned for ord.: after CPS B 91.0m

1998 $ 130m

1999 $ 169m

2000 $ 219.7m

2001 $ 285.61m

117.25m

156.25m

206.95m

272.86m

0.269

0.358

0.474

0.626

121.0m

160.m

210.7m

276.61m

EPOS (B)

0.208

0.277

0.367

0.483

0.634

Ord. share price: after rights issue (8 × PE)

1.48

1.93

2.51

3.27

4.25

Ord. share price: after CPS A (8 × PE)

1.61

2.15

2.86

3.79

5.00

Ord. share price: after CPS B (8 × PE)

1.66

2.21

2.93

3.86

5.07

Ord. share price: after CPS A (13 × PE)

2.62

3.49

4.65

6.16

8.13

Ord. share price: after CPS B (13 × PE)

2.70

3.60

4.77

6.27

8.24

It may be observed from this analysis that the predicted ordinary share price in June 2001 is in the range $5.00 to $8.24, if a CPS issue proceeds in 1996. This assumes a constant earnings growth, and a constant PE of 8 × at the bottom end of the range, and 13 × at the top end (13 × is in fact still below the current market PE for the banking sector).

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The analysis highlights the considerable efficiency gains available through an issue of CPS in appropriate surrounding economic circumstances. These beneﬁts are available both at the ﬁrm level and in the marketplace: ■ the CPS offers the potential for a lower cost of capital than an issue of ordi-

nary equity; ■ the lower cost translates to a higher earnings per share than would arise

through an issue of ordinary equity; ■ the CPS issue generates a dynamic leverage effect on the underlying ordi-

nary share price, driving it higher in comparison to an ordinary equity issue; ■ investment in the CPS offers an effective yield higher than that available by

investment in comparable maturity government or semi-government bonds; ■ investment in the CPS offers a new risk transfer mechanism to the market,

since the conversion mechanism offers downside risk protection to the investor but with equity upside; ■ the CPS offers a number of new investment strategies, ranging from a

switch from physical stock to the CPS, a buy–write (buy CPS/sell call options), or direct portfolio investment.

CASE STUDY: TIER I CAPITAL INSTRUMENTS In 1999 the Commonwealth Bank of Australia (CBA) issued a new form of share, known as a ‘PERLS’, which it used to raise $750 million of capital to expand its business. The PERLS are classiﬁed as tier I capital in accordance with Reserve Bank of Australia Prudential Guidelines. These PERLS (perpetual exchangeable resettable listed securities) are part of a relatively new family of instruments known generally as ‘reset convertible preference shares’, and are similar to the simple converting preference shares which have been popular with Australian companies and investors since the early 1990s. Reset convertible preference shares offer potentially strong ﬁnancial beneﬁts and, subject to the credit quality of the issuer, these products are almost mandatory buying for Australian investors. In fact, so popular are these products, once the (often complex) terms are properly understood, the main investor drawback is their scarcity. Astute investors watch for announcements of pending convertible preference shares by quality issuers, and view them as great investment opportunities. 70

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Unlike the tax ‘aggression’ which became the hallmark of the ‘income securities’ which were issued by many Australian companies in 1999 and early 2000, convertible preference shares are clearly legitimate under current tax rules. Convertible preference shares offer capital protection through the operation of the conversion mechanism and, prior to conversion, they offer a high, fully franked dividend. Convertible preference shares, such as the CBA PERLS, are suitable for use as a high-yield, fixed interest security, and although they are classiﬁed as an equity interest under tax rules, they are normally held in the investor’s cash or ﬁxed interest portfolio.

Product structure CBA PERLS are convertible (at the investor’s election, no sooner than ﬁve years after issue) into ordinary CBA shares, based on a conversion formula which ensures that ordinary shares at least equal to the face value of the PERLS are held by the investor after conversion. Prior to conversion, the dividend yield on the PERLS is ﬁxed (and is expected to be fully franked). This combination of fixed yield and capital protection means that the PERLS behave like a high-yield bond, with franking credits attached, with CBA credit risk. This is a powerful feature in volatile equity markets, where prevailing interest rates and returns on ﬁxed interest securities are low. In addition, since the PERLS are convertible into ordinary CBA shares, they ultimately provide exposure to improvements in the CBA ordinary share price, giving opportunities for additional gain to the investor after conversion. The dividend payable on the CBA PERLS is set at a margin above the prevailing bank bill rate (the indicative interest rates paid by banks on simple bank bills – the rate is quoted in daily newspapers). The total return to investors is set at a margin of 2% above the bank bill rate. Of course, this assumes that an investor can purchase the PERLS at par, and with current PERLS prices at a slight premium to par, the effective yield is slightly lower. The PERLS were issued with a face value of $200 and have traded since at slight premiums. They are perpetual (that is, they have no ﬁxed maturity date) but in certain situations the CBA can buy them back for par (that is, $200) after year 5. In addition, investors can elect to convert the PERLS to ordinary CBA shares at year 5, and then at each ﬁfth year anniversary. Where the investor elects to convert, they will receive CBA shares at a 2.5% discount to the prevailing share price. However, if an investor elects to convert, the CBA may sell that investor’s PERLS to another investor (but must pay the seller at least par). Investors can also elect to convert if dividends on the PERLS are not fully franked. Dividends are not cumulative, but under the terms of issue of the PERLS, the CBA is unable to pay ordinary dividends if it misses payment of 71

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the PERLS dividends. It is highly unlikely under current circumstances that the CBA will miss a dividend on the PERLS. The CBA PERLS contain a number of features which may result in investors receiving cash instead of shares even if a conversion event occurs. PERLS and other convertible preference shares cannot be replicated by investors. The capital protection which the product contains is a feature of the conversion mechanism, and provides the same price protection that is only otherwise available by using more expensive put options. The power of convertible preference shares is that the company which issues them does not charge investors for the effective cost of the capital protection. Similarly, although PERLS holders do not get the beneﬁt of any increases in dividends on ordinary shares, the dividend on the PERLS is ﬁxed and will normally be above the level of ordinary dividends. PERLS and other convertible preference shares behave like franked, high yielding bonds. They will normally strongly outperform bank deposits and other interest-bearing instruments and managed funds. PERLS do not involve additional fees or charges, other than normal brokerage. The CBA PERLS were issued prior to the enactment of the Debt/Equity Act in July 2001, and were a brave foray into uncharted regulatory waters. However, they are unduly complicated and involve intricacies which do not produce any tangible beneﬁts to investors. Some of the promotional jargon involved appears more motivated by a desire to appear innovative than by any real need (that is, the conversion of PERLS into ordinary CBA shares is misleadingly described as an ‘exchange’). This complexity means that PERLS investors need to pay close attention to information relating to them, especially any dividend reset and redemption notices provided by CBA. Since the CBA has the conditional right to redeem the PERLS after year 5, investors should understand that this redemption is a possibility (and in fact some analysts see this early redemption as a strong probability). Like all shares which pay fully franked dividends, investors holding PERLS as individuals or through a superannuation fund need to be aware that they can use franking credits on the PERLS to reduce taxes, and since 1 July 2001, any surplus franking credits are fully refundable by the ATO (Australian Tax Office). The PERLS value as calculated by the CBA assumes that investors will only be able to use 75% of the fair value of those franking credits, and since the reality is that investors can fully utilize franking credits, the real yield on PERLS is incrementally higher than that nominated by the CBA. Since the conversion of PERLS involves the allotment of ordinary shares by the CBA, there should be no capital gains tax payable on conversion of the PERLS, and the resulting ordinary shares will be taxable on sale at discount capital gains tax rates (for eligible taxpayers, for example individual investors and complying superannuation funds). 72

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Although the CBA PERLS are complex and intricate, they offer significant financial and tax benefits to investors. They are particularly useful within the fixed interest component of superannuation funds, and investors may find them (and other similar issues) a good low-cost way of boosting overall investment returns. Prospective investors do need to pay close attention to price, since actual yields will fall if the PERLS are purchased at premiums to par. Investors watch the market for announcements of future issues of convertible preference shares, but do need to closely monitor the terms of issue of these securities.

CBA PERLS KEY TERMS ■ Issuer: CBA ■ Security: PERLS (preferred exchangeable resettable listed shares) ■ Size: $700m ■ PERLS rating: A– (S&P)/ a1 (Moody’s) ■ Issue price: $200 ■ Maturity: Perpetual subject to: ◆ Investor can convert on rollover date or dividend date (if dividend not

fully franked) ◆ CBA cash buyback right (at par) after yr 5, at dividend payment date or

rollover date ■ Dividend: Non-cumulative payable quarterly in arrears ■ Floating rate at 2% margin above BBSW (margin resettable after yr 10) ■ Rollover dates: First rollover at yr 5 ■ CBA may reset terms apart from margin, prior to each rollover date ■ Holders may convert on rollover date ■ Holder conversion: If holder elects to convert, CBA has option to: ◆ Deliver ordinary shares at 2.5% discount to issue price ◆ Sell PERLS to new investors and deliver cash equal to issue price ◆ Buyback PERLS and deliver cash equal to issue price (the cash buyback

option can only be exercised by the CBA either with Reserve Bank of Australia approval or out of the proceeds of a fresh equity issue ■ Issuer conversion: six months prior to year 5 at CBA’s option ■ Listing: ASX

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Instruments like the CBA PERLS provide low-cost access to tier I regulatory capital for ﬁnancial services institutions. Similar instruments are also being used by industrial companies for capital management purposes. With the recent announcement of a $65 million reset preference share (RPS) issue, David Jones has joined the ranks of leading Australian companies which have issued these innovative structured products to lower their capital management costs and boost returns to ordinary shareholders. Since these instruments are shares but have a ﬁnancial proﬁle like debt (through the ‘money back’ feature of the conversion mechanism) they are commonly referred to as ‘hybrids’. Hybrids are in huge demand from investors and in 2001 and 2002 new hybrid issues outstripped the IPO market. Here we examine the features, beneﬁts and risks of the DJ RPS. When compared to similar securities issued by other Australian companies, the DJ RPSs adequately compensate investors for the risk inherent in the offer, and should provide an attractive investment return for the fixed interest component of investment portfolios. The DJ RPSs were issued with a face value of $100 and are preference shares issued by David Jones Ltd. The terms of the RPS include the following key features:

DJ RPS KEY TERMS ■ Dividend rate: the dividend rate was set at the date of issue of the RPS (1 July

2002) at 8.2% pa fully franked, a margin of 2% above the ﬁve-year swap rate as at 1 July 2002 ■ Reset: DJ may reset the dividend rate on reset dates, which begin on 1

August 2007 and thereafter the company may specify when the next dividend reset date will be. DJ is required by the terms of issue of the RPS to give notice 30 days prior to any reset date specifying what the new dividend rate will be ■ Conversion: the RPSs are perpetual securities subject to a number of rights

given to the holder and DJ to trigger a conversion of the RPS to ordinary shares. The holder can elect to convert to ordinary shares on the reset date and may choose to do so where notice has been given that the dividend will be reset at a rate which the holder feels is insufficient. At conversion, ordinary shares are issued at a 5% discount to the price determined in accordance with the conversion formula ■ Conversion formula: the terms of issue specify the number of ordinary shares

which are to be allotted if a conversion occurs. The conversion process

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involves a calculation which is made with reference to the volume weighted price of DJ’s ordinary shares in the 20 days prior to the conversion date. Under this formula, the minimum number of ordinary shares available on conversion is 70.1754 per RPS and the maximum is 105.26316 ■ Cash redemption instead of conversion: DJ has the right where an investor

has triggered a conversion to pay the investor a cash amount equal to the value of shares which would have been available had a conversion occurred in accordance with the terms of issue of the RPS ■ Listing: the DJ RPS will be listed on the ASX ■ Franking: the prospectus for the DJ RPS contains a tax opinion which

conﬁrms that the dividends on the RPS are frankable ■ Priority: the DJ RPSs are preference shares and include a right to receive

dividends as speciﬁed by the terms of issue in priority to any dividends payable to ordinary shareholders

As we have seen, the accepted valuation methodology of an RPS is to break the product into three separate ﬁnancial components, with the total value of the RPS being calculated by adding together the value of each of those components. Using this method, the fair value of the DJ RPS, expressed as an effective yield, and based on the original issue price of $100, is in the range 11.5–12% pa. This valuation compares favourably with the RPS issued by: ■ Coles Myer (CMLPA) which is currently trading at a 7% premium to its

original issue price (OIP), equating to a cash yield of 4.07%, which reﬂects a pre-tax equivalent bond yield of 5.81% (which is relatively full price compared to a three-year swap rate of 6.05%); ■ St George Bank (SGBPB) which is currently trading at a 10% premium to its

OIP, equating to a cash yield of 6.93%, which reﬂects a pre-tax equivalent bond yield of 9.9% (a margin of 3.0% over the current ﬁve-year swap rate); ■ Fairfax (FXJPA) which is currently trading at a 11.75%% premium to its OIP,

equating to a cash yield of 8.1%, which reﬂects a pre-tax equivalent bond yield of 11.57% (a margin of 5.27% over the current ﬁve-year swap rate); ■ Computershare (CPUPA) which is currently trading at a 7.45% discount to

its OIP, equating to a cash yield of 12.5%, which reﬂects a pre-tax equivalent bond yield of 17.85% (a margin of 11.55% over the current ﬁve-year swap rate). 75

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The two key risks for the DJ RPSs are that DJ is not able to pay the dividends speciﬁed in the terms of issue and that DJ’s ordinary shares are illiquid or unlisted at the time a conversion occurs. The RPS contains some mechanical and commercial features which mitigate these risks. If DJ fails to pay the RPS dividend for any period, the company is prevented by the RPS terms of issue from paying ordinary dividends until it has made at least two RPS dividend payments. An RPS holder can elect to convert the RPS at any time and will receive the minimum number of ordinary shares (cl. 6.3 (a) (3) RPS Terms of Issue). While the capacity of DJ to pay the RPS dividend is a function of the future profitability of DJ, institutional investors typically consider the level of retained earnings in a company as a measure of the risk involved with future dividend payments. In the case of DJ, the prospectus discloses that the total retained earnings in the company as at 26 January 2002 is $102,371,000. This amount is well in excess of the $39.1 million required to pay the RPS dividend for the period prior to the ﬁrst reset date. There will be a large number of ordinary shares issued if the RPS converts at the maximum number of shares available under the conversion formula. The likelihood of this occurring will be reﬂected in the ordinary share price of DJ immediately prior to conversion. Based on the current DJ ordinary share price of $1.12, the risk of an RPS holder receiving a large number of low-priced ordinary shares at conversion is minimal, but investors need to be aware of this issue. Institutional investors seeking exposure to a quasi-ﬁxed interest return using hybrids such as the RPS typically sell the RPS prior to the ﬁrst available conversion date. RPSs behave similarly to an investment in ordinary shares plus the purchase of a put option and simultaneous sale of a call option over them, which would allow the investor to exercise the put option if the ordinary share price declines over time. Put options are expensive especially if they are longdated and offer full capital protection, even if call options on the share are sold to defray the cost of that put. In the case of convertible preference shares, the price the investor pays for the capital protection is the loss of any potential to participate in dividend increases (if any) on the company’s ordinary shares, as well as the giving up of any potential to share in rises in value of those ordinary shares. In short, the ﬁxed dividend and capital protection of the convertible preference share is a trade-off against the opportunity for gain on the ordinary shares prior to conversion. Convertible preference shares make sense where the cost of a comparable DIY strategy (that is, buy stock and put/sell call) is more expensive than the hybrid. The David Jones RPS reﬂects many of the commercial features of the reset preference share issued by the Coles Myer group in 2000. The signiﬁcant commercial difference between the two issues relates to the inclusion of upside 76

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value in the Coles Myer instrument, resulting from the setting of the conversion price at levels not signiﬁcantly above the ordinary share price at the time of issue.

COLES MYER RESET PREFERENCE SHARE ■ Description: Resettable convertible Australian preference shares (ReCAPS) with

$100 face value ■ Issue size: $500m plus $200m in oversubscriptions ■ Rating: Coles Myer is rated ‘A/A3’. The ReCAPS have been rated ‘BBB+/baa1’ ■ Maturity: Perpetual, with ﬁrst reset date at yr 5 ■ Dividend rate: Higher of swap rate and 6.50% semi annual, non-cumulative ■ Coupon payment tests: Coupon is at the discretion of directors and subject to

there being funds legally available for distribution ■ Dividend stopper: No ordinary dividends can be paid until two consecutive

dividends are paid ■ Investor conversion: Investor has option to convert at the conversion price at yr

5. Early conversion may take place if trigger events occur including liquidation, cont’d

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takeover, failure to pay dividend, suspension of trading and so on. Early conversion will also be available from the start of yr 5 at the maximum price of $10.96 ■ Issuer conversion: Issuer has option to force conversion at the conversion price

at the end of yr 5. The early conversion is accelerated in the event of a takeover or a tax event occurence. Early conversion will be available after 4.5 years subject to $100 million of the CPS remaining on issue to the reset date ■ Conversion price: The lower of: (i) a discount of 5% to the market price on

conversion, and (ii) a maximum price of $10.96 being approximately 157% of issue share price (being $7.00) ■ Maximum and minimum shares: The maximum number of shares on conver-

sion is 100 and minimum is 9.6 ■ Investor protection: Provided for events including takeover, capital restructure

or capital distribution (including return of capital or special dividends) ■ Listing: ASX

CASE STUDY: AMP RESET PREFERENCE SHARES In September 2002, AMP was ﬁnalising one of the largest recent hybrid issues in the Australian market. Conducted amidst signiﬁcant ﬁnancial and management turmoil, the issue exempliﬁes how poor corporate relations can destroy investor conﬁdence. Amidst this uncertainty some strong signals emerge, which should encourage astute investors to consider carefully the investment beneﬁts of the AMP issue. The issue was announced in early September 2002 and involves the issue by AMP Henderson Global Investors Ltd (AMPH) of A$750 million face value reset preferred securities (RPS), convertible into shares of AMP Limited and guaranteed by AMP Group Holdings Ltd (AMPGHL). The RPS are ‘stapled securities’ comprising: ■ units in the AMP reset preferred securities trust, issued by AMPH, which is

also the responsible entity of that trust. These units entitle the RPS holder to a beneﬁcial interest in subordinated notes issued by AMP (UK) Finance Services plc, which pay the coupon to which the RPS holder is entitled; ■ options to convert the RPS into AMP ordinary shares and rights to acquire

preference shares issued by AMP, rights which are exercisable in certain circumstances, as set out in the RP S prospectus and summarized below. 78

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This novel structure is designed to maximize the taxation and capital management beneﬁts to the AMP group which arise as a result of an issue of this sort. Although this issue is the ﬁrst to use this particular structure, the approach is contemplated by and legitimately available under the new Australian tax rules. The issue of RPS has occurred at a time of some ﬁnancial and regulatory capital stress for AMP. RPS and similar instruments are issued by companies which are endeavouring to increase gearing levels as part of general growth and cost management strategies, or by companies which need to recapitalize. In cases of ﬁnancial distress, the RPS, if properly priced and serviceable (based on current or even significantly worsened financial performance between issue and conversion), normally underpin a recovery in the ﬁnancial fortunes of the issuer. A classic example of this occurred in recent Australian corporate history, in the case of the 1993 CPS issue by Westpac Banking Corporation and a similar issue in that year by TNT Limited (see Chapter 1). In the case of Westpac, which was in a position of ﬁnancial uncertainty at the time of issue, the recapitalization was followed by an ordinary share price rise from $3.50 at time of issue to over $12.00 at conversion in 1998. This recovery was despite the failure only several months earlier of a discounted rights issue (at $2.90), a large proportion of which had reverted to the underwriters because of insufficient investor demand. The positive prospects for AMP following a successful RPS issue have been acknowledged by ratings agencies such as S&P, which is stated in the prospectus of the RPS to be planning to upgrade its rating for AMP from A– to A. In cases of RPS issues when the issuer is ﬁnancially distressed, close attention needs to be paid to the terms of issue to assess the risks inherent in the instrument and the mechanisms available to limit that risk. The RPS are to be issued with a face value of $100 and are units issued by AMPH as the responsible entity for the RPS trust.

AMP RPS KEY TERMS ■ Distribution rate: the distribution rate until October 2007 will be set at a rate

of 8.4% ■ Reset: AMP may reset the dividend rate and applicable conversion discount on

reset dates, which begin on 24 October 2007 ■ Conversion: the RPS are perpetual securities which allow the holder and AMP to

trigger a conversion of the RPS to ordinary shares. The holder can elect to convert to ordinary shares at the time of reset and if AMP defaults on the notes cont’d 79

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■ Guarantee: AMPGHL guarantees the payment of the speciﬁed coupon on the

RPS but can in certain circumstances issue shares in satisfaction of its guarantee obligations ■ Conversion calculation: the terms of issue specify the number of ordinary

shares which are to be allotted if a conversion occurs. Conversion will be at a rate sufficient to provide capital protection to investors ■ Issuer conversion/redemption: AMP can convert or redeem the RPS if the

aggregate amount outstanding is less than A$100 million or after a regulatory or tax event ■ Listing: the RPS will be listed on the ASX ■ Franking: the prospectus for the RPS contains a tax opinion which conﬁrms

that the distributions on the RPS are not frankable and takes the view that there is no liability for any withholding tax on distributions made on the RPS even though they are sourced in the UK ■ Priority: the RPS include a right to receive distributions as speciﬁed by the terms

of issue in priority to any dividends payable to AMP ordinary shareholders. If a RPS dividend is missed, AMP may not pay an ordinary dividend until two RPS dividends have been paid or until a shortfall dividend has been paid

Notes 1

Modigliani F and Miller M: ‘The Cost of Capital Corporation Finance and the Theory of Investment (1958) American Economic Review 48, pp. 261–97. Modigliani F and Miller M: ‘Corporate Income Taxes and the Cost of Capital – A Correction’ (1959) American Economic Review 433; Miller M and Modigliani F: ‘Dividend Policy, Growth, and the Valuation of Shares’ (1961) The Journal of Business; Miller M: ‘Debt and Taxes’ (1977) The Journal of Finance 261. Modigliani F and Miller M (1958), op. cit., at p. 268. Op. cit at p. 270. Op. cit at p. 292 (emphasis added). Op. cit at p. 262. Op. cit at p. 272. Modigliani F and Miller M: ‘Corporate Income Taxes and the Cost of Capital: A Correction’ (1959) The American Economic Review 433, at 434 (emphases added). Scholes MS and Wolfson MA ‘The Cost of Capital and Changes in Tax Regimes’ in Aaron HJ, Galper H, Pechman JA (eds) Uneasy Compromise: Problems of a Hybrid Income – Consumption Tax (1987, Brookings, Washington), at p. 163.

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TAX TECHNICAL ANALYSIS – UK, US AND AUSTRALIA

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CHAPTER 4

UK TAXATION OF EQUITY DERIVATIVES AND STRUCTURED PRODUCTS Mohammed Amin

OVERVIEW OF RELEVANT PARTS OF THE UK TAX SYSTEM The outline details below obviously do not provide a comprehensive guide to the UK tax system. Their goal is to provide a context for the detailed discussion which follows. The law is stated as at 31 July 2002.

Basic principles Like the USA and Australia, the UK tax system distinguishes between ordinary income/losses and capital gains/losses. The fundamental tests for deciding whether a receipt gives rise to a capital gain or ordinary income are similar in all three countries, since they are rooted in common law principles. Of course the UK, like Australia and the USA, then overlays speciﬁc statutory rules. Ordinary income itself is then subdivided into a number of Schedules, with some of the Schedules themselves divided into Cases. While all income is aggregated to determine the rate of tax applicable, losses are subject to complex rules governing what categories of income they can be offset against. Individuals, trusts and estates are then charged with income tax on their ordinary income, and capital gains tax on their capital gains. UK resident comp83

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anies and non-UK resident companies which trade in the UK through a branch or agency (a ‘permanent establishment’ in tax treaty language) are charged with corporation tax on their ordinary income and their capital gains. Henceforth, for simplicity, these two categories of taxpayers will simply be referred to as ‘individuals’ and ‘companies’. The basic rules for computing ordinary income and capital gains are the same for individuals and companies, except where statute law speciﬁes otherwise.

Development of the law in the UK A few speciﬁc statutory provisions have been enacted which impact upon individuals’ transactions in equity derivatives. These are discussed below. Otherwise, one is thrown back upon general tax principles to decide whether a transaction receives capital gains or ordinary income treatment, and if ordinary income, whether it is ‘trading income’ (taxed under Schedule D Case 1) or ‘other income’ (taxed under Schedule D Case 6). The position was the same for companies until the Finance Act (hereafter abbreviated to FA) 1994, which enacted a comprehensive code for interest rate and currency derivatives (only). The FA 2002 has just replaced the FA 1994 code and applies to all derivatives, subject to certain exclusions. One of the exclusions is equity derivatives, so the boundaries of the FA 2002 code need analysis. When equity derivatives fall outside the FA 2002 code, companies are subject to broadly the same rules as individuals in deciding between capital gains and ordinary income.

Bifurcation While there have been developments in case law over the past 25 years, in essence the UK tax system proceeds by determining the legal form of a transaction, and then taxing that legal form. The alternative approach of seeking the (economic) substance and then taxing by reference to that economic substance has been rejected by the courts on innumerable occasions. Accordingly, there is no general concept of bifurcation, whereby a single instrument can be decomposed into its economic parts, with those parts being taxed separately. Instead, one proceeds by analysing the legal form of the instrument to determine the legal rights and duties of the parties. If one has a loan, it is taxed as a loan even if it has equity characteristics, such as convertible debt. There are speciﬁc statutory provisions which apply in certain cases (for example the treatment of convertible debt in FA 1996 s.92) but such provisions only apply to their own precisely deﬁned subject matter. 84

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It therefore becomes essential to analyse the instrument to decide if one is dealing with, for example ■ a share in a company ■ a loan ■ an insurance policy ■ an option or future

since each of these has its own tax rules. The same economic outcome can sometimes be achieved in many forms.

INVESTMENTS BY INDIVIDUALS Apart from direct purchase of equities, individuals can invest with equity participation in a number of ways, including ■ equity options over single shares, settled by delivery ■ equity index options, which are cash settled ■ warrants to subscribe for equity shares ■ convertible debt and asset-linked debt ■ betting ■ insurance policies where the payment is linked to equity performance ■ contracts for differences linked to single shares or an equity index.

As there is no general bifurcation concept, one must ﬁrst identify the nature of the investment held, and then tax it accordingly. The key question when confronted with, or designing, a new investment is ‘What is it?’

Transactions by individuals in options and futures The speciﬁc legislation applicable to persons dealing in ‘commodity or ﬁnancial futures’ or in ‘qualifying options’ is contained in s.128 Income and Corporation Taxes Act (ICTA) 1988 and s.143 Taxation of Chargeable Gains Act (TCGA) 1992.

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■ Section 128 provides that proﬁts and gains arising in the course of ‘dealing’

in ‘commodity or ﬁnancial futures’ or in ‘qualifying options’ which would, without the effect of this section, be chargeable to tax as income otherwise than as the proﬁts of a ﬁnancial trade, shall not, in fact, be chargeable to tax as income. ■ Section 143(1) TCGA 1992 then provides that outstanding obligations under

any commodity or ﬁnancial futures contract entered into, and any qualifying option granted or acquired, in the course of that ‘dealing’ shall be subject to capital gains rules. The combined effect of s.128 ICTA 1988 and s.143 TCGA 1992 is therefore to remove transactions in commodity or ﬁnancial futures and qualifying options from the charge to tax as income, where such transactions do not give rise to proﬁts of a ﬁnancial trade. Such transactions are taxed according to capital gains rules. The terms ‘commodity or ﬁnancial futures’ and ‘qualifying options’ are deﬁned in s.143(2) TCGA 1992. Commodity or ﬁnancial futures are deﬁned as ‘commodity futures or ﬁnancial futures which are dealt in on a recognized futures exchange’. In this context, the term ‘dealing in’ is interpreted by the Inland Revenue (Inland Revenue Manuals, paras 11.2.5.1–11.2.5.3) to mean ‘entering into’. Furthermore, the interpretation of ‘ﬁnancial futures’ is wide ranging and includes: ■ contracts for future delivery of shares, securities, foreign currency or other

ﬁnancial instruments; ■ contracts that are settled by payment of cash differences, determined by

movements in the price of such instruments (including contracts where settlement is based on the application of an interest rate or a financial index to a notional principal amount), as well as contracts settled by delivery; ■ both exchange-traded and over-the-counter contracts.

Qualifying options mean traded options or ﬁnancial options, as deﬁned in s.144(8) TCGA 1992. This deﬁnition is again fairly wide, but includes options which relate to currency, shares, securities or an interest rate and are granted by a member of a recognized stock exchange, by an authorized person within the meaning of the Financial Services and Markets Act 2000. The Inland Revenue’s interpretation of whether individuals are carrying on a ﬁnancial trade is contained in Statement of Practice 14/91. This statement states that ‘whether or not a taxpayer is trading is a question of fact and 86

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degree, to be determined by reference to all the facts and circumstances of the particular case’. In particular, however, it states that ‘an individual is unlikely to be regarded as trading as a result of purely speculative transactions in ﬁnancial futures or options’. Case law in the UK shows many individuals failing to demonstrate that they are carrying on a ﬁnancial trade, although the decided cases normally involve individuals who have made losses trying to establish after the event that they were ﬁnancial traders, so that their losses would be deductible from ordinary income, instead of being capital losses. The obvious exception is individuals actually conducting a ﬁnancial business personally. Despite the general trend towards incorporation, there are still some partnerships between individuals in the UK conducting stockbroking businesses, and any dealings by the partnership on its own account should give rise to trading income. There are also individuals who are full-time ‘ﬂoor traders’ on the London International Financial Futures Exchange (LIFFE) who are clearly carrying on a ﬁnancial trade. The Inland Revenue statement of practice is, in practice, targeted at private investors trying to obtain ordinary income relief for their losses. Hence, it can be concluded that individuals entering into transactions in commodity or financial futures and options would normally be chargeable to tax under capital gains principles unless they are market professionals in their own right (as opposed to being employees of companies engaged in market activities).

Guaranteed returns from transactions in derivatives

It is now well known that linked transactions in derivatives can produce a guaranteed return equivalent to interest. This is illustrated diagrammatically below, with transactions in four options. Consider a share priced at £105. The company transacts the following options exercisable in 12 months’ time. 1. Buy call exercisable at £100, paying premium of £7 2. Sell put exercisable at £100, receiving premium of £3 3. Sell call exercisable at £110, receiving premium of £3 4. Buy put exercisable at £110, paying premium of £7. The company’s proceeds will be a ﬁxed £10, that is, E2 − E1, regardless of the share’s price in 12 months’ time. 87

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Buy call Premium C1 = £7

Sell call Premium C2 = £3

£105 present spot price

£100 E1

£110 E2

Buy put Premium P2 = £7

Sell put Premium P1 = £3

Table 4.1 demonstrates this, using a spectrum of future share prices. The company’s initial cost was £7+£7 (two options purchased) less £3+£3 proceeds (two options sold) making a net cost of £8, that is, C1 +P2 − C2 − P1. Fixed overall proceeds of £10 mean a net gain of £2 on investment of £8, that is, 25% pa, risk-free using these illustrative ﬁgures. In reality, with an efficient options market, the prices C1, C2, P1, P2, E1 and E2 will produce an actual rate of return (ignoring transaction costs) equating to a risk-free interest rate. Transaction costs should be manageable. The options box structure was used to great effect by Citibank Investments Ltd, a UK subsidiary of what is now Citigroup. Citibank had capital losses, so capital gains would be tax-free, while interest income would be taxable. Citibank entered into its option contracts with a fellow company, Citibank International plc, which was an options trader. The two calls required by the

Table 4.1 Share price

(1) Bought £100 call

(2) Sold £100 put

(3) Sold £110 call

(4) Bought £110 put

Net company out-turn

99

0

(1)

0

11

10

103

3

0

0

7

10

107

7

0

0

3

10

111

11

0

(1)

0

10

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‘box’ were combined into a capped call option on the FTSE 100 Index, and the two puts combined into a ﬂoored put option on the FTSE 100 Index. It paid an aggregate £150 million to purchase the two option contracts, and realized some £165 million on expiry. The Inland Revenue sought to tax the gain of £15 million as income rather than as a capital gain sheltered by capital losses. The case was litigated as Griffin (Inspector of Taxes) v. Citibank Investments. The decision illustrates some of the fundamental points about UK tax law mentioned above. The courts appreciated that the transactions carried out were economically equivalent to Citibank depositing £150 million and receiving interest of some £15 million on maturity of the deposit. However, this was of no assistance to the Inland Revenue. It is well established that if there are two ways of achieving a particular commercial goal, the taxpayer is entitled to choose the route that costs the least amount of tax, as conﬁrmed in the case Vestey v. IRC. The Inland Revenue could not tax Citibank as if it had made a bank deposit, since it hadn’t. The Inland Revenue also tried arguing that the contracts were not option contracts, in particular because together they carried no risk. This argument also failed, since the International Swaps and Derivatives Association (ISDA) documentation used was clearly that of options not bank deposits. Many transactions have equivalent economic consequences but different tax consequences, for example a ﬁxed rate borrowing repayable with all interest rolled up as a ﬁnal bullet payment is equivalent to a zero-coupon bond issued at a discount. However, in the hands of an individual investor, they are taxed quite differently. Even before the Citibank case reached the courts, legislation was passed in 1997 to create Schedule 5AA ICTA 1988, which deals with guaranteed returns on transactions in futures and options by both individuals and companies. The transactions to which this schedule applies are disposals of futures or options which are one of two or more related transactions designed to produce a guaranteed return. A guaranteed return is one produced from one or more disposals of futures or options where risks from ﬂuctuations in values, interest rates or indices are so eliminated or reduced that the return is not to any signiﬁcant extent attributable to such ﬂuctuations and equates in substance to interest. The impact of Sch. 5AA is to treat proﬁts or gains from transactions in futures or options which produce a guaranteed return as income rather than under capital gains rules.

Options held by reason of employment

Individuals often receive options in their employer company, because they work there and the option is intended to motivate them. Speciﬁc legislation 89

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makes gains on such options taxable as employment income when the option is exercised. There are also speciﬁc provisions enabling employers to set up ‘approved’ share option schemes, which escape income treatment. Under these schemes, the employee has only a capital gain which arises when he sells the shares acquired by exercising the option. The precise employment tax rules are not appropriate for coverage here.

Transactions by individuals in contracts for differences Prior to FA 2002, the term ‘contract for differences’ occurs only once in UK tax legislation, in a provision concerned with the avoidance of social security contributions. The FA 2002 code concerns only companies. Accordingly, there is no statute law expressly addressing their taxation in the hands of individuals. The Inland Revenue’s own guidance manual for inspectors of taxes (which has no legal force but is sometimes helpful to consult) also only mentions the phrase once, in connection with life assurance companies. On ﬁrst principles, a contract for differences is an asset within the scope of capital gains tax. Accordingly, transactions by individuals (excluding ﬁnancial traders) give rise to capital gains and not ordinary income when a gain is made by closing out the contract for differences. The difficulty of tax analysis in the absence of speciﬁc legislation becomes starker when considering the periodical payments that can arise under a contract for differences. If an individual uses a contract for differences to run a ‘short’ position on a share, he will typically ■ pay to the counterparty the dividends due on the shares ■ receive from the counterparty money representing interest on cash equal to

the market value of the shares when the contract for differences was initiated. The two payment streams would be netted in most cases. If the individual is receiving recurrent payments, these would appear to have the quality of income and be taxable as such. However, if the individual is making recurrent payments, they do not fall under any of the headings that would give entitlement to a tax deduction. It would appear better to ‘roll up’ such (notional) periodic payments into the ﬁnal settlement payment under the contract for differences, with uplifts for the delay in settlement. This should result in capital gain treatment on the entire settlement payment, and avoid the risk of the individual making payments which otherwise attract no form of tax relief.

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Betting transactions In the UK, there is an active industry promoting ﬁnancial betting. For example, in a contract with a bookmaker, the investor ‘purchases’ company A shares at 90p with a multiple of £10 per penny of share price movement. If over the life of the bet, the share appreciates by 5 pence, the bookmaker will pay the ‘investor’ 5 × £10 = £50 and vice versa. The bookmaker always quotes a spread, just as ﬁnancial markets do, for example if the market price for a share is 90p, the bookmaker will quote say 87–95p. A gambler wishing to be ‘long’ will ‘buy’ at 95p and therefore beneﬁt from appreciation above 95p, while paying the bookmaker if the price falls below 95p when the bet is closed out. For obvious reasons, this is known as ‘spread betting’. The contract is legally a gaming contract. The strict tax law analysis of the gambler’s position is difficult, and there are arguments for an individual’s proﬁts being taxable as income. However, the Inland Revenue has a clear practice of not seeking to tax such proﬁts. It has even formally conﬁrmed to some spread betting companies that they can advertise that gains made by individuals placing spread bets with them are tax-free. However, the bookmaker is conducting a trade, and is subject to normal business income taxation as well as to the special additional taxes paid in the UK by bookmakers.

Individuals’ investment in convertible or asset-linked debt Another way for individuals to gain equity exposure is to invest in convertible debt or asset-linked debt. Convertible debt gives the holder the right to subscribe for newly issued shares of the borrower at a ﬁxed price, by tendering the bond to pay the subscription price. Asset-linked debt involves the redemption amount of the debt being linked to the value of a speciﬁc share or equity index.

Is it a relevant discounted security?

The ﬁrst step is to decide if the instrument constitutes a relevant discounted security (RDS). If it does, the investor realizes ordinary income both on all interest received and also on any gain made upon sale or conversion of the debt. The test for determining whether one has an RDS is set out in FA 1996 Sch. 13 para. 3. Very brieﬂy, if the terms on issue are such that the investor will or might realize a ‘deep gain’ on redemption, then one has an RDS. A deep gain is a gain of 1⁄ 2% pa, or a gain exceeding 15% if the debt has a life of over 30 years. 91

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Accordingly, a convertible ten-year debt issued for £100 and redeemable for £100 is not an RDS. The value of the conversion option is ignored, since one is looking at the amount payable on redemption. If the debt had been issued for £95.23 or less, then it would be an RDS, since the gain would exceed 5% (10 × 1⁄ 2%) of the amount subscribed.

Convertible debt

If the convertible debt is not an RDS, then any gains on sale give rise to capital gain not ordinary income. If the debt is actually converted into shares, that is not a taxable event; instead the shares issued have the same base cost as the purchase price of the debt.

Asset-linked debt/excluded indexed securities

Prima facie, asset-linked debt would always be an RDS, since (unless uplifts are capped at a derisory 1⁄ 2% pa) increases in the underlying linked asset or index might cause a deep gain to arise on redemption. As such, any gains would be ordinary income. There is statutory protection for asset-linked debt if it meets the precise statutory requirements for excluded indexed securities (EIS) set out in FA 1996 Sch. 13 para. 13. If the debt qualiﬁes as an EIS, it is not an RDS, and gains on sale or redemption are capital gains, not ordinary income. The key conditions for qualifying as an EIS are that: ■ any index linking must be applied precisely, both up and down ■ any floor to the redemption value cannot exceed 10% of the amount

subscribed, that is, 90% of the investor’s capital must be at risk. The index can be the value of a speciﬁc chargeable asset (for example one share in Microsoft Corporation) or a basket of chargeable assets such as an equity index. However the retail price index (RPI) and similar foreign consumer price indices are prohibited.

Insurance policies A very common way for individuals in the UK to gain exposure to equities is via insurance policies, particularly policies whose value is linked directly to 92

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the price of a mutual fund. The taxation of insurance policies depends critically on whether they are qualifying or non-qualifying.

Qualifying policies

The requirements are set out in ICTA 1988 Sch. 15. Very brieﬂy, a qualifying insurance policy is one which has level (or almost level) premiums paid annually or, more frequently, which is written for a ten-year period. Provided a policy runs for at least seven and a half years, the investor’s gain on the policy is exempt from tax. This is not quite as generous as it seems, since the issuing insurance company will have been taxed on the growth in value of the assets underlying the policy. Such policies, being relatively long term, are usually used for indirect investment in a mutual fund such as a unit trust. (‘With proﬁts’ insurance policies are outside the scope of this book.)

Non-qualifying policies

Non-qualifying life insurance policies are any policies other than qualifying policies. They are usually written as single premium bonds, redeemable at a ﬁxed future date (or on earlier death). The amount of death cover is limited to the minimum required by the tax rules and typically only needs a small part of the premium to fund its cost. Accordingly, they are marketed entirely as investment products. Single premium bonds became a very common form of equity derivative targeted at retail investors in the UK, with the main selling point being the downside protection. A very common format marketed recently is along the following lines: ■ investment for a ﬁxed ﬁve-year period ■ upside participation equal to, say, half the increase (if any) in an equity

index ■ downside risk limited to zero.

This is conventionally described as a ‘guaranteed equity bond’. The investor is effectively giving up dividend income and part of the upside growth in order to avoid downside risk. The underlying investment strategy for the issuing insurance company is to purchase a derivative from an investment bank which replicates the payoff 93

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promised to the retail investors. The insurance company makes money by selling the derivative packaged into the insurance bond for a higher price than it pays the investment bank for the wholesale derivative. The investment bank typically hedges its risk by putting the premiums received on deposit and using the interest earned to purchase call options on the equity index. More complex hedging strategies are adopted in practice, but all involve a combination of interest returns and equity exposure to offset the investment bank’s position under the derivative. In recent years, falls in interest rates and increases in market volatility (and therefore the cost of call options) has made true guaranteed equity bonds appear unattractive. With a 100% capital guarantee, relatively little upside index participation can be achieved. Consequently, insurers have taken to worsening the terms of the guaranteed ﬂoor payment on redemption. Products are often sold where the investor can lose 50%, or even 100% of his investment, if the reference shares or indices fall sufficiently in value. In some cases, the investors may not be aware of the risks they are running. A gain on a non-qualifying policy is subject to higher rate (40%) tax with a credit given for basic rate tax. The gain is not grossed up, for example: Gain Higher rate tax @ 40% Basic tax credit 22% Tax actually payable

£10,000 £4,000 (2,200) £1,800

As with qualifying life policies, this basis of taxation is less attractive than it seems, since the insurance company will already have suffered tax on the underlying investments before computing the proceeds paid on redemption of the policy.

CORPORATION TAX TREATMENT OF DERIVATIVES TRANSACTIONS Like individuals, companies can gain equity participation in a number of ways. Taking into account the different tax treatments, corporate investors are most likely to be involved in investing in: ■ equity options and futures ■ warrants to subscribe for shares ■ convertible debt 94

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■ asset-linked debt ■ contracts for differences, including total return swaps.

As well as considering companies as investors, one also needs to consider their position as issuers of the above instruments. Prior to 1994, the tax rules for companies were essentially the same as those for individuals. However, they are now quite different, and much more responsive to recent ﬁnancial innovation. As with individuals, when a company is looking at a proposed transaction, the ﬁrst question must be ‘what is it?’ The answer has to fall in a single tax classiﬁcation, since there is no general bifurcation concept. The key categories will be: ■ derivative contracts falling inside the FA 2002 regime, with gains treated as

ordinary income ■ derivatives outside the FA 2002 regime, with gains being treated as capital

gains ■ loan relationships.

Overview of corporate derivatives legislation FA 2002 rewrites the code governing transactions in derivatives by companies which are UK resident. It also applies to non-UK resident companies which have a permanent establishment in the UK. It applies to accounting periods beginning on or after 1 October 2002. Consequently, for companies with 31 December year ends, the new rules will take effect from 1 January 2003. The legislation provides that all derivative contracts will be subject to tax as ordinary income. In most cases, this will mean that gains and losses are taxed as they are recognized in the company’s statutory accounts. However, a limited range of derivatives will continue to give rise to capital gains or losses.

Scope of the new derivatives legislation The legislation deﬁnes a ‘derivative contract’ in FA 2002 Sch. 26 para. 2(1) to be any of a company’s ‘relevant contracts’ which satisfy the provisions of the Schedule. Except where otherwise indicated, all paragraph references in this section are to FA 2002 Sch. 26. Paragraph 2(2) provides that, for the purposes of the schedule, a ‘relevant contract’ is: 95

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■ an option ■ a future ■ a contract for differences.

The terms ‘future’ and ‘contract for differences’ are further deﬁned in para. 12. No further explanation is given for the expression ‘option’ except that para. 12 does note that an option includes a warrant. The deﬁnition of ‘future’ is found within para. 12(6) which provides that: A ‘future’ is a contract for the sale of property under which delivery is to be made at a future date agreed when the contract is made, and at a price so agreed.

Paragraph 12 deﬁnes a ‘contract for differences’, as ‘a contract, the purpose, or pretended purpose, of which is to make a proﬁt or avoid a loss by reference to ﬂuctuations in: ■ the value or price of property referred to in the contract, or ■ an index or other factor designated in the contract’.

Paragraph 12(5) does exclude certain contracts from constituting contracts for differences. One of those is a contract of insurance. Paragraph 12(10) states that: References to a future or option do not include references to a contract whose terms provide that one party is liable to make, and the other party is liable to receive, a payment in full settlement of all obligations under the contract, and do not provide for the delivery of any property.

Accordingly, cash-settled futures or options are in fact contracts for differences for tax purposes. This has been conﬁrmed by a note on the Inland Revenue web site. To summarize, if a contract falls within the regime governing derivative contracts (as deﬁned), then gains and losses on it made by companies are ordinary income.

Exclusions from scope of derivative contracts regime Paragraph 4(1) states that:

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A relevant contract is not a derivative contract if its underlying subject matter consists wholly of one or more of:

■ ■ ■ ■ ■ ■

land, whether situated in the United Kingdom or elsewhere; tangible moveable property, other than commodities which are tangible assets; intangible ﬁxed assets; shares in a company; rights of a unit holder under a unit trust scheme; any assets representing loan relationships to which either section 92 or 93 of the Finance Act 1996 applies.

Shares in a company, and intangible ﬁxed assets are deﬁned in para. 12. ‘Underlying subject matter’ is further clariﬁed by para. 11. Paragraph 11(2) provides that: The underlying subject matter of an option is

■ the property which would fall to be delivered if the option were exercised, or ■ where the property which would so fall to be delivered is a derivative contract, the underlying subject matter of that derivative contract.

Paragraph 11(3) provides that: The underlying subject matter of a future is

■ the property which would fall to be delivered if the future were allowed to run to delivery, or

■ where the property which would so fall to be delivered is a derivative contract, the underlying subject matter of that derivative contract.

Paragraph 11(4) provides that: The underlying subject matter of a contract for differences is: ■ the property whose value or price is referred to in the contract for differences, or ■ where an index or factor is designated in the contract, the matter by reference to which the index or factor is determined.

The underlying subject matter exclusion causes little difficulty in the case of an option or future, since under these someone becomes (or may become with an option) entitled to acquire something. It is more problematical with a contract for differences, discussed below in the context of total return swaps.

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Illustration of total return swaps between companies

Two investors in quoted shares may wish to exchange their investments. Direct sales in the market, or even an exchange of shares, will give rise to a taxable disposal for capital gains tax purposes. Instead, they choose to transact a total return swap.

Company A

Dividends

Company B Quarterly swap payments

Investment 1

Dividends

Investment 2

Each quarter, they will compute: ■ the dividends paid by investment 1 to company A ■ plus the appreciation in value of investment 1 (or deduct the fall in value of

investment 1) ■ less the dividends paid by investment 2 to company B. ■ less the appreciation in value of investment 2 (or add the fall in value of

investment 2). If the total is a positive number, company A will pay it to company B, and vice versa. Prima facie, one would expect this contract to be outside the derivative contracts regime, since the property whose value is referenced (investment 1 and investment 2) are shares in a company. I would not expect the reference to dividends to disqualify this, since dividends themselves arise on the shares.

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It should be noticed that company A no longer has any economic exposure to investment 1, and is instead fully exposed to investment 2. However, under UK law this is not treated as a constructive sale by company A of investment 1. A taxable sale will only arise when company A actually sells investment 1. In the absence of statute law, the proper tax analysis of the swap is very difficult. Prior to FA 1994 which provided the ﬁrst statutory treatment in the UK for interest rate swaps, the Inland Revenue had published a concession that enabled companies which were not trading to treat periodical interest rate swap payments as a charge against taxable income. This approach has the major disadvantage of converting all the appreciation return on the economic investment into taxable income (albeit with the receipt of cash) with no certaintly of a deduction for the reverse payments. A more tax effective way to structure the total return swap might be to reflect increases/reductions in market value of the investments only in the ﬁnal closeout payment, which would give rise to a capital gain or loss, leaving periodical payments only for dividend income. However, under a standard total return swap, the periodical payments would not be assimilated to dividends unless they are manufactured payments, according to UK anti-avoidance legislation. There are speciﬁc situations under this legislation where there is a requirement to assimilate periodical payments to dividends, for example where beneﬁcial ownership of the underlying investment is transferred or a taxpayer enters into sale and repurchase arrangements (in which case the legislation may deem a separate dividend to exist). If this is done, then on general tax principles the periodical payments, representing only dividends, should be treated for tax purposes as if they were dividends. In the UK, dividends received from another UK company are not subject to corporate tax, and also non-deductible. The delay in settling the increase/decrease in the market value of the investments does, however, create credit risk, for example if investment 1 appreciates by much more than investment 2, company B would have credit risk. The risk could be controlled by requiring collateral to be posted with the counterparty to reﬂect differential movements in the values of the investments. It is worth noting that ﬁnancial traders cannot beneﬁt from the UK dividend income exclusion and therefore if company A or company B is a ﬁnancial trader the periodical payments will be taxed as ordinary income/expenses. As a result, a total return swap between market professionals would typically avoid any transfer of securities (with the risk of a transaction tax such as stamp duty) and the manufactured payment rules (which can create obligations to account for withholding tax).

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If company A had wished to ‘economically divest’ investment 1 without acquiring exposure to a new investment, it could have transacted a total return swap against cash, illustrated below.

Company A

Dividends

Derivatives dealer Quarterly swap payments

Investment 1

Interest

Cash

At inception of the swap, the cash amount is set equal to the market value of investment 1. (The cash is notional; the derivatives dealer is not required to hold an actual cash deposit.) For the quarter, one computes: ■ the dividends received on investment 1 ■ less LIBOR (London interbank offered rate) (usually) interest on the cash

amount ■ plus the increase (or less the decrease) in the value of investment 1.

If the amount is positive, company A pays the derivatives dealer and vice versa. The notional cash amount is reset at the end of the quarter to the new market value of investment 1. While the economic consequences for company A are equivalent to a sale of investment 1 for cash, again there is no constructive sale by company A for tax purposes. The underlying subject matter of this contract for differences is partly shares (investment 1) and partly cash. Since it is not entirely shares, this contract is therefore within the derivative contracts regime, and all payments/receipts (or more precisely all amounts recognized in the company A and derivative dealer’s proﬁt and loss accounts) give rise to ordinary income. The existence of statutory rules makes the tax analysis straightforward. 100

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Limitations to the exclusions from derivative regime Relevant contracts over excluded underlying subject matter are prima facie outside the new regime. However, they can be dragged back in if they fall within certain paragraphs which limit the exclusions to the new regime. There are four limitations to the exclusions: ■ where the relevant contract is held for the purposes of a trade and its under-

lying subject matter is shares, units in a unit trust, or FA 1996 s.92 or s.93 assets. This will only impact upon ﬁnancial traders in practice. ■ where the relevant contract (or the relevant contract and certain other speci-

ﬁed transactions) are held for the purposes of producing a guaranteed return and the relevant contract’s underlying subject matter is shares, units in a unit trust, or FA 1996 s.92 or s.93 assets. As indicated above, the UK tax system is now extremely focused on closing any opportunities to make guaranteed returns that might qualify for capital treatment. This is discussed below. ■ where the relevant contract (or the relevant contract and certain other

specified transactions) is designed to secure that the amount received at maturity is at least 80% of the amount invested and the relevant contract’s underlying subject matter is shares, units in a unit trust, or FA 1996 s.92 or s.93 assets. This reverses the effect of an important tax case and is also discussed below. ■ where the relevant contract is entered into by an insurance company in order

to provide beneﬁts to policyholders under a high income bond (that is, payments to policyholders at annual or more frequent intervals, and equating to an interest type return). This is a ‘catch-all’ provision targeted at insurance companies, in case someone designs an equity derivative giving an interest type return which falls outside the two exclusions mentioned above. In any of these circumstances, the relevant contract will be taxed as a derivative contract giving rise to ordinary income or ordinary losses.

Limitations to the exclusions – guaranteed return

Paragraph 6 provides that if a relevant contract is designed to produce a guaranteed return either alone or with any associated transactions, it may still fall to be a derivative contract even if it falls within the exclusions of para. 4.

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Associated transactions

Associated transactions are deﬁned in para. 10. Transactions are only associated if they are entered into in pursuance of the same scheme or arrangements, which includes schemes, arrangements or understandings of any kind whether or not they are legally enforceable. Transactions with different parties or transactions with parties different from the parties to the scheme or arrangements can be associated transactions. Included within the meaning of associated transactions are cases where: It would be reasonable to assume, from either or both of – the likely effect of the transactions, and – the circumstances in which the transactions are entered into or acquired, that neither of them or, as the case may be, none of them would have been entered into or acquired independently of the other or the others.

Paragraph 6(5) provides that a relevant contract, or a relevant contract together with other associated transactions, is designed to produce a guaranteed return if it would be reasonable to assume from considering: ■ the likely effect of the contract and the transactions, and ■ the circumstances in which the contract is entered into or acquired

that the main purpose (or one of the main purposes) of the contract in question, or of the contract and any one or more of the other associated transactions, is or was the production of a guaranteed return from the contract, or from the contract and any one or more of the transactions. The associated transactions do not have to be transactions in relevant contracts (that is, derivatives). The provisions also apply to associated transactions in assets governed by FA 1996 s.92 (convertible debt) or s.93 (asset-linked debt). This plugs a weakness in ICTA 1988 Sch. 5AA which only applied if all the transactions were in options and futures. Accordingly, it could be sidestepped by combining options/futures transactions with transactions in, say, convertible debt, in view of its embedded call option over the underlying shares. Schedule 5AA did not apply, since it could not be said of the options/futures transactions that they produced a guaranteed return by themselves.

Limitations to the exclusions – guaranteed amount at maturity

Whilst this exclusion is not specific to insurance companies, the Inland Revenue wrote to the insurance industry stating that this paragraph was 102

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brought in to counter the types of arrangements litigated in HSBC v. Stubbs at the Special Commissioners (where the Inland Revenue lost). That was one of the most signiﬁcant tax cases litigated in recent years, since it impacted upon almost all UK insurance companies which had issued guaranteed equity bonds. Accordingly, the overall value of the transactions at issue ran into many billions of pounds. The transactions were typically structured as follows.

Retail investors

Cash for guaranteed equity bonds

Policy maturity payment Insurance company

Purchase of derivatives

Derivatives dealer

Derivatives maturity payment Cash deposit Repayment of cash deposit at maturity Interest on cash deposit

As indicated above, insurance companies sold equity-linked single premium insurance policies to retail investors. Typically, the policies contained guarantees regarding the amounts repayable, which varied by reference to share price indices. The insurance company hedged its risk by purchasing a derivative from a derivatives dealer. The purchase created a new risk for the insurance company, counterparty credit risk, as the derivatives dealer might default. To reduce this risk, the derivatives dealer was required to make a cash deposit with the insurance company. From the perspective of the Inland Revenue, the structure created several unfavourable tax asymmetries: 103

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■ The insurance company’s policy payments to the retail investors were an

expense in computing its trading proﬁts. (In practice, most of the time, UK insurers are taxed on investment income less management expenses, rather than trading proﬁts.) ■ The insurance company’s capital gain from the derivative was reduced by

the indexation allowance (relief for inﬂation given by uplifting the base cost) and was taxable only on disposal of the derivative. ■ The derivatives dealer received current relief as ordinary income/expense

on a mark-to-market basis. The Inland Revenue argued that the derivatives should be treated as loan relationships. This would mean any gain being taxed on the insurer as ordinary income and without the indexation allowance. This was rejected by the Special Commissioners. Even though the Special Commissioners are the lowest level of tax tribunal in the UK, the Inland Revenue did not appeal against the decision which is now ﬁnal. (Strictly speaking, the decision is only ‘persuasive precedent’, as decisions of the Special Commissioners apply only to the case litigated and are not formally precedent.) Paragraph 7 provides that if a relevant contract is designed to produce a guaranteed amount at maturity, either alone or in conjunction with certain other contracts, it will be a derivative contract even if it falls within the exclusions of para. 4. For a contract to constitute a derivative contract for this reason, it must be such that: its underlying subject matter consists, or is treated as consisting, wholly of:

■ shares in a company, ■ rights of a unit holder under a unit trust scheme, or ■ assets representing a loan relationship to which either section 92 or 93 of the Finance Act 1996 applies

and the contract is designed to produce a guaranteed amount at maturity, or it and any speciﬁed associated transactions are designed to produce a guaranteed amount at maturity. A relevant contract (together with any particular associated transactions) is deemed to produce a guaranteed amount at maturity if it would be reasonable to assume, from considering: ■ the likely effect of that contract or of that contract and the other associated

transactions, 104

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■ the circumstances in which that contract is entered into or acquired, or that

the contract and the other associated transactions, or any of them, are entered into and acquired, or ■ the matters in both of the above,

that the main purpose (or one of the main purposes) of that contract, or of that contract and other associated transactions, is or was to secure that the relevant amount so payable does not fall below the guaranteed amount. Guaranteed amount

The guaranteed amount per para. 7(5) is 80% of the consideration paid or payable by the company (or a connected company) for entering into or acquiring the relevant contract in question, or the relevant contract and any one or more of the other associated transactions. Likely effect of the relevant contract

The test for whether there is a guaranteed amount at maturity is to consider whether it would be ‘reasonable to assume’ that the ‘likely effect’ of the relevant contract (and/or associated transactions) was to produce a guaranteed amount at maturity. At the moment, there is no guidance as to how ‘likely effect’ will be interpreted by the Inland Revenue or how the phrase ‘reasonable to assume’ should be considered. One might hazard that ‘likely’ is a greater than 50% probability but to reﬁne it beyond that is not possible. Indeed it could be a considerably lower benchmark. The likely effect of the contracts can only be determined by making certain assumptions as to the likely movements in the underlying subject matter throughout the life of the relevant contract and associated transactions. Accounting method

Where a relevant contract falls to be treated as a derivative contract as a result of para. 7, para. 21 provides that the method of accounting to be used to determine what debits and credits should be brought into account is mark to market. Bifurcation election

As explained above, there is no general concept of bifurcation in the UK tax system. However, the FA 2002 code contains an explicit bifurcation election in these circumstances. 105

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Paragraph 48 provides that on the making of an election, a relevant contract, which is a derivative contract to which para. 7 applies, will be taxed as if it comprised two components: ■ a creditor relationship which is a relevant zero-coupon bond and ■ an option.

The underlying subject matter of the option is deemed to be that of the original relevant contract. Paragraph 48(3) provides a relevant zero-coupon bond (ZCB) is deemed to be one whose redemption value is the ‘guaranteed amount’ within the meaning of para. 7. The company is deemed to have acquired the ZCB with a redemption value of the guaranteed amount issued at the time the consideration for entering into the relevant contract was payable. The cost of entering into the arrangement is deemed to be the market value of such an instrument at the date of issue. It is not clear what range of market values would be acceptable (although market value for these purposes is as per TCGA 1992 s.272), but there will surely be a range and the range will vary depending on the yield curve and the credit rating of the company issuing the bond, that is, the counterparty under the derivative contract. The legislation is silent on what the precise terms of the deemed option should be, although para. 48(6) does state that all such apportionments as are just and reasonable should be made in giving effect to this election. In my view, the costs of entering into the arrangements can be split between the cost of the ZCB (determined by estimating the market value of the notional ZCB) with the balance attributed to the option. One is left to determine the other terms. Logically, the exercise price should be zero while the payoff should be the total return from the derivative contract less the guaranteed amount (if positive). This preserves capital gains treatment for that part of the payoff which is genuinely at risk. The zero-coupon bond is required to be taxed as if it had been accounted for on a mark-to-market basis (para. 48(4)). For new contracts, the election under this section must be made within two years of the end of the company’s ﬁrst accounting period for which it is a party to the relevant contract. Any election is irrevocable. Illustration of the effects of making a bifurcation election

An insurance company offers a ﬁve-year single premium insurance bond to retail individual investors. The initial investment is £1000 and after ﬁve years the investor will receive the greater of: 106

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■ £1000 uplifted (or reduced) by half of the percentage change in the FTSE 100

Index (dividends are ignored) ■ £800.

The insurance company sells 1000 bonds, receiving £1 million, and does not wish to bear any investment risk in respect of this product. It pays £900,000 to an investment bank and acquires a ﬁve-year derivative contract whose payoff is the greater of: ■ £800,000 ■ £1,000,000 uplifted (or reduced) by half of the percentage change in the

FTSE 100 Index, dividends ignored. By purchasing this derivative, the insurance company has locked in its commercial proﬁt of £100,000 and has no investment exposure. Without a bifurcation election, the insurance company’s entire proﬁt under the derivative contract will be ordinary income. (The guaranteed amount of £800,000 is more than 80% of the contract cost of £900,000.) It is also required to mark the derivative to market at each year end. The insurance company’s cumulative position after ﬁve years will depend entirely on the level of the FTSE 100 Index at that time, and can be illustrated in the following graph. As explained, all of the gain/(loss) will be ordinary income.

Derivative outcomes £1,400,000 £1,200,000

£800,000

Payoff Gain / (loss)

£600,000 £400,000 £200,000

0

0

00 ,0 10

00 9,

0 00

0

0

0 00

00 8,

7,

6,

00 5,

0 00

0 00

00 4,

3,

2,

00

0

£–-£200,000

1,

Amount

£1,000,000

FTSE value after 5 years

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Instead it makes a bifurcation election. It establishes that a ﬁve-year straight debt of the counterparty investment bank has a yield to maturity of 7%. Accordingly, the market value of a ﬁve-year ZCB redeemable for £800,000 would be £570,389. So it is taxed as if it had purchased such a ZCB. The notional ZCB is marked to market at each year end. (In reality the tax system gains little from requiring mark-to-market accounting here rather than allowing accruals accounting.) The outcome from the notional zero-coupon bond is illustrated by the graph below.

Amount

Notional zero-coupon bond outcome £900,000 £800,000 £700,000 £600,000 £500,000

Bond value Cumulative income

£400,000 £300,000 £200,000 £100,000 £0

1

2

3

4

5

Time in years

The balance of the £900,000 purchase price of the derivative is £329,611. This is deemed to be paid for an option. The exercise price of the notional option is zero, and the payoff is the greater of: ■ zero ■ £1,000,000 × (half the % change in the FTSE 100 Index) – £800,000.

This option gives rise to a capital gain or loss, since its underlying subject matter is the FTSE 100 Index. As a capital gains asset, the option will give rise to a capital gain or loss only when it is exercised (or abandoned) at the end of the ﬁve years, as illustrated below. The chart shows the economic capital gain or loss on the notional option. (The taxable capital gain will be lower as inﬂation indexation relief is given for the notional cost of the option, by reference to movements in the UK RPI. However, the indexation allowance will not augment the capital loss.) 108

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Notional option outcomes £500,000 £400,000 £200,000 Payoff Gain/(loss)

£100,000 9,000

8,000

7,000

6,000

5,000

4,000

–-£200,000

3,000

–-£100,000

2,000

£-

1,000

Amount

£300,000

–-£300,000 –-£400,000

FTSE Index value after 5 years

By making the bifurcation election, the insurance company will avoid annual volatility in its taxable income as the FTSE Index changes. The drawback is that it will have to recognize annual interest income on the notional zero-coupon bond, while risking being left with a capital loss (which can only be used against future capital gains) when the notional option matures after ﬁve years. However, as life insurance companies typically have large portfolios of share investments giving rise to capital gains, in most cases making the election may be worthwhile, if only because indexation allowance is then given when computing the capital gain on the notional option.

The loan relationships provisions – basic concepts

FA 1996 contains a complete code applying to transactions by companies in loan relationships. Section 81(1) FA 1996 provides that a company has a loan relationship when the company is either a creditor or a debtor for a money debt and that money debt has arisen from a transaction for the lending of money. Section 82(2) FA 1996 provides that a money debt has to be settled either in money or by a right to settlement under a different money debt. Money also includes all currencies. The debt does not have to be for a ﬁxed amount to be a money debt. It also includes debts where the amount payable may vary, for example if it is linked to some sort of index. A loan of money includes any advance of money (s.103 FA 1996). Normally, a loan will give rise to the obligation of the borrower to pay interest or an 109

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interest equivalent and make repayment of the principal borrowed. However, it is not unusual for the lender to forgo the rights to interest and guaranteed repayment of the full amount of the principal in return for a potentially higher variable return than the interest would provide. An example of a money debt which does not arise from the lending of money is unpaid purchase consideration. If company A sells land to company B, ownership passing immediately but with the price payable in a year’s time, then there is a money debt. However, no money was ever lent, and therefore this is not a loan relationship. However, where an instrument is issued for the purpose of representing security for, or the rights of a creditor in respect of, any money debt, then that debt shall be taken to arise as a result of a transaction for the lending of money (s.81(3) FA 1996) and it therefore becomes a loan relationship. This matters because in general the detailed rules in FA 1996 apply only to loan relationships.

Taxation of loan relationships

The provisions in FA 1996, in broad terms, result in a company being taxed on the proﬁts, gains and losses arising from its loan relationships as income and in accordance with how those amounts are treated in the company’s accounts. This treatment, however, is provided that the accounting method used by the company to account for its loan relationships complies with the relevant legislation (s.85 FA 1996). The authorized accounting methods permitted for by this section are an accruals basis of accounting and a mark-to-market basis of accounting. An authorized accruals basis requires the following: ■ generally accepted accountancy practice must allow the use of that partic-

ular method in those circumstances; ■ the method must contain proper provision for allocating payments under a

loan relationship to accounting periods; ■ the method must assume that every amount due under the loan relation-

ship will be paid in full when due, apart from the authorized arrangements for bad debt and certain government investments; ■ the method must not, apart from authorized bad debt provisions, make any

debits arising from valuations of the loan relationship; ■ the method must make proper adjustments for bad and doubtful debt, for

recovery and for the effect of releases on the debtor. 110

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A particular issue relates to the application of this basis of accounting to discounts. Both discount on original issue and premiums that will arise on redemption should be accrued by the investor in a loan relationship. The authorized accruals basis requires that payments should be brought into the accounts in the period to which they relate. This means that discount should be accrued over the life of a security. This broadly corresponds with the US treatment of original issue discount. It is easy for the accrual of discount on redemption to be computed when the loan relationship has a known redemption date and value. In many other circumstances, it will be possible to estimate the accrual, for example where the redemption value is to be calculated by reference to the RPI in ﬁve years’ time, an accrual based on the RPI at each year end would be a good estimate. It is less easy, and in some circumstances may not be appropriate, to compute discount accrual when the date of redemption is not known. The only principle which can be established is that the method used must be appropriate to the facts of the case. An authorized mark-to-market basis of accounting requires the following: ■ generally accepted accounting practice must allow the use of that particular

method in those circumstances; ■ it must use a fair value for all loan relationships on that basis; ■ it must bring that fair value into account in each accounting period; ■ it must allocate payments under a loan relationship to the accounting

period in which they become due and payable. Most companies which use the mark-to-market basis of accounting for loan relationships will be trading in those loan relationships, that is, they will hold the loan relationships with a view to selling them in the market when a suitable opportunity arises. If a company uses an authorized accounting method in preparing its ﬁnancial accounts, it must use that same method when preparing its tax return. In that case, the loan relationship proﬁts in the ﬁnancial accounts and the tax return would be identical. If, however, the ﬁnancial accounts use a method that only ‘equates’ to an authorized accounting method, then the tax return must use the authorized accounting method that the accounts equate to, that is, the ﬁnancial accounts will use a method that broadly looks like accruals or like marking to market. The tax return must then use that method, but in the authorized statutory manner, making adjustments to the ﬁnancial ﬁgures to produce tax return ﬁgures. 111

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FA 2002 amended the provisions to cater for foreign companies with UK branches, or foreign-registered companies that are UK resident. Under FA 1996 s.86(3A), if a UK-incorporated company (and therefore one governed by UK company law and UK generally accepted accounting practice) could use markto-market accounting, then the company is permitted to make an irrevocable election to use mark-to-market accounting for all its loan relationships, even if its (foreign) statutory accounts do not use mark-to-market accounting. Such an election automatically also extends to that company’s derivative contracts within the new derivative contracts regime.

Loan relationships linked to the value of chargeable assets

Speciﬁc legislation (s.93 FA 1996) applies to loan relationships where the amount repayable is linked to the value of chargeable assets (that is, assets within the capital gains tax rules) or an index of the value of chargeable assets. Following FA 2002, the deﬁnition of chargeable asset for this purpose is limited to land and ordinary shares (that is, common stock) listed on a recognized stock exchange. Treatment of corporate investor in asset-linked debt

Where s.93 FA 1996 does apply to a loan relationship, only interest arising from such a loan relationship is taxed as income. Other proﬁts, gains or losses derived from the loan relationship give rise to amounts taxed as capital gains rather than as ordinary income. Treatment of issuer of asset-linked debt

The interest paid is a deductible expense. Any loss or proﬁt from the repayment amount being more/less than the issue amount is a capital item, not ordinary income/expense. Under UK law, it is impossible to make a taxable capital gain/loss from a liability, as opposed to an asset. Accordingly, any gain is not a taxable capital gain, and any loss is not even a deductible loss for capital gains tax purposes. Instead it is a ‘nothing’ for tax purposes. There are detailed requirements similar to those for excluded indexed securities mentioned above. The linkage must be applied both upwards and downwards, and the only floor allowed on repayment is 10% of the amount subscribed (or less).

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Convertible debt

Because interest on debt is tax deductible while dividends on shares are not deductible, the UK tax system has always been concerned that companies might issue equity packaged in the form of debt. Tax provisions aimed against equity-related debt

For many years, the principal protection for the Inland Revenue has been contained in the provisions of ICTA 1988 s.209(2)(e), which treats interest paid on certain securities as a ‘distribution’, that is, equivalent to a dividend and not tax deductible. The provisions apply inter alia to: ■ Securities convertible into shares, not being securities listed on a recognized

stock exchange or issued on terms which are reasonably comparable with the terms of securities so listed. ■ Securities under which the interest (or other return to the lender) is to any

extent dependent on the results of the company’s business, unless the interest is received by another UK company which is not tax exempt. Accordingly, interest on listed convertible debt is tax deductible, without any detailed regulations. In principle, it should be possible for a company to issue listed convertible debt with the conversion right being deeply in-the-money instead of issuing new equity to its shareholders. However, I am not aware of listed companies having done this, despite the tax advantages. For non-listed convertible debt, the ‘comparability’ test is not applied by the Inland Revenue in a restrictive manner. However, a non-listed issue of deeply in-the-money convertible debt would clearly fail the comparability test. Treatment of issuers of convertible debt

The potential disallowance of the interest deduction in the case of non-listed and non-comparable convertible debt is discussed above. Otherwise the interest paid by the company is tax deductible. If the company repurchases its debts for cash, paying a premium (for example because the conversion right has come into the money), the expense arising from the premium is tax deductible, even though it effectively arises from an increase in the company’s share price. No such deduction arises if the convertible is actually converted into shares.

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Treatment of corporate investors in convertible debt

This depends critically on whether the debt meets the precise tests set out in FA 1996 s.92. If it does not, then any gain on redemption (or conversion) is treated as ordinary income. (The interest payable is of course always treated as ordinary income.) If the tests in s.92 are met, then any gain or loss on the debt (apart from interest) gives rise to a capital gain or loss, and conversion is not a taxable event for capital gains tax purposes, so any gain on conversion is deferred. FA 1996 s.92 has been amended several times since its original enactment, since the issuer/investor treatment asymmetry has been used for tax avoidance. Post-FA 2002, the key requirements for a debt to fall within s.92 are: ■ the shares into which the debt is convertible (or exchangeable) must be

ordinary shares (common stock) of a trading company or the holding company of a trading group. Both of these are precisely deﬁned terms. Preference shares which are mandatorily convertible into such ordinary shares are also permitted. ■ the conversion terms must create genuine equity linkage, for example a

£1000 bond ‘convertible into such number of shares as have an aggregate market value of £1000’ would fail this test. ■ the debt must not be an RDS or an EIS (see earlier discussion). ■ the convertible must not contain rights under which the investor could

require someone other than the issuer to acquire the debt for an amount which gives a ‘deep gain’ (deﬁned earlier). The exclusion of the issuer here is irrelevant, since if the issuer could be required to so acquire the debt, that would make it an RDS. Acquisitions by other persons need to be banned, since the deﬁnition of an RDS is based only on redemption payments by the issuer. ■ when the convertible is issued, there must be ‘more than a negligible like-

lihood’ that the conversion rights will in due course be exercised to a significant extent. This does not require the conversion right to be in-the-money on issue date. However, if it was so far out-of-the-money that there was no realistic likelihood of conversion ever happening, then the debt would fail to qualify under s.92 and any investor gains would be ordinary income. ■ the conversion rights, if fully exercised, would result in the debt being

wholly replaced by shares. While this is obvious in normal cases, the provision is aimed at the clever design of convertible debt for tax avoidance purposes.

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■ the debt must not be owned by a ﬁnancial trader. If the debt happens to be

owned by a trader in bonds, then this provision preserves taxation as ordinary income, since the debt is part of the bond dealer’s trading stock. ■ when the debt is created, the issuer and the investor must not be

‘connected’. Connection is deﬁned in FA 1996 s.87 and, broadly speaking, exists when companies are under common control. After several years of changes to counter tax planning structures using convertible debt between group members, tax law now prohibits such debt from obtaining capital gains treatment under s.92.

BANK CAPITAL ADEQUACY The Basel Committee on Banking Supervision, which is convened under the auspices of the Bank for International Settlements (BIS), sets the international standards for the capital requirements of banks. These are then implemented by each country under its domestic rules governing bank supervision; in the UK by the Financial Services Authority (FSA). Capital is divided into two ‘tiers’, with detailed rules governing how much capital a bank must hold, depending on its risk-weighted assets.

Share capital qualifying as tier I The FSA Interim Prudential Sourcebook: Banks, issued in June 2001, explains that there are two types of share capital eligible for tier I capital.

Ordinary shares, that is, allotted, called up and fully paid common stock

This should be net of any of its own shares that a bank holds. Share capital is the strongest form of capital in terms of insulating depositors from credit risk. This is because: ■ There is statutory subordination through the Companies Act and the Insol-

vency Act. Shareholders are the last to be paid in the event of the liquidation of a bank. ■ Dividends are discretionary and non-cumulative. They need only be paid

when the bank has sufficient distributable reserves.

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Perpetual non-cumulative preferred shares

This includes such shares redeemable at the option of the issuer (provided the FSA’s prior consent is required) and also such shares convertible into ordinary shares. Preference (or preferred) shares are shares where the holders rank before ordinary shareholders in claims on a bank, but where typically the shares carry no (or limited) voting rights. Preference shares may take several forms, being either perpetual or dated, and cumulative or non-cumulative. In order to be eligible for inclusion in tier I capital, preference shares should have the following characteristics: a. The bank should be able to eliminate the dividend on the shares. A one-off step-up in dividend from the tenth anniversary of issue associated with a call is permissible as long as the whole dividend can be waived. The FSA rules limit the permissible dividend step-up since a step-up is an indirect way of providing assurance to the investor that the issue will be redeemed (since it otherwise becomes an expensive coupon), even though the form of the issue is perpetual. Where a tier I instrument includes a step-up in dividends, it is regarded as ‘innovative’ under the Basel guidelines. Following Basel, the FSA therefore applies a limit of 15% of total tier I capital to any tier I issues that incorporate a step-up and/or are indirectly issued. There may be other instances where a tier I structure involves some innovative feature where the FSA will discuss with the issuer whether the 15% limit is also relevant. b. The dividend should be non-cumulative, that is, if the dividend is missed it cannot be rolled up. It is acceptable to pay the dividend in scrip if a cash dividend is withheld, as this is merely the conversion of one type of capital into another. However, the missed cash dividend should not cumulate. c. The shares should not be redeemable at the option of the holder. Call options subject to supervisory consent are permissible. These should be at the option of the issuer and are subject to a ﬁve-year minimum for the ﬁrst call. Thereafter, the issuer may have more frequent calls for market access purposes. d. The shares have no other provisions which require future redemption of the issue; and 116

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e. The shares are perpetual, that is, they have no maturity date. Preference shares which do not fulﬁl all these conditions should be classed as tier II. Non-cumulative undated preference shares issued by vehicle companies as well as directly issued ‘innovative’ instruments may count as tier I capital under limited conditions. To fulﬁl these criteria, the issue should offer a level of loss absorbency analogous to a directly issued preference share. The issuer should, inter alia, have an independent legal/accounting opinion to this effect. In addition, this route is available only where: ■ the issuer has a tier I ratio of at least 6% at and immediately after issue. An

issuer must meet the 6% ratio (excluding existing innovative instruments) before it can raise additional innovative capital; ■ the 6% ratio applies at both the solo and consolidated level; ■ the sum of innovative capital instruments does not exceed 15% of overall

tier I capital. These FSA rules implement guidance issued by the BIS on 27 October 1998. This guidance was needed because banks were increasingly issuing innovative tier I capital with the goal of achieving tax deductions for payments on that capital. These guidelines created a standard set of rules limiting the amount of innovative capital and specifying minimum requirements that such capital must meet.

Structures used by UK issuers A number of structures have been used by UK issuers to raise tier I capital while obtaining relief on the ﬁnancing costs. The precise form of the structure will depend on the investor base chosen, and to some extent on what is fashionable. Special purpose vehicles are normally used. The overall approach is illustrated below, using an issue made by a UK bank. The securities issued to the investor were ﬁxed interest euro step-up guaranteed non-voting non-cumulative preferred securities. Legally they were limited partnership interests in the Jersey Limited Partnership (JLP). After 12 years, the interest rate would change to a ﬁxed margin over EURIBOR. General Partner Ltd was a wholly owned subsidiary of Bank plc formed purely to act as general partner of JLP. 117

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Bank plc

Cash

Subordinated notes Investors

General Partner Ltd Limited partnership interests General partner

Cash Jersey Limited Partnership

JLP used the cash raised from the investors to subscribe for subordinated notes issued by Bank plc. The subordinated notes were euro-denominated undated callable debt, subordinated to other creditors. If Bank plc fell into arrears paying interest on these notes, holders of the preferred securities would have no rights to any catch up interest. Hence the clear non-cumulation of payments on the preferred securities. In certain circumstances, the holders of the preferred securities could be required to convert them into preference shares of Bank plc. The overall effect is that Bank plc receives a tax deduction for interest paid on the subordinated notes. However, for accounting purposes, the preferred securities are reported under the heading ‘Minority interests – non-equity’ in the consolidated balance sheet and are included in the calculation of tier I capital.

Investor treatment The investors in the structure above own limited partnership interests in JLP. If they are UK-resident, then the UK will ‘look through’ JLP to the underlying investments which are the subordinated notes issued by Bank plc. Accordingly, the investors will have taxable interest income, and possibly exchange gains taxed as income since the subordinated notes are euro-denominated.

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Reserve capital instruments (RCIs) Recently another approach has also been popular. This involves the use of directly issued debt instruments, with the issuer expecting to pay interest in cash but having the option of instead paying by issuing shares. These are generally referred to as RCIs. In February 2002, the Urgent Issues Task Force (which interprets UK accounting standards) caused consternation by releasing UITF Abstract 33 ‘Obligation in Capital Instruments’. This clariﬁes the criteria for deciding between ‘liabilities’ and ‘minority interests’. One UK bank has already announced that its RCIs will need to be reclassiﬁed as liabilities. There is a consequential impact on the proﬁt and loss account, since an item of proﬁt previously allocated to minority interests is now treated as interest expense, reducing the reported pre-tax proﬁt.

CONCLUSIONS Recently, the government has put signiﬁcant effort into modernizing the UK corporate tax system to respond to ﬁnancial innovation. This is reﬂected in the FA 1996 code for loan relationships and the FA 2002 code for derivatives. The tax law for individuals has not been modernized, perhaps due to low perceived participation rates by individuals in the more complex modern instruments. For both individuals and companies, the basic UK approach is to ﬁt the instrument into one of the existing tax classiﬁcations, and tax it accordingly.

ACKNOWLEDGEMENTS I would like to acknowledge the support given by my colleague Lisa McGinty who assisted me by researching available derivatives, and Cath Gallagher who transcribed many pages of illegible manuscript.

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CHAPTER 5

US FEDERAL INCOME TAXATION OF EQUITY DERIVATIVES Edward D Kleinbard

SECTION 1: INTRODUCTION This chapter provides a general overview of the US federal income taxation of equity derivatives, and is addressed to professionals (other than tax advisors) who deal with equity derivatives as part of their business. Section II contains a discussion of some important tax rules that apply to equity derivatives generally. These rules include the straddle rules, wash sale rules, rules governing the short sale of stock and rules that apply to limit the availability of the dividendsreceived deduction or foreign tax credits to a taxpayer that engages in certain risk reduction strategies in respect of stock. Section III discusses stock loans, which may be viewed as a simple form of equity derivative, and Section IV discusses forward contracts, equity futures and equity options, which are generally the simplest and most widely understood equity derivatives and are the building blocks of more complex instruments. Section V discusses the taxation of equity swaps. Section VI discusses so-called ‘mandatory exchangeable’ and ‘mandatory convertible’ instruments, which are well-established products in the public capital markets that combine the economics of a forward contract to purchase stock with an upfront cash payment to the issuer and periodic coupon payments to the investor. As a deﬁnitional matter, a mandatory exchangeable 120

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instrument is based upon a forward contract to sell the stock of a corporation other than the issuer, while a mandatory convertible instrument is based upon a contract to purchase the issuer’s own stock. Although this difference is of only limited signiﬁcance as an economic matter, it is of considerable significance to the tax analysis. Section VII discusses instruments that combine equity options with debt. Section VII ﬁrst discusses convertible and exchangeable bonds and so-called ‘contingent convertible bonds’, which are all unitary debt instruments with embedded equity options, and then discusses bond-warrant units, which are investment units consisting of equity options and bonds, each of which constitutes a separate and distinct instrument. This chapter does not discuss direct investment in equities, except in passing. This chapter is intended to serve only as an introduction to the US federal income taxation of equity derivatives, and cannot serve as advice with respect to any particular transaction. Moreover, readers are cautioned that the rules discussed in this chapter are subject to virtually constant change and revision, and that this chapter therefore reﬂects developments only up to 5 September 2002. The discussion below primarily addresses the taxation of institutional investors and non-dealer issuers of equity derivative instruments. Dealers, market-makers and individuals are frequently subject to special tax regimes different from those summarized below.1

SECTION II: STRADDLES, WASH SALES, SHORT SALES AND OTHER RISK REDUCTION RULES A. Straddle rules The straddle rules of the Internal Revenue Code of 1986, as amended, (the Code),2 require a taxpayer to defer an otherwise allowable loss deduction in respect of the disposition of a ‘position’ in ‘personal property’ to the extent that, at the close of the taxpayer’s year, the taxpayer has unrealized gain in one or more offsetting ‘positions’ (or certain successor positions). The purpose of the straddle rules is to match a taxpayer’s realized losses and unrealized gains in positions that are expected to hedge (in a colloquial sense) each other, in order to prevent taxpayers from accelerating loss deductions in respect of their straddle (or, to use a more value-neutral term, arbitrage) positions by closing out loss positions in one year, replacing those loss positions, and closing out the offsetting gain position (along with the new hedge) in a subsequent year.3 In general, three principal consequences ﬂow from entering into a straddle. First, as described above, a taxpayer’s realized loss from one position in a 121

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straddle cannot be deducted to the extent that the taxpayer has, at year end, unrealized gain on the offsetting position (or a successor position). Many taxpayers mistakenly believe that this loss deferral rule will allow the deduction of a loss in respect of a straddle position once a corresponding amount of gain is recognized in respect of the offsetting position. In fact, the rule is much harsher. Suppose, for example, that a taxpayer purchases 100 shares of XYZ stock for $10 per share. Then, when the stock is at $50, the taxpayer purchases put rights on the stock, paying a total of $500 for puts in respect of all 100 shares. If the stock price rises to $60 so that the puts expire worthless, the taxpayer will have $500 of loss realized but suspended under the straddle rules. The taxpayer in this situation might think that she/he could recognize the loss by simply selling 10 shares and recognizing $500 of gain ($60 price minus $10 basis, multiplied by 10 shares). In fact, the $500 loss is matched to the last $500 of unrealized gain. Therefore, assuming the stock remains at $60, the taxpayer may recognize none of the $500 loss as long as she/he holds 10 shares – in respect of which there is $500 of unrealized gain. The second principal consequence of entering into a straddle is that doing so erases the pre-straddle holding period for a straddle position and does not allow a new holding period to run until that position is no longer part of a straddle, but this rule applies only where the position’s pre-straddle holding period was shorter than the holding period required for long-term capital gain/loss treatment (currently longer than one year).4 As a corollary to the preservation of the pre-straddle long-term capital gain/loss holding period, a loss on the disposition of one or more positions of a straddle is treated as longterm capital loss if: (i) on the date the taxpayer acquired the loss leg of the straddle, the taxpayer held directly or indirectly one or more positions that offset that loss position, and (ii) all gain or loss with respect to one or more positions in the straddle would be treated as long-term capital gain/loss if such positions were disposed of on the day the loss leg was acquired. Thus, if the taxpayer in the above example did not meet the long-term capital gain holding period requirement in respect of her/his stock prior to entering into the straddle, then the pre-straddle holding period would be erased upon entering into the straddle.5 The third principal consequence of entering into a straddle is that a taxpayer who holds a straddle is required to capitalize the net interest expense and carrying charges, if any, attributable to carrying a straddle position (for example interest on debt incurred to carry the stock in the earlier example).6 The straddle rules are enormously complex in general, but become almost insurmountably baffling when applied to equity derivatives. Common sense would suggest that all equity derivatives whose values are determined by reference to publicly traded stock are within the scope of the straddle rules. The technical analysis, however, is more complex. Section 1092(d)(1) generally 122

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deﬁnes ‘personal property’ for purposes of the straddle rules as ‘any personal property of a type which is actively traded’. A ‘position’ in ‘personal property’ is an ‘interest (including a futures or forward contract or an option)’ in such personal property. A typical non-exchange-traded equity derivative (whether an option, a forward, or an equity swap) itself will not be personal property as deﬁned in sec. 1092(d)(l), because the derivative itself is not ‘actively traded’.7 In many cases, however, the stocks that underlie the derivative will be both ‘personal property’ (in the vernacular sense) and ‘actively traded’. A nonactively traded interest in actively traded ‘personal property’ is within the scope of the straddle rules (as a ‘position’ in such ‘personal property’). For many years, the Code’s technical deﬁnitions excluded most equity derivative products (other than stock options) from the scope of the straddle rules.8 Treasury regulations issued in 1995, however, extended the straddle rules to include all derivatives used to ‘hedge’ (in a colloquial, non-tax sense) the value of publicly traded stock (other than a simple short sale of the stock), where the value of such a derivative (1) reﬂects the performance of an enterprise (or an economic factor) and (2) changes in a manner that is ‘reasonably expected to approximate changes’ in the stock’s value.9 Although the issue is not as clear as it might be, it therefore appears that under current law the straddle rules apply to most offsetting positions that consist either of (i) stock versus a derivative, or (ii) one equity derivative versus another equity derivative, at least where the stock in question is itself publicly traded. Thus, by way of one obvious example, the straddle rules now apply to offsetting positions in publicly-traded stock and an equity swap on that stock.10 The relevant Treasury regulations also contain complex rules for applying these principles to baskets of stocks that are offset, for example, by an equity index futures or option contract.11 The straddle rules in general do not apply to arbitrage trades that consist of going long one equity and short another – for example, going long Microsoft and short IBM. The rules do apply, by contrast, to offsetting positions consisting of stock and convertible debentures of the same corporation, presumably on the theory that such a transaction is analogous to a stock versus equity option trade.12 The straddle rules are asymmetric in two interesting respects. First, they operate to defer recognition of loss, but never of gain, thereby allowing a taxpayer (deliberately or unwittingly) to accelerate gain by closing out one leg of a straddle. Second, the deﬁnition of ‘offsetting position’ does not require that each position substantially diminishes the risk of loss of holding the other position, but only that one such position does so. Thus, if a taxpayer owns 100 shares of XYZ common stock and writes an at-the-money call option on those 100 shares (that is not a ‘qualiﬁed covered call’, as described below), the taxpayer will have entered into a sec. 1092(d)(3)(B) straddle (consisting of 123

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stock and an option on that stock) – not because writing the call option substantially diminishes the risk of holding the stock, but rather because holding the stock substantially diminishes the risk of being short the call. The result in that last example in turn seemed too harsh even to the tax legislators, and so a special exception in sec. 1092(c)(4) – the ‘qualified covered call’ exception – carves out writing covered call options from the scope of the straddle rules, where (1) the call options are listed on one of several speciﬁed securities or commodities exchanges, (2) the options have a term of more than 30 days, and (3) the options meet certain speciﬁed criteria for not being deep-in-the-money.13 Under regulations, an option may not fall under this exception if it has a term of more than 33 months.14 Recent regulations expand the qualiﬁed covered call exception to an otherwise qualifying over-the-counter option and an exchange-traded option with flexible, non-standard terms (a ‘ﬂex option’) that meets all of the above-mentioned requirements, provided that (1) the only two payments permitted with respect to the option are a single, ﬁxed premium payable not later than ﬁve business days after the option grant date and a single ﬁxed strike price payable within ﬁve business days of exercise, (2) there is an exchange-traded option with standardized terms outstanding for the underlying equity, and (3) the underlying security is equity of a single corporation.15 No exception from the straddle rules exists for over-the-counter or exchange-traded put options, even in so-called ‘married put’ trades.

B. Wash sales The wash sale rules of sec. 1091 prevent investors from reporting artiﬁcial losses by selling securities at a loss at the end of one taxable year and immediately repurchasing the same (or substantially identical) securities in the next year. Generally, the wash sale rules disallow the recognition of loss where (1) the loss is from the sale or other disposition of stock or securities and (2) within a period of 30 days before or 30 days after the date of disposition the taxpayer has acquired substantially identical stock, securities or options, or has entered into a contract or option to acquire them. The wash sale rules do not apply to losses realized by a securities dealer in the ordinary course of his/her trade or business. If a loss is disallowed under the wash sale rules, the holding period of the property sold is added to the holding period of the newly acquired, substantially identical property.16 Where both the wash sale rules and the straddle rules would apply to a transaction, temporary regulations provide a modiﬁed wash sale rule applicable to straddles that defers the recognition of losses incurred in the transaction.17

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The wash sale rules do not apply to a taxpayer who simply closes out a sec. 1256 contract or other contract, whether by cash settlement or physical delivery. The wash sale rules do apply, however, to a taxpayer who, for example, sells stock at a loss and within the prohibited period enters into a contract or option to buy replacement stock. Options with maturity dates and/or strike prices that are different by more than a de minimis amount should not be ‘substantially identical’ within the meaning of the wash sale rules.18 Writing an in-the-money put generally should not prevent an investor from recognizing loss on the prior sale of underlying stock unless the put is exercised within the 30-day period. If, however, looking at general market conditions, the difference between the exercise price and the value of the stock is so substantial that the put is highly likely to be exercised, the loss may not be recognized.19

C. Short sales A ‘short sale’ of stock is a sale to the market of stock that the seller does not own – with the hope that the price of the stock will fall. The short seller must borrow the stock to deliver it to the market purchaser. At the end of the stock loan, the stock borrower must return stock of the same type to the original owner (the stock lender). If the stock price has declined during this period, the stock borrower will proﬁt by covering in the market at a price lower than the proceeds received from the short sale. A short sale generally will not give rise to a taxable event for the short seller until the short seller returns borrowed stock to the lender. Originally, the short sale rules of sec. 1233 operated to prevent an investor from effecting a short sale in respect of stock already owned by the investor (that is, being both long and short the same stock) risklessly to age unrealized short-term capital gains into realized long-term capital gains, or to convert long-term capital loss into short-term capital loss. Under current law, however, sec. 1259 treats such a ‘short-against-the-box’ on shares of stock as a constructive sale of such shares and, as a result, has eliminated the tax utility of such transactions.20 The short sale rules have little direct application to equity derivatives (other than equity-indexed debt instruments that are themselves securities within the scope of sec. 1233). The principal exceptions to this general rule are (1) the extension of short sale principles to all tax straddles, as described above in the discussion of straddles and (2) the fact that a put option is treated as a contract to sell the underlying property for the purposes of triggering the application of the short sale rules.21

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D. Other risk reduction rules 1. Dividends-received deduction Under sec. 243, a US corporation may claim as a deduction a specified percentage of dividends received from other US corporations. The dividends-received deduction thus functions as a partial palliative to the nonintegrated corporate tax system. The allowable deduction is equal to at least 70% of the dividends paid, but the 70% ﬁgure rises to 80% where the corporate investor owns 20% or more of the stock of the issuer (measured by vote and value and without regard to certain plain vanilla non-voting preferred stock), and the deduction rises to 100% in the case of dividends received from 80%-owned subsidiaries. Section 246(c) limits the availability of a dividends-received deduction for corporate taxpayers engaging in risk reduction strategies in respect of stock investments. The most troublesome such limitation is sec. 246(c)’s requirement that the investor own the stock for at least 46 days without recourse to various speciﬁed risk reduction strategies during the 90-day period beginning on the date that is 45 days prior to the date on which the stock becomes ex-dividend.22 The speciﬁed risk reduction strategies include buying a put on, selling a call on, selling short, or entering into a forward purchase of, ‘substantially similar stock’. In addition, certain transactions with respect to ‘substantially similar or related property’ entered into to diminish the taxpayer’s risk of loss would preclude a dividends-received deduction. Generally, reg. sec. 1.246-5 deﬁnes ‘substantially similar or related property’ to include property, the value of which (i) reﬂects the performance of an enterprise, the same industry or the same economic factor (such as interest rates), and (ii) changes in a manner that is ‘reasonably expected to approximate changes’ in the stock’s value. Thus, for example, if the primary asset of XYZ corporation were gold, such that changes in the value of XYZ stock approximated changes in the value of gold, then a short position in gold (or even in stock of another corporation that reﬂects the value of gold) would be a position in ‘substantially similar or related property’ for these purposes.23 2. Foreign tax credits Section 901(k) also imposes similar holding period requirements, except that the minimum holding periods are 16 days for common stock and 46 days for preferred stock, for purposes of claiming foreign tax credits for withholding taxes incurred in respect of dividends received on foreign stock.

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SECTION III: STOCK LOANS A. Typical transaction ﬂows A person who does not own a particular stock may need, in some cases, to borrow the stock from the owner, as in the case of a short sale. Securities dealers also frequently borrow stock to cover fails by a customer to deliver in a timely manner stock that the dealer already has sold for delivery to another customer. When it lends stock, the original investor no longer remains the registered owner of that stock. Instead, the market purchaser (from the short seller or dealer) becomes the record owner of the stock. The stock lender simply has a contractual agreement with the stock borrower under which the latter agrees to return equivalent stock at the end of the loan term. The stock borrower typically is required to collateralize its obligation with cash or other securities equal to the value (adjusted periodically) of the borrowed stock. The stock borrower also typically pays a borrow fee to the stock lender for use of the borrowed stock during the stock loan period; if the stock borrower posts cash collateral, that borrow fee ordinarily is netted against the interest paid to the borrower by the stock lender on the cash collateral. If the stock loan extends over a dividend record date, the stock borrower also makes a substitute payment (also called an in lieu payment) to the stock lender to compensate for the forgone dividend amount. The stock lender thus has the same economic proﬁle as if it continued to hold the stock (plus the incremental borrow fee). The stock lender, however, loses its legal ownership rights (including the right to vote) during the stock loan period and substitutes instead a fully collateralized contractual obligation of the stock borrower.24

B. US investors/stock lenders Section 1058 provides that a qualifying ‘securities loan’ is not a taxable sale and repurchase of the stock in question, but is rather a non-taxable exchange of the stock for the securities loan contract (and vice versa at maturity).25 The stock lender therefore does not recognize gain or loss upon the initiation or termination of a stock loan. US broker-dealers typically employ standardized stock loan forms that are intended to comply with the requirements of sec. 1058. There is no generally applicable authority concerning the nature of borrow fees for US tax purposes, and they do not fall easily into any of the traditional categories. Although borrow fees might be viewed as most closely resembling 127

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rental payments, the traditional criteria that look to the location where the rental property is ‘used’ are difficult to apply in the case of transferable securities. It is clear, however, that separately stated borrow fees are not ‘gain from the sale or exchange of a capital asset’ and therefore necessarily constitute ordinary income for a taxable US stock lender.26 Whether borrow fees received by a US stock lender from a non-US stock borrower should be treated as USsource or foreign-source income remains an open question. Proposed reg. sec. 1.1058-1(d) provides that substitute payments in respect of stock (that is, payments in lieu of dividends) are to be treated by the stock lender as a ‘fee for the temporary use of property’ and not as a dividend that qualiﬁes for the dividends-received deduction.27 This rule, as applied to a US stock lender that is a taxpaying corporation, is intended to prevent the duplication of tax beneﬁts that would arise if both the stock lender and the market purchaser who is the registered owner of a stock could claim the dividendsreceived deductions with respect to the same dividend income. Substitute payments and borrow fees paid by a stock borrower generally are deductible against ordinary income.28 For reasons that make surprisingly little sense the more one ruminates on the matter, stock borrow expenses are treated as akin to interest expense for purposes of a number of Code provisions limiting the deductibility of interest to carry certain stock positions.29 For a tax-exempt US institution that owns stocks, the primary issue with respect to stock lending is whether the income (from borrow fees and substitute payments) will be taxable as unrelated business taxable income. Section 512(b)(1) speciﬁes that all payments with respect to securities loans generally – including borrow fees, substitute payments and income on posted collateral – are excluded from treatment as unrelated business taxable income.30

C. Non-US investors/stock lenders A non-US stock lender generally is not subject to US tax with respect to initiating or closing out a stock loan, either under general US tax principles or under sec. 1058. There is no generally applicable authority with respect to the US tax treatment of borrow fees, when paid by a US stock borrower to a non-US stock lender. Such fees might be treated as akin to rent for the use of the stock, and (under that theory or some other) characterized as US-source ‘ﬁxed or determinable annual or periodic’ income that is subject to 30% US withholding tax (subject to potential treaty relief). A 1988 private lender ruling analysed borrower fees paid by a US broker-dealer to a non-US life insurance company as ‘industrial or commercial proﬁts’ and therefore exempt from US withholding tax under the relevant US tax treaty.31 The rationale of that ruling 128

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generally has been relied upon to avoid US withholding tax for borrow fees paid to stock lenders that are ﬁnancial institutions resident in treaty countries. An unresolved question is whether the same ‘business proﬁts’ rationale can be relied on for borrow fees paid to a non-US stock lender that is, for example, a foreign pension fund – which might not be viewed as engaged in ‘business’ for this purpose. One possible approach that could be implemented through regulations would be simply to treat borrow fees paid to a non-US stock lender as foreign-source income (and therefore as exempt from US withholding tax). That type of pragmatic solution was adopted to resolve similarly difficult characterization issues with respect to payments on notional principal contracts.32 The US taxation of dividend substitute payments received by a US stock lender creates possible anomalies when carried over to the case of a non-US stock lender. A non-US investor that receives actual dividends of US stocks will be subject to US withholding tax on those dividends. If, when it lends those stocks, a non-US investor receives a substitute payment that is characterized other than as a dividend, the same withholding tax regime may not apply. The issue is particularly relevant for stock lenders in jurisdictions whose treaties with the United States provide for a zero rate of withholding tax on unspeciﬁed ‘other income’.33 The opposite situation arises when a non-US investor lends a non-US stock into the United States – that is, there is a risk that US withholding tax will apply to a substitute payment made to the non-US lender when receipt of the actual foreign-source dividend payment would not attract US withholding tax. Regulations address this problem for cross-border securities loans. The regulations adopt a ‘transparency’ approach that would treat substitute payments as having the same source, character and income tax treaty treatment as the underlying distribution for which the payments substitute – irrespective of the residence of the substitute payment payer.34 Thus, substitute payments on loans of US stocks would be subject to the same US withholding tax as actual dividends (which are sourced by residence of the issuer of the stock), which means that even a substitute payment made by a foreign borrower of a US stock to a foreign lender may be subject to US withholding tax. The purpose of the transparency rule is to ensure that a non-US owner of US securities does not suffer (or obtain the beneﬁts of) different US withholding tax results if the owner lends its security to a US borrower than if it continues to hold the security directly. Imagine, for example, that a non-US person loans US equities to a US person in a transaction subject to the transparency rule. Substitute dividend payments made by the US borrower to the non-US lender generally will be treated as US-source dividend income subject to the 30% US withholding tax. In the absence of the transparency rule, owners of US equities in some jurisdictions (such as the United Kingdom) could take the view that substitute payments were not dividends (or otherwise described 129

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in the United States–United Kingdom Income Tax Treaty), and therefore were not subject to US withholding tax. Applied too literally, however, the transparency rule could result in multiple imposition of US withholding tax on the same dividend stream. For example, if a foreign shareholder of US stock resident in Country A lent that stock to a foreign borrower resident in Country B, which in turn re-lent the stock to a US securities dealer (and assuming that no tax treaties exist between the United States and either Country A or Country B), then the US dealer would be required to withhold $30 on a substitute dividend payment of $100 paid to the foreign stock borrower resident in Country B. If the transparency rule is left unchecked, then the Country B stock borrower would also be required to withhold another $30 when it makes the substitute dividend payment to the Country A stock lender, since the Country B borrower would be a withholding agent in respect of the substitute payment that has US source under the transparency rule. Relief from the potential tax scenario described above has been provided by Notice 97-66.35 The general rule of Notice 97-66 is that the payer of a substitute payment must withhold at the rate applicable to the underlying dividend or interest payment as if it were made by the US issuer of the security directly to the security lender, to the extent that such amount to be withheld exceeds the total US withholding tax previously imposed on that dividend/interest payment stream. The rule, however, is asymmetrical, because amounts previously withheld on a dividend/interest payment stream in excess of the rate of withholding tax applicable to a direct US dividend/interest paid to a foreign security lender are not creditable or refundable for US tax purposes to that lender. Thus, if in the example above, the rate of US withholding tax on a direct US dividend payment to the Country B stock borrower is 10%, and the rate of withholding tax on a direct US dividend payment to the Country A stock lender is 30%, then the Country B stock borrower must withhold 20% of the dividend amount from its substitute payment to the Country A lender. If instead, the rate of US withholding tax on US dividends to the Country B stock borrower is the full statutory 30%, then no withholding tax is imposed on the substitute payment by the Country B borrower to the Country A lender, regardless of the applicable rate of withholding tax on US dividends paid to Country A residents. If by treaty, the rate of US withholding tax on dividends paid to Country A residents is 10%, then even though 30% of the dividend was originally withheld on the dividend paid to the Country B shareholder/borrower, the Country A stock lender is not allowed a credit or refund for US tax purposes of the ‘excess’ 20% withheld.

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SECTION IV: BASIC EQUITY DERIVATIVES: FORWARDS, FUTURES AND EQUITY OPTIONS This section discusses the taxation of forwards, futures and equity options. Generally, the taxation of these instruments is not affected by whether an instrument is physically or cash settled.36 Section 1256, however, imposes a special set of tax rules on certain exchange-traded instruments, which are discussed below in Section IV.B.

A. Forward contracts A forward contract is a private contract that typically calls for the delivery of a speciﬁed quantity of property at a ﬁxed price at a set date in the future. No regulated exchange is involved in a forward contract, and any requirements to post collateral are the result of private negotiations.37 Because neither party to a forward contract fulﬁls its obligation to the other prior to settlement, forward contracts are traditionally viewed as having no tax effect until the settlement date, under the rationale that settlement is the point where the underlying transaction (the sale of property) actually occurs.38 However, because the opportunities for gain or loss in respect of the underlying property are transferred from the forward seller to the forward purchaser as an economic matter at the time the contract is entered into, secs 1259 and 1260, discussed below, apply in certain circumstances to override the general rule and create a deemed sale or purchase of the underlying property at the beginning of the contract term. A forward contract in respect of stock is not subject to the mark-to-market and special character rules of sec. 1256. For a tax-exempt investor or a non-US investor, however, the tax consequences of an equity forward contract are identical to those of a futures contract, as described below. Cash settlement of a forward contract has traditionally been treated for tax purposes as if the underlying property were delivered by the forward seller to the forward buyer and then sold immediately by the buyer for cash.

1. Section 1259

Entering into a forward contract to sell an appreciated ﬁnancial asset held by the forward seller (except for plain vanilla debt) will trigger a constructive current sale under sec. 1259, which was enacted as part of the Taxpayer Relief Act of 1997.39 Section 1259 was enacted to prevent taxpayers from achieving the economic effect of disposing appreciated ﬁnancial assets while deferring 131

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gain recognition (and in some cases avoiding it altogether), such as by entering into a short-against-the-box (which sec. 1259 treats as a constructive sale of the short seller’s long position in the stock shorted). The effect of a constructive sale of property held by a taxpayer is that the taxpayer is treated, solely (except as provided in regulations) for purposes of recognizing gain and establishing a holding period, as if it had sold the property in question for its fair market value and immediately reacquired the property.40 Under sec. 1259, a ‘constructive sale’ is deﬁned as: ■ a short sale; ■ an offsetting notional principal contract; ■ a futures or forward contract; ■ the acquisition of the property underlying any of the above, where the

taxpayer has an open position described above;41 or ■ to the extent provided in regulations, a transaction that has substantially the

same effect as the four listed transactions (the ‘catch-all provision’).42 These transactions give rise to a constructive sale only if entered into at a time when a taxpayer holds appreciated property – so that, for example, buying stock and immediately entering into an equity swap on that stock would not trigger sec. 125943 – and only to the extent that a hedge relates to the ‘same or substantially identical’ property.44

2. Section 1260

Just as sec. 1259 addresses the use of derivatives to effect a synthetic sale of assets, sec. 1260 addresses the use of derivatives to effect a synthetic purchase of assets. Section 1260 was enacted in 1999 to prevent taxpayers from using derivative instruments to invest in assets that generate current ordinary income in a manner that (i) could convert the ordinary income into long-term capital gain, and (ii) could defer the recognition of that income until the end of the derivative instrument’s term. For example, consider a US taxpayer wishing to invest in a hedge fund. Because hedge funds are generally treated as partnerships for US tax purposes, the taxpayer would be required to include in income on a current basis its allocable share of the fund’s income, and the income would have the same character in the taxpayer’s hands as it has in the hands of the fund (for example ordinary income recognized by the fund would generally be taxed as ordinary income to the taxpayer). Now consider the case in which the taxpayer enters into a 132

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three-year swap where at maturity the taxpayer receives a payment from its counterparty equal to any increase in the value of the hedge fund over the three-year swap term, and is required to make a payment to its counterparty equal to any decrease in the fund’s value. The taxpayer could then defer all recognition of gain in respect of the hedge fund until the swap’s maturity and, similarly, could (prior to the enactment of sec. 1260) take the position that all gain in respect of the swap constitutes long-term capital gain. Section 1260 responds to such synthetic investment transactions by providing that, if a taxpayer enters into a ‘constructive ownership transaction’ with respect to an underlying ‘ﬁnancial asset’, any long-term capital gain recognized by the taxpayer at the end of the constructive ownership transaction will be treated as ordinary income, to the extent that such gain exceeds the amount of long-term capital gain the taxpayer would have recognized had it acquired the underlying ﬁnancial asset for fair market value at the inception of the constructive ownership transaction and sold it for fair market value at the end of the constructive ownership transaction. In addition, in order to prevent taxpayers from beneﬁting from the deferral of income, sec. 1260 imposes an interest charge with respect to the tax on the recharacterized gain. For the purposes of sec. 1260, a ‘constructive ownership transaction’ is deﬁned to include: ■ a long position in a ﬁnancial asset under a notional principal contract; ■ a forward or futures contract to purchase a ﬁnancial asset; ■ a long position in a ﬁnancial asset that is achieved through the purchase of

a call option with respect to the asset and the issuance of a put option with respect to the asset, where the options have substantially the same strike prices and maturity dates; and ■ to the extent provided in regulations (which have not yet been issued), any

other transaction or series of transactions having substantially the same effect as the above-mentioned transactions. A ‘ﬁnancial asset’ is any equity interest in certain ‘pass-thru’ entities, such as a partnership, where the equity holders of the entity are taxed currently with respect to income recognized by the entity.45 In addition, the term ‘ﬁnancial asset’ may be expanded by regulations (not forthcoming to date) to include any debt instrument and any stock in a corporation.

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B. Equity index futures An equity index futures contract is a standardized contract, traded on a regulated futures exchange, that provides for the contracting party to make (a short contract) or to receive (a long contract) a cash payment based on the underlying price movement (usually excluding dividends) of a standardized basket of stocks over a set period. Examples include futures contracts on the S&P 500 Index (US), the FTSE 100 Index (UK) and the Nikkei 225 Index (Japan). Equity index futures that are traded on US futures exchanges constitute sec. 1256 contracts. US investors generally must ‘mark to market’ any such contracts that are open at year end (that is, treat the contracts as if they were closed out on the last day of the year), and include in income for that year the resulting gain or loss.46 Gain or loss from sec. 1256 contracts held by a US taxpaying investor is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, regardless of the length of time the futures contract has been held.47 The posting and release of margin is not treated as a taxable event for a US investor, on the unstated premise that such advances are security deposits and not absolute transfers to the counterparty (or the exchange, as intermediary). Equity index futures that are traded on non-US exchanges generally are not subject to the mark-to-market rules and typically produce capital gain or loss for a US taxpaying investor on expiration of the contract.48 Thus, a futures contract on the FTSE 100, traded in London, would not be subject to sec. 1256’s mark-to-market and ‘60/40’ regimes in the hands of a US taxpayer.

C. Securities futures49 A securities futures contract is an exchange-traded contract for the sale or purchase of a single equity security or a ‘narrow-based security index’.50 The trading of securities futures on US exchanges was made permissible only recently by certain changes in the US legal and regulatory regime, and actual trading has not yet begun as of the date of this writing. Securities futures generally do not constitute sec. 1256 contracts, except in the hands of a dealer, which for these purposes is a person that the US Treasury Department (Treasury) has officially determined fulﬁls the functions of market-maker or ﬂoor specialist in listed securities futures.51 Because US exchanges historically have not had officially designated market-makers or specialists in futures contracts, currently it is not clear exactly how the roles of market-maker and specialist will be fulﬁlled in the context of securities futures contracts, and to date the Treasury has made no determination as to which

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persons will qualify as ‘dealers’ of securities futures contracts for purposes of sec. 1256.52 In the abence of any potential application of sec. 1256, any gain or loss from the sale or exchange of a securities futures contract is capital gain or loss, if the underlying asset would have been a capital asset in the hands of the taxpayer, and in such a case any gain or loss realized in respect of a securities futures contract to sell the underlying asset (a short contract) will be treated as short-term capital gain or loss.53 As in the case with equity index futures and forward contracts, the holder of a securities future will receive no dividendsreceived deduction.

D. Tax rules generally applicable to equity index futures and securities futures For tax purposes, gain or loss arising from a futures contract (whether as a result of a year end mark to market or as a result of closing out the contract) is viewed as arising, in effect, from a deemed sale of the underlying stock or stocks; no separate analysis is made of any dividend equivalent component of the return on the futures contract. Thus, a US corporate investor cannot obtain a dividends-received deduction in respect of the implicit dividend equivalent component of the investor’s return on a long position in an equity futures contract. Tax-exempt investors can recognize gains from closing out a futures contract free of unrelated business income tax under the rules excepting sales or other dispositions of non-inventory property from the tax.54 Futures contracts entered into by non-US investors are treated as involving the sale of the underlying stocks in the same manner as for US investors, and therefore are not subject to US withholding tax. Similarly, posting and release of margin collateral by a non-US investor is not a US taxable event.

E. Equity options An equity option gives the investor the right, but not the obligation, to buy or sell speciﬁed stock for a set price at a speciﬁc time or over a speciﬁc period of time. A premium paid in respect of an option (whether or not exchangetraded) is not included in the income of an option writer or deductible by the option purchaser at the time the option is written. Instead, the premium is held in a suspense account, and not accounted for until the option lapses or is exercised. If an equity option expires unexercised, a non-dealer issuer generally recognizes short-term capital gain, and an investor-purchaser recognizes longterm or short-term capital loss equal to the amount of the premium, depending 135

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on whether the option has been held for more than one year.55 If an investor exercises a call option and takes delivery of the underlying equities, the premium paid by the investor is added to the investor’s basis for the newly acquired equities, and the investor’s holding period (for long-term capital gain/loss purposes) begins on the day following the date of exercise.56 The tax consequence of exercising a put option is the converse: the holder treats the premium paid as, in effect, a reduction in the sale proceeds received from the sale of the equities underlying the option. In the hands of investors (as opposed to dealers), exchange-traded options on individual stocks and exchanges-traded securities futures are not sec. 1256 contracts.57 On the other hand, exchange-traded options on stock indices for which future contracts exist on a qualified board or exchange (such as exchange-traded options on the S&P 500) are sec. 1256 contracts; confusingly, the Code labels such options as ‘nonequity options’.58 As a sec. 1256 contract, such an option is subject to the mark-to-market and 60/40 character rules described earlier. An option that would fall within sec. 1256, except that it is not listed on a qualiﬁed board or exchange, is not a sec. 1256 contract; thus, a privately negotiated option on the S&P 500, or a London exchange-traded option on the FTSE 100, is not a sec. 1256 contract.

SECTION V: EQUITY SWAPS A. Introduction An equity swap is a private contract between two parties that provides for payments based in part on the returns of a speciﬁed pool of stocks. Because an equity swap is a private contract, there are no standardized terms, and the parties can negotiate the relevant stock portfolio or equity index, payment dates and contract maturity. For example, a typical equity index swap is a multiyear contract that provides for one party to make periodic payments for a speciﬁed term of (1) amounts based on the increase in value, if any, during each period of a speciﬁed equity index – such as the S&P 500 – and (2) amounts equal to dividends paid on that index. In exchange, the other party agrees to make periodic payments of X, a ﬂoating rate of interest pegged (by way of example) to LIBOR, and Y, amounts based on the decrease in value during each period of the S&P 500. Payments due by the two parties on a payment date normally are netted, so that only the net liability is paid in cash. The notional principal amount against which all payments are calculated is typically adjusted each period to reﬂect the change in value in the equity index from the prior period.59 Other equity swaps (not keyed to an index) typically might have similar terms, except that 136

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the portfolio of underlying stocks would be custom tailored by the counterparties to suit their investment or hedging objectives. In economic substance, an equity index swap resembles a series of equity index forward contracts, where the parties are obligated to recontract on each payment date at the then current market level. Alternatively, the cash ﬂows on an equity swap can be viewed as equivalent to the results that would be obtained if the investor had (i) borrowed the notional principal amount from its counterparty upon entering into the swap, (ii) invested that amount in the equity securities that make up that equity index, (iii) sold those securities at the end of the period, and then (iv) reinvested the sale proceeds in the equities at the beginning of the next period. Unlike either a futures contract or a physical stock portfolio, however, an equity swap involves signiﬁcant credit risk with respect to the swap counterparty. There is no regulated board of exchange to absorb counterparty defaults or regulate ‘margin’ for swaps. Collateral arrangements (if any) for swaps must be negotiated and enforced privately between the parties. The credit risk associated with equity swaps in many cases limits the aggregate amount of swap transactions that counterparties are willing to have open with each other at any one time.

B. Taxation – US investors 1. Timing

Regulation sec. 1.446-3 governs the timing of income with respect to swaps generally. According to the regulations, payments made or received with respect to equity swaps are divided into three categories: periodic payments, non-periodic payments and termination payments. Periodic payments are deﬁned by reg. sec. 1.446-3 as ‘payments made or received … that are payable at intervals of one year or less during the entire term of the contract (including any extension periods provided for in the contract)’, and that are calculated by reference to a ‘speciﬁed index’ (which, for this purpose, does not include a series of ﬁxed rates, prices or amounts), and are based either on a single notional principal amount or on a notional principal amount that varies in the same proportion as the notional principal amount used to determine the counterparty’s payments. Non-periodic payments are all other payments pursuant to the negotiated terms of an equity swap. A termination payment is a payment made or received that extinguishes or assigns all or a proportion of the rights and obligations of any party under an equity swap.60 Each year, a party to an equity swap must include as income or deduction the net amount of all periodic payments with respect to that swap that are ‘recognized’ under a rateable daily accrual method that applies regardless of 137

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the taxpayer’s method of accounting. In the case of variable rate indices that are set in arrears, a taxpayer is required to calculate the rateable daily portion of a periodic payment that relates to a taxable year by treating the last day of the taxable year as the date on which the index is determined; any difference between that amount and the actual amount due for the period (determined on the actual reference date) is treated as income or deduction in the following year. If a non-periodic payment is made with respect to an equity swap, reg. sec. 1.446-3 in effect allocates that non-periodic payment over the term of the contract using a method that reﬂects the ‘economic substance’ of the contract.61 A party to the contract must include as taxable income (or expense) the amount of such non-periodic payment allocable to each day of the contract’s term under the same rateable daily accrual method applicable to periodic payments. Regarding contingent non-periodic payments, the Service explicitly acknowledged in the preamble to reg. sec. 1.446-3 that these regulations ‘do not include any examples of how to treat non-periodic payments that are not ﬁxed in amount at the inception of the contract’.62 Consequently, general common law principles governing the accrual of income will apply to contingent non-periodic payments. The common law treatment of contingent payments for taxation purposes can most appropriately be summarized as representing a ‘wait-and-see’ approach. In the absence of unusual features (such as a contingent payment whose maturity extends beyond the maturity of the debt interest as a whole), the instrument is not likely to be bifurcated. Payments denominated as interest, at least, are likely to be respected as such, and no tax consequences are likely to arise from contingent payments until those contingencies become ﬁxed. The result, of course, is a backloading regime of the sort that the Code has gradually been disallowing for contingent payments embedded in several other types of ﬁnancial instruments.63 In order to minimize this backloading, the Service may, where possible, bifurcate a nonperiodic payment into contingent and non-contingent components, so that the latter may be taxed under the economic accrual regime.64 Termination payments are treated, in effect, as arising from the sale of an equity swap. An assignment will trigger a tax realization event for the nonassigning counterparty only if the assigned notional principal contract differs materially from the unassigned contract. The assignment of most swaps that follow standard ISDA documentation may well result in a taxable event for the non-assigning counterparty, because the non-assigning counterparty must consent to the introduction of a new party to the contract.65

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2. Character

a. Periodic payments There is no deﬁnitive rule or guidance on determining whether a payment on an equity swap is capital or ordinary in character,66 and this issue is important for several reasons. First, there is a difference between the rate of taxation for individuals on ordinary income and capital gain. Of far greater importance for corporations, however, is the rule that capital losses may be used to offset only capital gains and not ordinary income. Because corporate operating income generally is ordinary, capital loss from an equity swap would not provide a tax beneﬁt unless the taxpayer has offsetting capital gains. This one-sided treatment of capital gain or loss should not be a substantial concern for taxpayers who use ﬁnancial derivatives as hedges of liabilities or dealer positions. Section 1221(a)(7) and reg. sec. 1.1221-2 generally characterize gain or loss recognized by a taxpayer on certain hedging transactions as ordinary income or loss.67 To qualify for this hedging regime, the asset or liability being hedged must itself give rise solely to ordinary income or loss in the hands of the taxpayer in question.68 In practice, therefore, if a taxpayer employs notional principal contracts to hedge, for example, its outstanding debt obligations or inventory assets, the taxpayer’s gain or loss incurred in respect of those notional principal contracts will be characterized exclusively as ordinary income or loss by virtue of reg. sec. 1.1221-2. By contrast, a taxpayer who uses a notional principal contract to hedge (in the colloquial sense of the word) the economic returns on a capital asset – such as equities held as investments by the taxpayer – generally cannot rely on the special hedging regime to characterize any gain or loss resulting from the hedge as ordinary income/loss.69 In addition, reg. sec. 1.446-3 does not provide any guidance with respect to the character of gain or loss in respect of swaps, because that regulation addresses only the timing of income and deduction from notional principal contracts. Consequently, the only current sources of guidance are private letter rulings and memoranda from the Service that have no precedential value, but do provide an indication of the Service’s thinking. The Service appears today to take the (in the author’s opinion, incorrect) view that any scheduled payment on a notional principal contract, whether ﬁxed or contingent, and whether periodic or non-periodic, gives rise to ordinary income or expense.70 Gain or loss from a negotiated assignment of a notional principal contract, by contrast, is said to produce capital gain or loss (in the hands of a non-dealer, of course). The Service’s position raises several policy concerns, because the character of an equity-based contingent payment should not depend upon whether the payment is documented as an option or forward contract or embedded into a 139

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larger derivative. For this reason, equity-based contingent payments under a notional principal contract should (one would have thought) have the same character that would apply if the payments were made separately from the notional principal contract (that is, capital if the underlying equity asset would be a capital asset in the hands of the taxpayer). Of course, the rules for taxing contingent payment debt instruments (CPDIs) already create such an asymmetry by treating virtually all gain or loss in respect of a CPDI as ordinary, even where the gain or loss is clearly attributable to an embedded option,71 and so the policy question becomes whether the CPDI rules are an example to be followed (presumably because of some preference for ordinary treatment where possible) or are merely a poorly thought-out exception to the general tax regime. As a technical matter, the issue of whether contingent equity-based payment on equity swaps may qualify for capital gains treatment comes down to a technical reading of sec. 1234A, which treats a payment as ‘gain or loss from the sale or exchange of a capital asset’ if two conditions are fulﬁlled. First, the payment must arise from a ‘right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer’. Second, the payment must arise from a ‘termination’ of that right or obligation. An equity swap, whether on a broad index or an individual stock, meets the ﬁrst requirement, because contract rights, including those provided under ﬁnancial instruments, generally constitute property for tax purposes. The second requirement of sec. 1234A is met if a payment results in the cancellation or termination of ‘a right or obligation’ of a taxpayer with respect to property. It is possible, therefore, that a payment could cancel or terminate ‘a right or obligation’ that a taxpayer has with respect to property, even though the contract pursuant to which that payment is made contemplates that the taxpayer may make (or receive) other payments in cancellation or termination of the taxpayer’s other severable rights or obligations with respect to property.72 Section 1234A thus applies not only to non-scheduled extinguishments of the kind that originally prompted its enactment, but also to the ﬁnal (and sole) payment on a cash-settled forward contract, and the loss realized on the lapse of a purchased cash-settlement option.73 Consider, for example, two cash-settled forward contracts on gold. The ﬁrst contract pays out (or requires payment of) an amount in 90 days measured by reference to the difference between the value of a speciﬁed quantity of gold today and the value of the same quantity of gold at the end of the 90 days. The second contract is identical, except that it pays out (or requires payment of) an amount in 180 days measured by reference to changes in the price of gold between day 91 and day 180. Each such hypothetical contract would be covered by sec. 1234A (assuming that gold was a capital asset in the hands of the taxpayer, and that reg. sec. 1.1221-2 did not otherwise apply). More rele140

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vantly, if the two contracts were stapled together into a single bilateral contract, it is the author’s view that sec. 1234A should apply to each of the two payments contemplated by the contract, because each payment terminates one of the taxpayer’s severable ‘bets’ on the price of gold. The Service addressed the application of sec. 1234A to periodic payments made pursuant to a swap for the ﬁrst time in Technical Advice Memorandum 9730007 (TAM 9730007), in which the Service concluded that those payments give rise to ordinary income or expense.74 In TAM 9730007, a taxpayer entered into an oil commodity swap that provided for monthly payments calculated by reference to a market-based ﬂoating price per barrel of oil and a price per barrel that was ﬁxed for the term of the swap. Unlike most commodity swaps, the swap was entered into to hedge an investment in oil, rather than inventory or supply needs. Viewing the swap as the economic equivalent of a series of 12 cash-settled forward contracts, the taxpayer treated amounts it paid under the swap as capital losses and amounts it received as capital gain (the taxpayer further argued that even if the interim periodic payments were not termination payments for the purposes of sec. 1234A, the ﬁnal periodic payment was a termination payment). The Service disagreed with that view, noting that a notional principal contract is a ‘single, indivisible ﬁnancial instrument’ and not a series of forward contracts. The Service held that payments made pursuant to the swap represented ordinary income or expense, since a periodic payment is not ‘attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to personal property within the meaning of section 1234A’, and therefore ‘does not give rise to capital gain or loss because there is no sale or exchange of a capital asset’. The Service supported its position by noting that the periodic payments made pursuant to the terms of the commodity swap (i) were ‘similar to dividends on stock or interest on securities … rather than amounts received on the sale or exchange of the underlying instrument’, (ii) did not terminate the commodity swap under sec. 1234A because they are ‘simply payments made according to the original terms of the single instrument’, and (iii) did not qualify as ‘termination payments’ under the swap timing regulations.75 The Service went on to conclude that the treatment of periodic payments under the swap timing regulations requires that periodic payments be accrued by the taxpayer in the taxable year to which the payment relates, which leaves no gain or loss to be recognized solely as a result of making or receiving the payment.76 There is a substantive difference, however, between an equity swap and the commodity swap described in TAM 9730007. Under a conventional commodity swap, like the one discussed in TAM 9730007, the payment obligations of one party are determined by reference to a price for the commodity 141

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that is ﬁxed at the outset of the contract and remains constant from period to period. Consequently, each period during which payments are made under the commodity swap is linked to every other payment period for that swap. A payment at the end of any one period, therefore, does not terminate the payer’s interest in the underlying asset, in the sense that a periodic payment under an equity swap, which, because the benchmark is reset to the level of the index each payment period (such that the payments will reﬂect the cumulative price change of the underlying asset over the term of the swap, as is the case in the example above of the stapled, cash-settled gold forward contracts), will terminate its interest in the changing value of the underlying stock or index.77 b. Assignment There is general agreement that an assignment payment received in connection with an equity swap held by a non-dealer should be treated as capital gain.78 It is less clear, but probably the case, that an assignment payment made in connection with an equity swap would be treated as a capital loss.79

C. Taxation – tax-exempt investors Regulations issued under sec. 512 clearly exclude income from ‘notional principal contracts’ from the definition of unrelated business taxable income. The regulations define notional principal contract by reference to both the regulations governing the source of notional principal contract income in reg. sec. 1.863-7 and the regulations governing the timing of swap income and expense in reg. sec. 1.446-3 (summarized above). Under those regulations, virtually all equity swaps (including equity swaps on single equities) will qualify for the exemption from unrelated business taxable income, thereby freeing tax-exempt investors to participate widely in the equity derivatives market.

D. Taxation – non-US investors Regulation sec. 1.863-7 eliminates US withholding tax for all equity swap payments by treating such payments to a non-US investor as foreign-source income (and thus not subject to the 30% withholding tax). In the 1992 preamble to proposed regulations governing substitute payments on securities loans, the Service indicated that it was studying the issue of appropriate withholding tax policy for dividend equivalent amounts included in equity swap payments.80 The Service’s concern, of course, is that all future stock loans could simply become documented as single stock 142

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‘swaps’, thereby avoiding any US withholding tax on dividend equivalent payments that would otherwise apply. In this regard, the policy tension is between the approach to securities loans, where contractual payments of substitute dividends are treated effectively as dividends themselves,81 and the rules for swap payments, where such payments are often treated differently from the underlying security to which they relate. This mismatch is similar to the mismatch discussed above between the character rules applicable to equity-based payments on options and forward contracts, and those applicable when such payments are embedded into a CPDI or (in the Service’s view) an equity swap. In the attempt to adopt a coherent policy towards the application of withholding tax to equity derivatives payments, it is worth noting that the general worldwide trend has been to eliminate withholding tax concerns for crossborder swap payments – including equity swaps – in an effort to promote the integration of worldwide capital markets. The author therefore hopes that the issue will be resolved without a reintroduction of withholding tax concerns into the global derivatives market.82

SECTION VI: PUBLICLY TRADED INSTRUMENTS BASED ON FORWARD CONTRACTS: MANDATORY EXCHANGEABLES AND MANDATORY CONVERTIBLES This section discusses publicly traded hybrid instruments that are based in part on forward contracts – that is, instruments that require the investor to purchase for a specified consideration at the end of a specified term an amount of stock that, in the typical case, varies according to a formula. In these so-called ‘mandatory exchangeable’ instruments,83 the issuer receives a payment upon issuance of the instrument, and the holder is entitled to receive both a current return in the form of periodic coupon payments and a variable amount of stock of a corporation other than the issuer’s at maturity. Mandatory exchangeable instruments have often been used as a means for the issuer to divest a significant equity investment in an affiliate. So-called ‘mandatory convertible’ instruments, on the other hand, are investment units, each consisting of a forward contract to purchase the issuer’s own stock and a debt obligation of the issuer that, as discussed in Section VI.C below, contains a coupon reset feature and a remarketing feature in order to facilitate the financing of the forward purchase price for the investor at the necessary time. Because mandatory exchangeable instruments and mandatory convertible instruments both require an upfront payment from the investor and provide for similar equity payouts, one might believe that they would be treated simi143

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larly for tax purposes. The differences between the ways these two types of instruments are characterized for tax purposes, however, are quite signiﬁcant.

A. Mandatory exchangeable instruments – prepaid forward contracts 1. Introduction to mandatory exchangeable instruments

By the standards of ﬁnancial products, mandatory exchangeable instruments have an ancient lineage (the ﬁrst one was issued in 1993 and retired in 1996),84 and have the distinction of being the ﬁrst publicly traded equity derivatives that could not be squarely characterized as either debt or equity – and consequently gave rise to a signiﬁcant debate about the proper tax treatment of such ‘hybrid’ securities. A mandatory exchangeable instrument obligates a holder, in return for a cash payment today, to take delivery in (for example) three years’ time of a variable number of shares of common stock of some identiﬁed issuer other than the issuer of the mandatory exchangeable instrument, as determined by a formula. During the term of the mandatory exchangeable instrument, the holder also receives a current ﬁxed coupon. The mandatory exchangeable payout formula gives the holder all the downside, and much of the upside, of owning the underlying equity. For example, if the underlying stock is trading at $50/share, a typical mandatory exchangeable instrument might provide that at maturity of the contract the holder will receive one share of stock if the stock is trading at $50 or lower at maturity; $50 worth of stock if the stock is trading between $50 and $60; and 5/6 share of stock if the stock is trading at $60 or higher.85 The mandatory exchangeable payout formula is like that of a forward contract to purchase the underlying stock, except that there is a band ($50 to $60 in the above case) in which the holder does not participate in the stock’s appreciation, and a point ($60) at which the participation resumes, but at a lower slope. Mandatory exchangeable instruments also can be analogized (in a pre-tax world) to buying a classic convertible security and writing an at-the-money put option; or to writing an at-the-money put option, buying an out-of-the-money call option on 5/6 share of stock, and agreeing to purchase a ﬁxed dollar’s worth of stock at its fair market value in the band between the two kinks; or to buying a share of common stock, writing an at-the-money call option, and buying an out-of-the-money call option on 5/6 share of stock.86 The coupon on a mandatory exchangeable instrument is a ﬁxed periodic coupon that generally represents a rate of return roughly comparable to that payable by the issuer on a conventional debt instrument, and thus is substan144

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tially higher than the dividend on the underlying stock. As an economic matter, the difference between the coupon and the rate of return on a conventional debt instrument (or the dividend yield on the underlying stock, depending on which analogy the reader prefers) is determined by the amount of the net premium for the options embedded in the mandatory exchangeable instrument’s payout structure. The coupon is payable in all events, however, so that the issuer of a mandatory exchangeable instrument is at risk if the dividend yield on the underlying stock falls during the instrument’s term. The issuer of a mandatory exchangeable instrument generally has the right to elect to cash settle the instrument by delivering cash equal to the value of the underlying stock at maturity rather than the shares. Under prior law, this cash settlement right was subject to certain limitations for non-tax reasons, and as a result might not have been exercisable with respect to all holders. During the term of a mandatory exchangeable instrument, the issuer retains all shareholder rights over the underlying shares and generally is not required to pledge the shares to the holders; the instrument also imposes no limitations on the issuer’s right to dispose of the shares to other purchasers. For issuers that hold substantial stakes in the underlying company, the retention of shareholder rights can be an important advantage of the mandatory exchangeable structure as compared to a current sale, because the mandatory exchangeable structure allows the issuer to continue to vote the stock and exercise control over the management of the underlying company. In other cases, the issuer of a mandatory exchangeable instrument (generally a ﬁnancial institution) does not hold the underlying shares. Such issuers may be accommodating (through a back-to-back mandatory exchangeable instrument) a shareholder that cannot issue a mandatory exchangeable instrument directly to the public, or may simply perceive a market for mandatory exchangeable instruments with respect to a particular stock. Certain categories of investors, for example equity-income mutual funds, may be interested in a high-tech stock because of its growth potential, but may not be willing to invest in stock that pays no dividends, or very low dividends. Those investors may be willing to give up some of the potential appreciation in the underlying stock in exchange for a current coupon. As described above, the mandatory exchangeable concept is simply a payout pattern, and can be embedded in different legal instruments with differing tax results. For example, mandatory exchangeable instruments have been issued as preferred stock.87 Most mandatory exchangeable instruments, however, have been denominated as debt issued by one corporation and exchangeable for the common shares of another and therefore this discussion, unless otherwise indicated, is addressed to mandatory exchangeable instruments issued in this form. For both legal and liquidity reasons, mandatory exchangeable instruments generally trade on a national stock exchange. 145

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2. Taxation

The key tax issues that have concerned mandatory exchangeable instruments over the years are (i) whether they constitute indebtedness of the issuer (in which case mandatory exchangeable instruments would be subject to the CPDI rules, discussed in Section VI.B below and (ii) whether they effect a current sale of the underlying stock (with future delivery) or a forward sale (pursuant to a forward contract). Mandatory exchangeable instruments, like many other derivative instruments, do not ﬁt neatly into any existing tax mould. Nonetheless, the consensus view among tax advisers is that a mandatory exchangeable instrument (i) does not constitute a debt instrument for tax purposes and (ii) does not give rise to a current sale of the underlying stock. The reasons for these two conclusions are developed below. If mandatory exchangeable instruments were characterized as CPDIs, the parties to them would accrue interest at the ‘comparable yield’ for the issuer prescribed in the CPDI regulations, which might be either higher or lower than the coupon actually paid.88 That interest would be treated as original issue discount, so that a cash method holder of a mandatory exchangeable instrument would be required to accrue it currently. More signiﬁcantly, if the underlying stock appreciated in value, the holder would treat the receipt of that stock as giving rise to current interest income equal to the difference between the value of the stock and the ‘adjusted issue price’ of the instrument (which would be equal to the instrument’s original issue price plus the accrued yield, less coupon payments received), and would take a then-fair market value basis in the stock. The issuer would be entitled to a corresponding interest expense deduction, although that deduction might be deferred in part89 – and would be treated as selling the stock for its then-fair market value. The CPDI regulations, however, apply only to obligations that constitute indebtedness under general principles of US income tax law and thus will not apply to mandatory exchangeable instruments unless mandatory exchangeable instruments constitute indebtedness for tax purposes independently of the regulations.90 a. Not a debt instrument

Other than a designation as debt for corporate and securities law purposes, mandatory exchangeable instruments have little in common with debt instruments, and there is little reason to view them as debt instruments for tax purposes. By contract, mandatory exchangeable instruments require the delivery of stock (unless the issuer, not the investor, elects to pay cash) equal in number (not in value) to what an equivalent dollar investment would have purchased on the date the instruments were issued. These instruments are 146

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payable in stock, have dollar-for-dollar downside equity risk, and provide comparable participation in equity appreciation – all these features are completely inconsistent with treating mandatory exchangeable instruments as debt. The author confesses some mystiﬁcation as to why this question has been considered difficult. Some observers may have become confused by the interest payable on a mandatory exchangeable instrument. That interest is a ﬁxed rate (non-contingent) obligation, payable in respect of the cash that the investor deposits at the outset to secure the investor’s purchase obligation under the forward purchase contract. Price volatility of the underlying stock typically will dwarf in economic importance the interest paid to the buyer on the cash deposited at the outset. The economic essence of the contract – what the investor and issuer alike view as the heart of the investment decision – accordingly is a forward sale of stock. To let the interest paid on the cash deposited at the outset turn what, in terms of economic risk and reward, in fact is a forward contract into a debt instrument is to let a very modest tail wag a very large dog. It also creates a world in which every option becomes a debt instrument, for if a mandatory exchangeable instrument is a CPDI, then there is no reason not to apply the same treatment to an option.91 It might be argued that an instrument must be one thing or another, and if interest is paid in respect of some aspect of the transaction, then the entire transaction is a debt instrument. One might respond that in such a world all house purchases are CPDIs, because when we buy our houses we pay deposits and receive (or negotiate for the sellers to receive) interest thereon pending closing. The fact is that interest often is paid as an integral but ancillary part of a larger transaction (home purchases, stock borrowings); that interest is treated as such, but the larger transaction must be analysed in accordance with its economic substance. The case in point of which the author is most directly aware holds that interest paid by an issuer on a prepayment of the subscription price for a share of stock – which prepayment, as in the case of a mandatory exchangeable instrument, was not refundable to the investor – is deductible as interest expense.92 The holding of the case is conclusory, so that it is difficult to know precisely what is the basis of the court’s holding. The most complete statement of the case’s reasoning reads: The sums deposited with [the company] by its installment subscribers under the [subscription] agreement created a debtor–creditor relationship between the parties and the amount [the company] paid in accordance with such agreement upon such sums to the depositors was interest paid on indebtedness.

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The court’s reference to ‘sums deposited with [the company]’ suggests that the court viewed the amounts prepaid by the subscribers as a deposit on which the interest was paid, since the substance of the transaction as a whole clearly was that of a sale of stock. The treatment of the prepayment as a deposit relating to a forward sale of stock is questionable when the issuer’s own stock is the subject of the forward contract, but is entirely appropriate where the underlying stock is that of a third party.93 If the prepayment to the issuer in the case of a mandatory exchangeable instrument is viewed as a deposit (and the author believes the prepayment should be so viewed), then the issuer should be entitled to treat the coupons as interest paid in respect of cash collateral and therefore receive an interest deduction in respect of the coupons, subject to the straddle rules. This treatment is consistent with the view that a mandatory exchangeable instrument is not itself a debt instrument. b. Not a current sale

In determining whether a mandatory exchangeable instrument gives rise to a current sale, it is necessary to consider both the relevant common law and the more recent standards for constructive sales of appreciated ﬁnancial positions set forth under sec. 1259. i. Common law principles. Under the relevant common law standards, a mandatory exchangeable instrument does not give rise to a current sale of the underlying stock. In general, under a line of cases following Lucas v. North Texas Lumber Company, an executory contract for the sale of property does not give rise to a sale for tax purposes until the property has been transferred to the buyer.94 Performance by a seller but not the buyer is tantamount to an installment sale. By contrast, when the seller has not yet performed, the object of the sale – the transfer of property – has not taken place, and the contract remains open (that is, executory), even though the buyer may have paid in full.95 The general immateriality of upfront cash transfers for tax purposes reﬂects commercial norms, under which sellers of property regularly receive prepayments or down payments under forward contracts to mitigate their credit exposures to buyers; these payments do not trigger recognition of gain for tax purposes.96 Under common law, therefore, relevant considerations for determining whether property has in fact been transferred include whether title has passed, whether possession has been delivered, whether the buyer has become unconditionally obligated to pay the purchase price and which 148

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party bears the beneﬁts and burdens of ownership of the property being transferred.97 The Service has similarly emphasized the importance of the transfer to the buyer of the title or actual possession and the burdens and beneﬁts of ownership.98 The key economic factor in determining whether an investor owns fungible personal property such as a publicly traded security for US federal income tax purposes would appear to be whether that investor has the freedom to dispose of the security – that is, the right to convey outright both legal title and market risks/opportunities thereof to a purchaser.99 In a standard mandatory exchangeable instrument, the issuer retains the right to dispose of the underlying shares of stock, and either reacquire the necessary shares to fulﬁll its obligations or deliver cash instead. It is not relevant for tax purposes under common law (as opposed to sec. 1259, discussed below) that a forward seller under an executory contract has reduced or eliminated his exposure to market ﬂuctuations in the value of the property underlying the contract. Such an argument proves too much, in that it would turn every forward contract into a current sale, contrary to the authorities cited above. A standard that focuses on the transfer of economic risk and opportunity with respect to property also suffers from the defect, when applied to fungible securities, that under common law there is no manner in which the taxpayer’s gain from such a transfer can be determined if the sale is treated as taking place at the time the taxpayer enters into a forward contract, because the taxpayer may deliver either securities held at that time or securities subsequently acquired that have a different tax basis.100 The tax basis of the stock ultimately delivered to settle a mandatory exchangeable instrument (if the transaction indeed is physically settled) cannot be determined at the outset. The issuer has the right to cash settle the mandatory exchangeable contract and thus retain the underlying stock. Even if the issuer physically settles a mandatory exchangeable instrument, the tax basis of the shares of stock delivered thereunder cannot be determined until maturity of the agreement, from which it follows that the issuer’s gain or loss from a mandatory exchangeable instrument also cannot be determined until maturity.101 This reasoning applies with particular force when the underlying property is fungible, publicly traded securities, because the receipt of any cash upfront does not alter the fact that the identity (and tax basis) of the speciﬁc shares of stock ultimately to be delivered, if any, to settle a mandatory exchangeable contract cannot be determined until maturity of the agreement. 149

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Finally, the mandatory exchangeable issuer retains full voting rights of the underlying stock, which also argues strongly for treating the issuer as the owner of the stock102 – especially in the case of a issuer that owns a substantial amount of stock and exerts signiﬁcant inﬂuence or control over the issuer of the underlying stock. ii. Section 1259. Here we consider whether a mandatory exchangeable instrument is subject to the constructive sale rules of sec. 1259, discussed in Section IV.A.1 above. A mandatory exchangeable issuer generally will enter into a mandatory exchangeable instrument in respect of stock that has appreciated, and will thus hold an ‘appreciated financial position’. A mandatory exchangeable contract clearly relates to the same property as the appreciated financial position of the mandatory exchangeable issuer – namely, the underlying stock. A mandatory exchangeable instrument, however, does not constitute a short sale, an offsetting notional principal contract or the fourth type of transaction listed in sec. 1259(c)(1)(D). The constructive sale rules thus will apply only if a mandatory exchangeable instrument constitutes a ‘forward contract’ or falls within the ‘catch-all’ provision of sec. 1259(c)(1)(E). Section 1259(d)(1) deﬁnes a ‘forward contract’ generally as ‘a contract to deliver a substantially ﬁxed amount of property for a substantially ﬁxed price’ (emphasis added). The statute itself does not explain the deﬁnition any further, but the legislative history elaborates on the statutory language by noting that ‘a forward contract providing for delivery of an amount of property, such as shares of stock, that is subject to signiﬁcant variation under the contract terms does not result in a constructive sale’.103 The House and Senate reports to sec. 1259 discuss the catch-all provision – in particular, as it might apply to common hedging transactions such as collars. Both reports provide an example of a collar as the kind of transaction for which future regulations should provide speciﬁc standards for applying the catch-all provision.104 To alleviate immediate concerns with respect to existing market-standard collars, the Conference report stipulates that future Treasury regulations applicable to collars will be applied prospectively, except in cases of abuse.105 As described above, a mandatory exchangeable contract provides for the delivery of a variable quantity of stock. The range in the potential number of shares delivered typically is between 5/6 of a share and one share of stock for each mandatory exchangeable unit. As such, the number of shares of underlying stock to be delivered under a mandatory exchangeable contract should be viewed as subject to significant variation. Consequently, a mandatory exchangeable contract should not constitute a contract to deliver 150

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a ‘substantially ﬁxed’ amount of property, and therefore should not constitute a forward contract for the purposes of sec. 1259.106 A mandatory exchangeable instrument economically is very similar to a collateralized collar, which is a type of transaction that could fall under the catch-all provision. The catch-all provision, however, is not self-executing; rather that provision will be implemented through the issuance of Treasury regulations. While it is possible that mandatory exchangeable instruments may fall within the scope of the catch-all provision under future Treasury regulations providing guidance on collars, any such regulations will have prospective effect only, except in cases of abuse. A mandatory exchangeable instrument that is comparable to marketstandard collars should not be considered abusive, and therefore should not be covered by retroactive regulations.107 Moreover, in light of the considerable variability of returns contemplated by the standard mandatory exchangeable formula, and the revisions by Congress to the deﬁnition of ‘forward contract’ to exclude ‘variable-quantity’ forwards from the scope of sec. 1259, the author (at least) believes that mandatory exchangeable instruments with standard terms ought to fall outside the scope of any regulatory extension of sec. 1259.108

3. Other issues relevant to mandatory exchangeable instruments a. Section 163(l)

Section 163(l) was enacted in 1997 to deny interest deductions in respect of debt obligations where the interest or the principal amount is payable in the issuer’s stock (or stock of a related party).109 Section 163(l) does not apply to mandatory exchangeable instruments because, as discussed above, mandatory exchangeable instruments are not debt instruments to begin with, and sec. 163(l), by its own terms, applies only to debt. According to the legislative history of sec. 163(l), that provision itself is not intended to affect the characterization of instruments as debt or equity under existing law.110 Moreover, sec. 163(l) applies to debt instruments convertible into equity of the issuer, whereas traditional mandatory exchangeable instruments are exchangeable for equity of a corporation unrelated to the mandatory exchangeable issuer. b. Application of straddle rules to mandatory exchangeable instruments

One ﬁnal question is whether the seller has a tax ‘straddle’ as a result of a mandatory exchangeable instrument. As discussed in Section II.A above, the 151

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straddle rules have three potential consequences to a taxpayer that has entered into a hedge of appreciated stock: ﬁrst, the recognition of any loss realized on closing the hedge is deferred to the extent of unrealized gain on the stock at the end of the taxable year in which the loss is realized;111 second, the holding period of the hedged stock may disappear;112 and third, interest expense and certain other costs relating to purchasing or ‘carrying’ the hedged stock are required to be capitalized and added to the basis of the stock.113 A ‘straddle’ is deﬁned as ‘offsetting positions’ with respect to ‘personal property’.114 A taxpayer holds ‘offsetting positions’ if there is a substantial diminution of the taxpayer’s risk of loss from holding any position with respect to personal property (for example owning stock) by reason of holding another position with respect to personal property (for example the hedge). Since the seller in a mandatory exchangeable instrument is treated as owning stock, and having entered into a forward contract to sell that stock which protects the seller against the risk that the stock will fall in value, it is clear that a tax straddle exists.115 Under current law, it is clear that the loss deferral rule of sec. 1092 described above will apply to any mandatory exchangeable instrument. Assuming that the seller in fact delivers the underlying stock under the forward contract, however, the seller will recognize gain (on the sale of the stock) rather than loss. The loss deferral rule therefore is irrelevant as a practical matter. Similarly, the holding period rule described above is not relevant as a practical matter, since the rule affects the holding period on stock held by the sellers only if the stock has been held for one year or less and the stock underlying a mandatory exchangeable instrument as a practical matter has always been held for a longer period. For corporate sellers, the holding period rule would have no effect even if it applied, since there is no difference in the rate of taxation applicable to short-term and long-term capital gains. Finally, proposed regulations published in January 2001 under secs 263(g) and 1092 would, if adopted in ﬁnal form, make it clear that the current coupon payments made in connection with a mandatory exchangeable instrument are expenses required to be capitalized under the straddle rules, although the issue is open to considerable question prior to the effective date of the proposed regulations.116 Proposed reg. sec. 1.263(g)-3(b)(3) defines the universe of interest and ‘carrying’ charges subject to the sec. 263(g) capitalization rules to include ‘otherwise deductible payments or accruals on ﬁnancial instruments that are part of a straddle’, and it is clear that coupon payments on mandatory exchangeable instruments meet this deﬁnition.117 Furthermore, the deﬁnition quoted above of interest and carrying charges is sufficiently broad that it appears that, by its terms, a cash payment made to settle a mandatory exchangeable instrument also would be capitalized,

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although one may question whether the regulations can or are intended to override the loss deferral rules of sec. 1092 in this manner.118 If ﬁnalized in their current form, the proposed regulations would apply to payments made after the date the regulations are ﬁnalized, on any straddle established on or after 18 January 2001.119

C. Mandatory convertibles instruments – collateralized forward contract units 1. Introduction

So-called ‘mandatory convertible’ instruments obligate the investor to purchase stock of the issuer at the end of a speciﬁed term. Although the term ‘convertible’ implies a single instrument that is ‘converted’ into stock, a mandatory convertible instrument in fact is structured as an investment unit consisting of a forward contract on issuer stock and a separate and distinct note of the issuer. The purpose of this bifurcated structure is to allow the issuer to receive cash in respect of the note upon the issuance of the mandatory convertible instrument and retain the ability to deduct the interest payments on the note. If, as in the case of a mandatory exchangeable instrument, the issuer were to issue an integrated prepaid forward contract on its own stock, there is little question but that the prepaid forward would itself be treated as stock of the issuer, with the result that cash payments made in respect of the prepaid forward would constitute non-deductible dividends. A typical mandatory convertible unit has the following terms: it will be issued as an investment unit consisting of (i) a ﬁve-year note of the unit issuer, and (ii) a forward contract with a term of three years under which the investor will purchase a variable number of shares of issuer stock determined under a formula similar to that of a mandatory exchangeable instrument. The face amount of the note equals the purchase price due under the forward contract, but the note may not be tendered in payment of the purchase price. If a holder wishes to exercise the forward contract prior to the end of its three-year term, it may pay the exercise price to the issuer in cash, and in exchange the holder will receive the minimum amount of stock issuable under the payout formula. Because the forward contract in a mandatory convertible unit is not prepaid, as in the case of a mandatory exchangeable instrument, the note is pledged to the issuer to secure the holder’s obligation to deliver the purchase price for the underlying stock. Separation of the note and the forward contract is permitted, however, provided that the holder pledges substitute collateral to the issuer in the form of zero-coupon US Treasury obligations. 153

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Because the note in a mandatory convertible unit will not mature until two years after the maturity of the forward contract, an agent appointed by the issuer but acting on behalf of the noteholders will remarket the notes of all holders who wish to participate in the remarketing. Usually the remarketing will occur three months prior to the forward contract maturity date. No holder is obligated to participate in the remarketing, and any holder wishing to fund the payment of the exercise price through different means may do so. In connection with the remarketing, the interest rate on the notes will be reset for all holders (whether or not participating in the remarketing) to a level such that the remarketing proceeds per note will equal 100.5% of the then-market price of zero-coupon US Treasury obligations maturing immediately prior to the maturity date of the forward contract in an amount equal to the sum of (i) the exercise price to be delivered to the issuer under the forward contract and (ii) the amount of a single coupon payment in respect of the note (at the rate prior to the reset). In the case of remarketed notes that continue to serve as collateral for the forward contract immediately prior to the remarketing (and assuming the holder has not made other provisions for the payment of the forward contract purchase price), the remarketing proceeds will be used, ﬁrst to purchase the relevant US Treasury obligations, and then to pay the remarketing agent a fee of 25 basis points. All other proceeds will be distributed directly to the holders. In the case of remarketed notes that trade separately from the forward contracts at the time of remarketing, all remarketing proceeds, net of the 25-basis-point fee, will be distributed directly to the holders. If the remarketing fails, the holders will have the right to put the notes to the issuer for par, and to use the put proceeds to pay the exercise price. It is the author’s understanding, however, that failed remarketings are expected to be extremely rare. Assuming that the issuer is reasonably creditworthy, one would expect there to be an interest rate that would allow the notes to be remarketed for the target price in the absence of a severe market disruption. In this regard, it is important that the reset rate for the note not be limited by any interest rate cap. The primary tax beneﬁt afforded to an issuer by the mandatory convertible unit structure is the ability to deduct interest payments in respect of a larger transaction on the issuer’s own stock, and this beneﬁt in turn centres on the treatment of the note for tax purposes as an instrument that is separate and distinct from the forward contract. As discussed above, if a corporation were to issue a prepaid forward contract on its own stock, the contract itself would properly constitute an equity interest in the corporation, and any coupon payments in respect of the contract would constitute non-deductible dividends.120 For these reasons, the key tax considerations concerning collateralized forward purchase contract units are: (i) whether the units should be treated 154

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for tax purposes as units consisting of two separate and distinct components, or whether the equity security should be integrated into the debt security to create a convertible bond, and (ii) whether sec. 163 could apply to deny the issuer interest deductions in respect of the note. Most tax practitioners agree that units of the types discussed above should be treated as investment consisting of separate components and that sec. 163(l) should not apply to deny an issuer interest deductions in respect of the notes. Under the terms of each mandatory convertible unit, the forward contract will be cancelled and become null and void upon the issuer’s bankruptcy, while the note will continue to remain outstanding.

2. Unit or convertible bond?

There are a number of factors supporting the view that the note and forward contract in a collateralized forward contract should be treated as two separate instruments for US tax purposes. First, and most obvious, the note and the forward contract are structured as separate ﬁnancial contracts. Although there is no case law specifically addressing the tax treatment of collateralized forward contract units, the case law distinguishing bond-warrant units from convertible bonds is certainly relevant and, as discussed in Section VII.D below, that case law puts primary emphasis on the fact that investment units comprise distinct sets of legal obligations of the issuer – one of which could be extinguished while the other continued to remain outstanding. In the case of the collateralized forward contract unit described above, the note will, in the absence of the highly unlikely event of a failed remarketing, remain outstanding two years following the scheduled settlement of the forward contract, and the difference between the two instruments’ maturities could be even greater if a holder were to exercise the forward contract early. Second, the note and forward contract may trade separately if a holder posts substitute collateral, and will in any event trade separately for the three months prior to the forward contract’s maturity date because of the remarketing. Third, the fact that the forward contract becomes null and void upon the issuer’s bankruptcy while the note remains outstanding is a factor demonstrating the separateness of the two instruments.

3. Section 163(l)

Notwithstanding the conclusion that the debt and equity components of a collateralized forward contract unit should be treated as separate and distinct securities for tax purposes, consideration must be given to whether sec. 163(l) 155

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may apply to disallow the issuer’s interest deductions on the note. As discussed in more detail in Section VII.A below, sec. 163(l) disallows deductions for any interest paid or accrued on a ‘disqualiﬁed debt instrument’, which is deﬁned as a debt instrument that is payable in equity of the issuer or a related party.121 A debt instrument is treated as payable in equity of the issuer if, among other circumstances, the debt is part of an arrangement designed to result in a substantial amount of the principal or interest on the debt instrument to be paid in, or converted into, equity of the issuer or a related party.122 For these purposes, if the holder of a debt instrument has an option to receive a substantial amount of the principal or interest in the form of equity of the issuer, the instrument will constitute part of an ‘arrangement’ under sec. 163(l) if the holder’s exercise of that option is a ‘substantial certainty’ at the time the debt instrument is issued.123 The note is not by its terms payable in issuer stock to any degree. Although it is true that, in the event of a failed remarketing, the note may be put to the issuer and the proceeds used to pay the exercise price on the forward contract, this feature of the unit should not implicate sec. 163(l). Debt will be considered to be payable in equity of the issuer within the meaning of sec. 163(l) only if, as of its issue date, the debt is part of an arrangement reasonably expected to result in the payment in issuer stock of the principal on the debt, and assuming a creditworthy issuer at the time the unit is issued, a failed remarketing that could allow a holder to put its note to the issuer is highly unlikely – and not reasonably expected. One might argue that the interest rate reset in connection with the remarketing should cause the note to be treated as if it matured on the interest rate reset date, and new debt were then issued by the issuer to the purchaser of the note in the remarketing. To illustrate this potential recharacterization at its starkest, if the coupon reset took place automatically, and at the same time as the exercise of the forward contract, a possible recharacterization would make it more likely for sec. 163(l) to apply to the note, on the theory that the original debt matured on the exercise date and was retired by the issuer for cash that was used by the holders to purchase issuer stock under the forward contract. Under this possible approach, it could be argued that the note was part of an arrangement designed to result in payment in issuer stock, with the issuer issuing new debt on the interest rate reset date to investors that had no interest in the notes prior to that time. Such a putative recharacterization is unpersuasive, because every bond with an interest rate reset feature could be characterized as having been retired and reissued at the time of its reset, but Treasury regulations do not adopt such an approach. In particular, under reg. sec. 1.1001-3(d), Example 1, a coupon rate reset that is automatic under the terms of the bond once certain conditions are met does not trigger a constructive retirement/reissuance of the bond.124 156

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Moreover, to treat the remarketing as a redemption/reissuance ignores the actual terms of the remarketing. The remarketing agent acts as an agent for the holders, not the issuer, as demonstrated by the fact that the holders are obligated to pay the remarketing agent’s fee (25 basis points in the example above), and that, other than in the highly unlikely event of a remarketing failure, the economic risks and rewards of the remarketing will be for the account of the holders – who expect to make a 25-basis-point proﬁt on the remarketing.

4. Income streaming variant

As discussed above, the pairing of an issuer note with a forward contract or warrant on issuer stock is intended to allow the issuer to receive interest deductions in the context of a larger transaction on the issuer’s own stock. However, where an issuer is averse to issuing additional debt (typically for regulatory reasons), the technique of ‘income streaming’ (described below) may be used to achieve the effect of an interest deduction with respect to a payment by excluding the income that funds the payment. In June 2002, Provident Financial Group, Inc. (PFGI) used this technique in the context of a collateralized forward contract unit termed ‘Income PRIDESSM’. 125 In a typical income streaming transaction, an issuer will raise ﬁnancing through the use of a subsidiary that is treated as ﬁscally transparent for tax purposes (for example a ‘captive’ real estate investment trust (REIT), or a limited liability company that is taxed as a partnership). The subsidiary will issue preferred equity interests that provide for current payments, and the proceeds of the equity issuance will be used by the subsidiary to purchase assets from the parent (for example a portfolio of mortgages) that will in turn generate the income to fund the current payments on the equity. The result is that the parent has received cash, and the income generated by the subsidiary’s assets will be paid to the subsidiary’s preferred equity holders without the imposition of an entity-level tax, that is, the parent is in the same general tax position as if it had issued debt directly and used the interest deduction to offset the recognition of income required to fund the interest payments. The PFGI Income PRIDESSM used the technique of income streaming in the context of a collateralized forward contract. Specifically, PFGI issued a variable forward contract in respect of its own stock, and the contract was collateralized by preferred stock of a captive REIT owned primarily by Provident Bank, itself a subsidiary of PFGI. In a manner similar to a standard collateralized forward contract unit, proceeds from a remarketing of the preferred REIT shares were expected to fund the payment to PFGI in respect of the forward contract.

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SECTION VII: OPTION-BASED INSTRUMENTS This section discusses derivatives that are based on options to acquire stock. Section VII.A discusses the classic convertible bond, which is the simplest example of such an instrument, and which economically is a bond with an embedded call option in the form of a conversion feature. Exchangeable bonds, which contain an embedded option to purchase stock of a party other than the issuer, are generally taxed under the rules for CPDIs and are discussed in Section VI.B. Section VII.C then discusses so-called ‘contingent convertible bonds’, which are convertible bonds that provide for one or more contingent payments (in addition to the contingent payment of stock upon conversion) and thus are also taxed under the CPDI rules. Section VII.D discusses classic bond-warrant units. Although classic bond-warrant units are seldom issued in the US public securities markets, nonetheless they deserve attention in this chapter, because the tax law providing the standards for distinguishing such units from convertible bonds is central to the tax analysis of so-called mandatory convertible instruments, discussed in Section VI.C above, as well as the analysis of more highly structured bond-warrant units, such as SQUARZ, a product recently issued by Berkshire Hathaway, Inc. that is discussed in Section VII.D below.

A. Convertible bonds The tax characteristics of convertible bonds are well deﬁned and derive from the fact that US federal income tax law generally ignores the existence of the embedded option prior to the time the bond is converted. Thus, upon issuance of a convertible bond, none of the purchase price is separately allocated to the embedded option, and the issuer is never treated for tax purposes as receiving a premium in respect of the embedded option.126 This rule belies economic reality, because the embedded option causes interest to accrue in respect of convertible bonds at rates that are signiﬁcantly lower than the rates on comparable non-convertible bonds. The value of the conversion feature is not completely ignored by US tax law, however, a secondary purchaser of a convertible bond may not amortize the market premium paid for the convertible bond that is attributable to the conversion feature (consistent with the non-amortizability of option premiums).127 The conversion of the convertible bond is treated as a non-taxable event to a holder (and in almost all cases to the issuer), either under the theory that the conversion effects a ‘recapitalization’ of the issuer, or on the theory that the exercise of an option is not a taxable event.128

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1. Section 163(l)

Section 163(l) limits the extent to which a convertible bond can feature ‘equity’ characteristics and still permit the issuer to deduct coupon payments thereon; the provision does not affect the tax treatment of a holder of a convertible. The principal operative rule of sec. 163(l) denies interest expense deductions on debt if ‘a substantial amount of the principal or interest is required to be paid or converted, or at the option of the issuer … is payable in, or convertible into’, equity of the issuer or the cash equivalent thereof (emphasis added). Section 163(l) also applies if ‘the indebtedness is part of an arrangement which is reasonably expected to result in’ a transaction described in the principal operative rule. An additional hurdle that must be passed is set forth in the ﬂush language at the end of sec. 163(l)(3), which states that ‘for purposes of this paragraph, principal or interest shall be treated as required to be … paid [or] converted [into issuer equity] … if it may be required at the option of the holder … and there is a substantial certainty the option will be exercised’. Section 163(l) appears to apply (wrongly, in the author’s view) to disallow interest deductions where an issuer promises to repay its debt in its own stock having a value equal to the principal amount of the debt (so-called ‘constant dollar value convertibles’). At the same time, the Service has indicated that an issuer of securities of the type described in Rev. Rul. 85-119,129 which at ﬁrst reading seems to address a species of constant dollar value convertibles, may continue to claim interest deductions on such securities.130 The reconciliation of the apparent conﬂict appears to lie in the fact that the issuer in Rev. Rul. 85-119 was required (at the holder’s election) to sell the stock to which a holder was entitled on the open market and deliver (via the market sale mechanism) cash to the holder equal to the instrument’s stated principal amount – a distinction that no doubt will seem less profound to capital market professionals than it does to tax legislators. Section 163(l) is not intended to apply to traditional convertible bonds that feature a ‘signiﬁcant’ conversion premium (typically 20–25% above the price of the issuer’s stock at issuance).131 Rather, sec. 163(l) is intended to apply to some of the more recent innovations of convertible/exchangeable debt instruments described below.132

B. Exchangeable bonds: CPDI rules Unlike the economically inaccurate treatment of conventional convertible bonds, debt instruments with significant equity-based payouts that do not fit this conventional structure are taxed under the rules for contingent payment debt instruments (CPDIs).133 The CPDI rules do not apply where 159

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the only contingent payment on a bond is a conversion feature (whether physically settled or cash settled) or a right to exchange the bond for stock of a party related to the issuer or an equivalent cash payment.134 The CPDI rules do apply (among other cases) to ‘exchangeable debt’, which for these purposes means indebtedness that is exchangeable at the holder’s option for stock of a party who is not related to the issuer (for example for portfolio stock held by the issuer) and to equity-index-linked bonds (that is, bonds providing for payments linked to changes in the value of an equity index, such as the S&P 500.) Under the CPDI rules, equity derivatives embedded into debt are integrated fully into the debt instrument for tax purposes, so that the resulting instrument is taxed exclusively under the rules applicable to debt, with the equity payouts relevant merely as contingent payments to be taken into account in determining the bond’s expected yield and projected payment schedule. Therefore, this discussion is fundamentally concerned with how equity-based payments are taken into account under the regime for taxation of debt, which itself is chieﬂy concerned with taxing economic income by reference to a consistent internal rate of return. Under the CPDI rules, a bond will be taxed under the ‘constant-yield’ method if a non-de mininis portion of the bond’s overall return is provided through payments other than ﬁxed payments of stated interest made at least annually.135 Under the constant-yield method, interest will accrue for tax purposes based on the bond’s constant yield to maturity, which is the internal rate of the return for the bond over its life. In other words, the constant-yield method places all taxpayers on the accrual method of tax accounting for these purposes. However, in the case of bonds where either the time or amount of future payments is contingent on some future event (as in the case of a bond with payments determined by reference to future equity prices), the bond’s constant yield to maturity cannot be determined at issuance. In the case of such a bond (assuming the bond is not a ‘variable rate debt instrument’),136 the CPDI regulations construct a surrogate measure of a constant yield to maturity based upon an ‘expectations’ model of taxation. The economic expectations model is premised on the observation that rational investors expect the economic income from a CPDI to be no less than the economic income from a non-contingent bond of the same issuer with otherwise comparable terms.137 The CPDI rules implement the economic expectations model by taxing a CPDI holder and issuer on a current basis on the constant yield that reﬂects the economic income from a comparable noncontingent bond.138 The issuer is required by the CPDI rules to construct a ‘projected payment schedule’ for the bond, which must include projected times and amounts for contingent payments on the bond that are consistent with the comparable non-contingent yield used for interest accrual purposes. 160

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If the actual contingent payments are made at times or in amounts different from those projected in the schedule, there will be a corresponding upward or downward adjustment to income/deductions in respect of the bond at the time of the payment. By requiring a current accrual of an economic amount of interest, the CPDI rules tax contingent bonds in a more accurate manner than do traditional tax ‘wait-and-see’ accrual principles, and thereby reduce economic distortions in the tax laws. In addition to requiring the accrual of interest at the comparable yield, the CPDI rules also provide that gain from the sale of a CPDI will generally be classiﬁed as ordinary interest income to the seller, and not as capital gain. Loss from the sale of a CPDI will be ordinary loss to the extent of the holder’s total interest inclusions with respect to the CPDIs that were not offset by downward adjustments previously to take account of differences between actual payments and payments listed on the projected payment schedule. The CPDI rules apply to debt instruments (other than ‘variable rate debt instruments’) that provide for at least one contingent payment that is neither ‘remote’ nor ‘incidental’, which for these purposes means that (i) there is more than a remote level of uncertainty about whether the payment will be made or not, and (ii) there is at least one reasonable scenario where the amount of the payment will be economically signiﬁcant.139 The rules apply only to instruments that constitute debt under the general principles of tax law.140 For a simple example of how the CPDI rules work, consider a ﬁve-year debt instrument paying a 4% coupon annually, except that the ﬁnal payment at maturity will be increased by an amount determined by reference to appreciation in the S&P 500. The ﬁnal payment is a contingent payment that is neither remote nor incidental under the above standards and, therefore, the bond is a CPDI. If the issuer’s comparable yield is 7%, then the bondholders and the issuer will accrue interest income and expense at 7% (that is, in excess of the interest actually paid currently), on the theory that the right to the S&P 500based payment is equal in value to the 3% reduction from the current return that the holders would have received from the issuer in respect of a noncontingent bond. Under this treatment, the projected payment schedule established at the bond’s issuance would show the single contingent payment at maturity in an amount exactly equal to the excess of the interest accrued during the bond’s term over the 4% coupon actually paid. If, however, the S&P 500-based payment turns out to be greater or less than the scheduled payment, then there will be a corresponding positive or negative adjustment to the interest accruals that will be taken into account (through the appropriate accruals of ordinary income and deductions) for the taxable year in which the adjustment is made (that is, the adjustment does not affect accruals for previous years).

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C. Contingent convertible bonds a. Generally

As noted above, the CPDI rules do not apply to a debt instrument merely because it provides for contingent payments through a conversion feature (including a cash-settled conversion feature), or a right (including a cash-settled right) to exchange the debt for stock or debt of the party related to the issuer (such as the issuer’s parent).141 However, if a convertible bond also provides for at least one additional contingent payment that is neither remote nor incidental within the meaning of the CPDI rules, then the bond (a so-called ‘contingent convertible bond’) will be taxed as a CPDI, and the conversion feature will then be treated as would any other contingent payment.142 In such a case, the delivery of stock to a bondholder would be treated as a payment of interest and/or principal, and the expected timing and value of a stock payment would need to be accounted for under the projected payment schedule (in a manner reﬂecting the bond’s non-contingent comparable yield); conversion will not in that case be subject to the tax-free ‘recapitalization’ treatment applicable for conventional convertible bonds. Currently there are several variations of contingent convertible bonds marketed under several different tradenames, such as contingent interest LYONsSM, CARZSM, CZARSSM, OCEANSSM and CODESSM. These instruments combine conversion features with additional contingent payment features, so that if one of the additional contingent payment features provided in such a bond meets the ‘remote’ and ‘incidental’ requirements discussed above, the bond will qualify as a CPDI, with the result that the issuer will accrue interest deductions at the non-contingent comparable yield, rather than at the artiﬁcially low yield of conventional convertible debt, where the value of the conversion option is ignored. By way of illustration, under one typical contingent convertible bond structure, the conversion right is embedded into a zero-coupon debt instrument and will become exerciseable only if the issuer’s stock price crosses a speciﬁed threshold. Once the right becomes exercisable, the bond will make current cash payments of interest that are based either on dividends in respect of the underlying stock or on a percentage of the bond’s trading price (typically not less than 25 basis points). Many issuers view these payments as disincentives for investors to exercise their conversion rights prior to maturity, and also take the position that the payments are non-remote and non-incidental contingent payments that place the bonds under the CPDI rules.143 Although the Service has recently published guidance conﬁrming that convertible bonds featuring non-remote and non-incidental payments of current contingent interest will qualify as CPDIs, the Service has also expressed concern over the disparity in 162

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tax treatment between conventional convertible bonds (where the conversion or exchange feature is ignored for purposes of computing the yield) and contingent convertibles (where the conversion or exchange feature is taken into account).141

b. Potential application of sections 163(l) and 249 to contingent convertible bonds

Although sec. 163(l), discussed above, denies interest deductions in respect of certain bonds with equity-linked payouts, it does not apply to deny interest deductions on a contingent convertible bond merely because a certain portion of the bond’s yield is accounted for through a conversion or exchange feature.145 Rather, the appropriate inquiry is the same as applies in the case of any other convertible bond, that is, whether the holder’s option to convert is substantially certain to be exercised. As mentioned in Section VII.A, the legislative history of sec. 163(l) makes it clear that the section is not intended to apply to convertible bonds issued with market-rate conversion premiums (for example 20–25%), and therefore sec. 163(l) should not apply to contingent convertible bonds (such as the typical contingent convertibles in the current marketplace) with similar or greater premiums, in the absence of some other feature for the payment of interest or principal in stock. Section 249 denies an issuer of convertible debt a deduction for premiums paid to redeem the convertible debt to the extent that the premium exceeds a ‘normal call premium’ for a non-convertible bond (that is, to the extent that the premium is attributable to the value of the conversion feature). In the case of a contingent convertible bond, the issuance of stock upon conversion of the bond may give rise to a premium to which sec. 249 could potentially apply if the value of the stock issued results in payments in excess of the issuer’s noncontingent comparable yield and cannot be justified as a ‘normal call premium’ that would be paid to redeem a non-convertible bond.146 Issuers of contingent convertible bonds are thus well advised not to seek deductions on the bond in excess of the comparable yield.

D. Basic bond-warrant units A bond-warrant unit is a bond issued together with a warrant (that is, a call option on issuer stock). In a classic bond-warrant unit, the face amount of the bond equals the warrant exercise price, and the bond and warrant typically have the same maturity date. The holder of the unit will, however, typically have the right to separate the two components (for example to sell one while 163

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continuing to hold the other) and, in contrast to a convertible bond (where the holder must tender the bond in order to convert), the holder of a bond-warrant unit typically may not tender the bond to the issuer in payment of the warrant exercise price. Because the tax law treats the debt and equity components of a bondwarrant unit as two separate and distinct instruments, the tax treatment of the units is very different from that of a convertible bond. In the case of a bond-warrant unit, for example, the issue price of the unit is allocated between the debt and warrant components in accordance with their fair market values,147 with the result that the issuer is treated as receiving a premium in respect of the warrant (which is not taken into income by the issuer under sec. 1032),148 and the bond’s issue price is reduced to a level such that the bond has a market rate yield to maturity. Given the economic similarities between a classic bond-warrant unit and a convertible bond (a holder pays an upfront price in exchange for a guaranteed return plus the option to purchase issuer stock), it is not surprising that case law looks primarily to the difference between the legal structures of the two instruments, as opposed to any profound economic differences. The leading case in this area, Chock Full O’Nuts Corp. v. United States,149 attaches great signiﬁcance to the fact that a bond-warrant unit, at least as a matter of form, represents two separate legal obligations of the issuer. In that case, the issuer of a conventional convertible bond claimed a deduction for the ratable portion of original issue discount that would have existed had the debt component of the debenture been issued for its value as a separate debt instrument (that is, the issuer was attempting to bifurcate that which, as a matter of legal form, was integrated). In holding against the issuer, the court stated: The convertible debenture is an indivisible unit; the issuer has but one obligation to meet, either redemption or conversion. It can never be required to do both. With the bond-warrant investment unit, however, the holder receives and the issuer incurs two separate and independent obligations, and both may have to be fulﬁlled. Indeed, while the warrant and debt obligations are often issued as a package, since they are far more attractive to investors in unison than they would be separately, they are totally independent and separable obligations, and the warrant, unlike the conversion privilege, should be independently valued.150

Subsequent cases have followed Chock Full O’Nuts by emphasizing the fact that a bond-warrant unit represents two separate legal obligations of the issuer, because the issuer of a bond-warrant unit could be required to issue stock in respect of the warrant while the debt component remained outstanding. As the Tax Court reiterated in Hunt Foods and Industries,151 the holder of a bond-warrant unit ‘may exercise the option and at once become a 164

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stockholder and a creditor of the issuer’, while in the case of convertible debt the holder ‘must either be a creditor of the issuer or one of its stockholders; he cannot simultaneously enjoy the rights of both’.152

E. SQUARZ: Structured bond-warrant units 1. Introduction

In SQUARZ, a transaction recently developed by Goldman, Sachs & Co., the terms of a bond-warrant unit are structured to replicate, to a certain extent, the current cash ﬂows of a convertible bond. Whereas the investor in a traditional bond-warrant unit is required to pay the entire premium in respect of the warrant upon the unit’s issuance, the investor in SQUARZ makes no upfront premium payment, but is instead obligated to make ﬁxed premium payments in arrears on a semi-annual basis over the warrant’s term. The premium payment dates match the coupon payment dates for the bond, with the result that the investor may apply the interest coupons against its obligation to make payments of premium, so long as the two components are held together in a unit. Therefore, just as the coupon rate on a convertible bond is reduced to take account of the value of the conversion feature on a current basis over the bond’s term, the net ﬂows to the investor in respect of SQUARZ are similarly reduced. The principal issue raised by SQUARZ is whether, and in which circumstances, a bond-warrant unit that is structured to replicate certain economic features of convertible debt should be treated as convertible debt for tax purposes. As at the time of writing, only one SQUARZ issuance had been completed (issued by Berkshire Hathaway Inc.), and it is difficult at this stage to predict what variations in subsequent SQUARZ structures (or competing structures that may be devised by different investment banks) may arise. However, the Berkshire Hathaway SQUARZ transaction (which the author believes should be treated as bond-warrant units for US federal income tax purposes) serves to illustrate how the standards for distinguishing bond-warrant units from convertible bonds apply in the case of highly structured products. The SQUARZ issued by Berkshire Hathaway consist of bond-warrant units in which the bonds have a term of ﬁve and a half years and pay semi-annual interest at a ﬁxed rate, and the warrants have a term of ﬁve years. As in the case of most bond-warrant units, the issue price on the bonds is equal to the exercise price of the warrants, but a holder may not tender a bond to Berkshire Hathaway as payment of the warrant exercise price. As discussed above, the premium in respect of the warrants was not paid by the holders upon issuance of the SQUARZ, but rather is payable currently over the warrants’ term 165

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through ﬁxed semi-annual payments due on the same dates that interest becomes payable on the bonds. In order to collateralize the holders’ obligations to pay warrant premiums, the bonds were pledged (to the extent of their interest payments) to the issuer upon the issuance of the SQUARZ, and the coupon payments on the bonds will be applied to the warrant premium payment (in the absence of an alternative premium payment by the holder). In an interesting twist, the warrant premiums are greater than the coupon payments on the bonds, so that the SQUARZ holders were required to pledge zero-coupon US Treasury obligations to Berkshire Hathaway as collateral of a type and amount such that, on each warrant premium payment date, there would be proceeds available from the maturity of a portion of the obligations sufficient to make up each semi-annual shortfall. For this reason, SQUARZ were described in the press as ‘negative coupon’ instruments.153 A holder wishing to separate a bond from a warrant in the SQUARZ structure may do so if it releases the bond from the pledge to the issuer by providing substitute collateral in the form of zero-coupon US Treasury obligations. The warrants may be exercised at any time over their term by a payment of the exercise price to the issuer, plus (if a warrant is exercised between premium payment dates) the premium payment that otherwise would have been due on the following premium payment date. Once the warrant is exercised, the holder will be under no further obligation to make future premium payments to Berkshire Hathaway in respect of the exercised warrant; a result that approximates to the economics of a convertible bond, where the issuer loses the beneﬁt of the below-market coupon once the bond is converted. A SQUARZ holder may put its bond to Berkshire Hathaway for par on each anniversary of the SQUARZ issue date other than the ﬁfth anniversary, except that (i) in order to put the bond, the holder must simultaneously surrender a warrant for cancellation, and (ii) if a holder exercises its warrant within 90 days prior to a put date for the bonds, the holder forfeits the right to put the related bond to the issuer on that put date (assuming of course that the warrant is still held as part of a SQUARZ unit at the time of exercise). Although a holder may not tender a bond to Berkshire Hathaway in payment of a warrant exercise price, the bonds will be subject to a remarketing shortly before the end of the warrant term. In connection with the remarketing, the interest rate on the bonds will be reset for all holders (whether or not participating in the remarketing) to a level designed to ensure that the remarketing proceeds per bond will be slightly in excess of par. The remarketing thus is expected to facilitate the payment of the exercise price by holders choosing to exercise their warrants, and also to allow the holder to make a slight proﬁt on the remarketing.154

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If the remarketing fails, the holder will have the right to put the note to the issuer for par, and to use the proceeds to pay the exercise price. However, it is the author’s understanding that a failed remarketing is considered to be highly unlikely, because it is expected that there will be an interest rate that would allow Berkshire Hathaway debt with a remaining term of six months to trade at the target price.

2. Unit or convertible bond?

As discussed in Section VII.D above, Chock Full O’Nuts and the other relevant cases distinguish a convertible bond from a bond-warrant unit by focusing on the fact that a bond-warrant unit consists of two separate sets of legal obligations of the issuer. The issuer of a bond-warrant unit may be forced to issue stock upon the exercise of a warrant while the bond remains outstanding, and this result cannot be replicated by a convertible bond. In applying this standard to the Berkshire Hathaway SQUARZ, there are several factors supporting the treatment of SQUARZ as a bond-warrant unit (and not as a convertible bond) for tax purposes. First, if both the bonds and warrants remain outstanding until their stated maturity dates, the bonds will survive the warrants as independent obligations of the issuer for six months. Second, because a bond that is part of a SQUARZ unit may not be put to the issuer within 90 days of the exercise of the related warrant, the exercise of the related warrant will create precisely the fact pattern contemplated by case law for a period of not less than 90 days. In addition, the investors’ ability to separate the bonds from the warrants also argues in favour of treating the bonds and warrants as separate instruments. Accordingly, the author believes that SQUARZ should be treated as bond-warrant units for US federal income tax purposes, with the result that the issuer should be entitled to interest deductions in respect of the bonds to the same extent as if the bonds had been issued independently of the warrants.

ACKNOWLEDGEMENTS I would like to acknowledge with thanks the assistance provided by William L McRae in the preparation of this chapter.

Notes 1 For a discussion of special mark-to-market rules applicable to dealers and electing traders, see Kleinbard ED and Evans TL, ‘The Role of Mark-to-Market Accounting in a Realization-Based Tax System,’ 75 Taxes 788 (1997). 167

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2 Unless otherwise indicated, all section references in the chapter are either to the Code or to US Treasury regulations promulgated thereunder. 3 The straddle rules do not apply to straddles consisting exclusively of sec. 1256 contracts, discussed in Section IV.B, because those contracts are marked to market at year end and accordingly never have unrealized gains. 4 Temporary reg. sec. 1.1092(b)-2T. These rules are generally understood as an extension to the straddle arena of the special short sale rules applicable to transactions in physical stocks. 5 Where, as in the example above, the unrealized gain on one leg of a straddle exceeds the realized loss on the other leg thereof, it remains unclear whether the holding period is erased for that portion of the taxpayer’s gain position that is exactly offset by the realized loss (that is,10 shares of stock in the above example), or whether the holding period of the taxpayer’s entire gain position is erased (that is, all 100 shares of stock in the example). 6 Section 263(g). Section 263(g)(2) provides that ‘interest and carrying charges’ means the net cost attributable to the sum of ‘interest on indebtedness incurred or continued to purchase or carry the personal property’ and all other amounts similarly paid or incurred to ‘carry’ the personal property, over the sum of interest, dividends and certain other items of income arising from the personal property. Proposed regulations under secs 1092 and 263(g) would, if ﬁnalized, apply this cost capitalization rule to coupons made in respect of certain mandatory exchangeable instruments, as discussed in more detail in Section VI.A.3.b. 7 Regulation sec. 1.1092(d)-1 treats as actively traded personal property for sec. 1092 purposes any notional principal contract if indicative rates are regularly quoted on interdealer screens (such as those operated by Reuters) for new contracts with similar terms. The over-the-counter equity derivatives markets (including the market for equity index swaps), at least as at the time of writing, are probably not sufficiently standardized to satisfy the criteria of the regulations’ ‘screen trading’ test. 8 Section 1092(d)(3)(A) provides that: ‘For purposes of [sec. 1092(d)(l)] … the term ‘personal property’ does not include stock [unless that stock is part of a straddle described in sec. 1092(d)(3)(B)]. The preceding sentence shall not apply to any interest in stock.’ Under sec. 1092(d)(3)(B), the straddle rules apply to offsetting positions in personal property consisting of stock and either an option or ‘under regulations, a position with respect to similar or related property’. The next sentence in the text describes the regulations issued pursuant to this authority. 9 Regulation secs l.1092(d)-2(a), 1.246-5(b). 10 Regulation secs l.1092(d)-2(a), 1.246-5(b). 11 Regulation secs l.1092(d)-2(a), 1.246-5(c). 12 Regulation sec. 1.1092(d)-2(b)(2). 13 Generally, a call option is considered ‘deep-in-the-money’ for purposes of the ‘qualiﬁed covered call option’ exception if the strike price thereof is below the ‘lowest qualiﬁed benchmark’, sec. 1092(c)(4)(C). In the case of an option with a term of not more than 12 months, the lowest qualiﬁed benchmark is generally deﬁned as the highest available strike price on an exchange-traded standardized option on the same stock that is lower than the price of the underlying stock at the time the covered call option is granted, sec. 1092(c)(4)(D), reg. sec. 1.1092(c)-1(b). In the case of an option with a term greater than 12 months (but not greater than 33 months), the benchmark is determined by multiplying the strike price mentioned in the previous sentence by an ‘adjustment factor’ that is intended to take account of the longer option term, reg. secs 1.1092(c)1(b)(2), -4(e). 14 Regulation sec. 1.1092(c)-1(b). 15 Regulation secs 1.1092(c)-2,-3. 168

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16 Regulation sec. 1.1223-1(d). 17 Temporary reg. sec. 1.1092(b)-1T(e). 18 See Rev. Rul. 58-211, 1958-1 C.B. 529 (securities not substantially identical if substantially different in any material feature); Rev. Rul. 56-406, 1956-2 C.B. 523 (loss from sale of stock warrants allowable unless taxpayer purchases common stock within a 30-day window and ‘relative values and price changes’ are so similar that warrants and stock substantially identical); Hanlin v. Commissioner, 108 F.2d 429 (3d Cir. 1939) (long-term bonds issued by same obliger were substantially identical where differences in maturity dates resulted in change of yield of no more than ﬁve basis points); but see General Counsel Memorandum 38285 (February 22, 1980) (call options on same stock with same expiration dates but different strike prices considered substantially identical). 19 Revenue Rul. 85-87, 1985-1 C.B. 268. 20 Section 1259 is discussed in greater detail in Section V.A. on ‘Mandatory exchangeable instruments’. 21 For an extensive discussion of the short sale rules and their application to more recent equity derivative strategies, see Kleinbard ED and Nijenhuis EW, ‘Short Sales and Short Sale Principles in Contemporary Applications,’ 53 New York University’s Annual Institutes on Federal Taxation, ch. 17 (1995). 22 In the case of stock receiving preferred dividends that are attributable to an aggregate period longer than 366 days, the requirement is changed so that the stock must be held for 91 days falling during a 180-day period. 23 Regulations sec. 1.246-5(d), Example 2. Common stock of one corporation generally will not be ‘substantially similar or related’ to common stock of another corporation, however, because the value of a corporation’s common stock is considered to depend upon factors that are speciﬁc to that corporation, such as management decisions and capital structure. This conclusion will hold even where the values of two different stocks are both expected to reﬂect broadly the state of a single industry (for example the stock of two automobile manufacturers), reg. sec. 1.246-5(d), Example 1. 24 For purposes of the asset diversiﬁcation requirements imposed upon regulated investment companies (such as mutual funds) by sec. 851(b)(3), the Internal Revenue Service (the Service) has ruled that securities of a mutual fund transferred under a securities loan remain assets of the fund. Private Letter Ruling 9030048 (citing Rev. Rul. 77-59, 1977-1 C.B. 196, which held that a real estate investment trust (REIT) that repoed out securities is treated as owning such securities for the REIT asset diversiﬁcation requirements of sec. 856(c)(4)). 25 A stock loan qualiﬁes under sec. 1058 if it: (i) provides for the return of identical stock, (ii) requires substitute payments equal to all distributions on the borrowed stock during the stock loan term, (iii) does not reduce the risk of loss or opportunity for gain of the stock lender with respect to the borrowed stock, and (iv) meets any other requirements set out in regulations. Proposed regulations under sec. 1058 were issued in 1983, but have not yet been ﬁnalized. 26 In the more common case of borrow fees embedded in the ‘rebate fee’ paid by the stock lender to the stock borrower in respect of the stock borrower’s cash collateral, the embedded borrow fee is reﬂected on the stock lender’s tax return as the difference between (i) the rate of interest earned (and retained) by the lender on that collateral, and (ii) the rebate fee paid to the stock borrower. 27 See also Rev. Rul. 60-177, 1960-1 C.B. 9. 28 Under sec. 263(h), certain dividend substitute (or ‘in lieu’) payments made with respect to stock used in a short sale may not be deducted. This limitation generally applies only to the extent that dividend equivalent payments made by a stock borrower exceed rebate amounts paid by the stock lender to the short seller. In particular, sec. 263(h)(1) provides that dividend equivalent payments made by a stock borrower (net of rebate 169

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fees received from the stock lender) are not deductible if the short sale is closed within 45 days after the transaction was entered into (one year, in the case of certain extraordinary dividends). Instead, the amount of such payments is capitalized by adding it to the basis of the stock used to close the short sale. For example, sec. 246A (reduction in dividends-received deduction in the case of debtﬁnanced portfolio stock) and sec. 263(g) (interest to carry straddle positions). The rules make less sense than ﬁrst meets the eye for the simple reason that short sales, unlike cash borrowings, generally do not generate investable cash, since the proceeds of the short sale are typically posted with the stock lender. See Kleinbard ED and Nijenhuis EW, ‘Short Sales and Short Sale Principles in Contemporary Applications,’ 53 New York University’s Annual Institutes on Federal Taxation, ch. 17 (1995). Section 512 imposes two additional requirements for a qualifying stock loan by a taxexempt institution: (i) the fair market value of collateral posted by the stock borrower must not be less than the fair market value of the borrowed stock (adjusted daily), and (ii) the stock loan must be terminable by the tax-exempt stock lender on ﬁve business days’ notice. This latter requirement effectively prevents tax-exempt institutions from participating in the market for ‘term’ stock loan transactions. Private Letter Ruling 8822061. See reg. sec. 1.863–7; reg. sec. 1.988–4(a). The regulations concerning substitute payments on cross-border securities loans (discussed in the text below) do not address the treatment of borrow fees. Current treaties that have this feature include those with the Austria, Barbados, the Czech Republic, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, the Netherlands, the Russian Federation, the Slovak Republic, Slovenia, South Africa, Spain, Sweden, Switzerland, Tunisia, Turkey, Ukraine and the United Kingdom. As US tax treaties with other countries are updated, a zero tax on unspeciﬁed income may become more widespread. Regulation secs 1.861-2(a)(7), 1.861-3(a)(6), 1.864-5(b)(2)(ii), 1.871-7(b)(2), 1.8812(b)(2), and 1.894-1(c). 1997-48 I.R.B. 8. The Service stated in the Notice that it intends to propose new regulations to provide guidance on the treatment of substitute dividend payments between two foreign residents. Until then, taxpayers may rely on the relief provided by Notice 9766. See, for example, sec. 1234(c) (dealing with cash-settled options); sec. 1256(c)(l) (dealing with sec. 1256 contracts); Rev. Rul. 88-31, 1988-1 C.B. 302. Capital gain or loss to the writer of a call option is always short term if the option is cash settled, but may be long term if the writer delivers underlying stock that it has held for more than one year at the time the option was written (or, in certain limited circumstances, at the time the option was exercised). To alleviate credit concerns, the parties may of course agree to post collateral to each other at speciﬁed times. Lucas v. North Texas Lumber, 281 U.S. 11 (1930); Commissioner v. Segall, 114 F.2d 706 (6th Cir. 1940), cert. denied, 313 U.S. 562 (1941); Kleinbard ED, ‘Risky and Riskless Positions in Securities,’ 71 Taxes 783 (1993). P.L. 105-34, 105th Cong., 1st Sess. H.R. Rep. No. 148, 105th Cong., 1st Sess., 189, 190 (1997) (the House Report). For example, if a taxpayer owns no XYZ stock but has an open short sale on that stock, the acquisition of XYZ stock will be treated as giving rise to a constructive sale of the short position if the short position has positive value at that time (that is, the price of XYZ stock has fallen). See also Rev. Rul. 2002-24; 2002-19 I.R.B. 848 (the acquisition of stock to close out an appreciated short position gives rise to a constructive sale of the short under sec. 1259, but the short sale is not consummated for purposes of the

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general short sale rules under sec. 1233 until the stock is actually delivered to the stock lender). See discussion of sec. 1259 in Section VI.A. on ‘Mandatory exchangeable instruments’ for a further description of this ‘catch-all’ provision and Congress’s intent regarding the Treasury’s regulatory authority in respect thereof. Such a combination of transactions, however, will subject the taxpayer to the straddle rules of sec. 1092(c), discussed in section II.A above. An exception to the constructive sale rules is provided for certain short-term hedging transactions, which effectively allows a taxpayer to hedge fully its appreciated ﬁnancial position for a maximum period of ten months each year, sec. 1259(c)(3). For further discussion of sec. 1259, and the extent to which a position in an appreciated ﬁnancial asset may be partially hedged, see the discussion of ‘Mandatory exchangeable instruments’ in the text below. Speciﬁcally, sec. 1260(c)(2) deﬁnes ‘pass-thru entity’ as (i) a regulated investment company (that is, a mutual fund), (ii) a real estate investment trust (REIT), (iii) an ‘S’ corporation, (iv) a partnership, (v) a trust, (vi) a common trust fund, (vii) a passive foreign investment company, as deﬁned by sec. 1297 (subject to certain adjustments), (viii) a foreign personal holding company, (ix) a foreign investment company, and (x) a real estate mortgage investment conduit (REMIC). Special rules apply for mixed straddles, where a taxpayer has offsetting positions only one of which would be marked to market as a sec. 1256 contract. See temporary reg. secs 1.1092(b)-3T, -4T; straddles are discussed generally in the text above. Section 1256(e) also provides an exemption from the mark-to-market requirement for sec. 1256 contracts that are identiﬁed as ‘hedging transactions’ in connection with the taxpayer’s normal trade or business. A futures contract will qualify as part of a hedging transaction for this purpose only if the position being hedged gives rise exclusively to ordinary income or loss – a test that, when applied to stock index futures, is difficult for nondealers to satisfy. See reg. sec. 1.1221-2, discussed in the ‘Equity swaps’ section. There is no metaphysical imperative underlying the ‘60/40’ split; the 60% long-term capital treatment presumably was provided to make the sec. 1256 mark-to-market requirement easier to swallow for futures traders. Section 1256(g)(7)(C) gives the Service the authority to designate speciﬁc non-US exchanges as ‘qualiﬁed boards or exchanges’, thereby bringing futures contracts traded on such exchanges into the regime of sec. 1256. To date, the Service has designated the International Futures Exchange (Bermuda) Ltd., the Mercantile Division of the Montreal Exchange, and, for certain purposes, the Singapore International Monetary Exchange Limited. For a detailed analysis of the tax issues presented by securities futures, see Nijenhuis EW, ‘Taxation of Securities Futures Contracts,’ in Tax Strategies For Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations and Restructurings (Practicing Law Institute, New York, 2002). This term generally refers to an index with nine or fewer component securities in which a smaller number of securities account for a disproportionately large percentage of the index’s weighting. See sec. (3)(a)(55)(B) of the Securities Exchange Act of 1934. See sec. 1256(g)(9). In March, 2001 the Service issued Notice 2001-27, 2001-13 I.R.B. 842, requesting comments regarding the proper standards that should be set for determining who should qualify as a ‘dealer’ of securities futures. In March, 2002 the Service issued Revenue Procedure 2002-11, 2002-7 I.R.B. 526, containing procedures by which exchanges that have developed rules and standards for the operation of market-makers and ﬂoor specialists may receive rulings on an expedited basis to allow the exchanges to determine which of their traders may qualify as ‘securities dealers’ for these purposes. 171

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The Revenue Procedure does not itself set standards for the conduct of dealers; instead the Service appears to be waiting for guidance to come from the exchanges as to how the new dealer rules may best reﬂect market realities. See sec. 1234B. Section 512(b)(5). Sections 511-515 effectively impose net income tax on the income of otherwise tax-exempt institutions to the extent attributable to any ‘unrelated trade or business’, as deﬁned in sec. 513. Broadly speaking, the purpose of the unrelated business taxable income provisions is to prevent tax-exempt organizations from using their taxfavoured status to compete unfairly with taxpaying business organizations. As a practical matter, most analyses of unrelated business taxable income issues consist of searching for an exception to the broad scope of the deﬁnition of an unrelated trade or business. The most useful constellation of exceptions is contained in sec. 512(b), which excludes from the scope of unrelated business taxable income interest, dividends, and gains from the sale of non-inventory property (among other categories). In addition, reg. sec. 1.512(b)-1(a) also exempts income from notional principal contracts. Section 1234; Rev. Rul. 78-182, 1978-1 C.B. 265; Rev. Rul. 58-234, 1958-1 C.B. 279. Under an important exception to this general rule, a corporate issuer does not recognize gain or loss from trading (whether as a writer or a purchaser) in options (whether puts or calls) on its own stock, sec. 1032(a). Notwithstanding the general rule, the exercise of an option to acquire a sec. 1256 contract is treated as a taxable event, sec. 1234(c)(l). Additionally, taxpayers are permitted to ‘tack’ holding periods for stock received pursuant to the exercise of certain stock rights received in tax-free distributions from the issuer, sec. 1223(5). Thus, for example, long-term equity anticipation securities (LEAPS), which are longdated options on individual stocks, are not sec. 1256 contracts, even though they are traded on the Chicago Board Options Exchange and several stock exchanges. Section 1256(b)(3), (g)(6). This function in notional principal amount mimics an investment in a constant quantity of ‘units’ of the index, in which, hypothetically, the units are sold at the end of each period and immediately repurchased at their market value, thereby affecting the amount of deemed cash invested in the hypothetical transaction. Because equity returns are more volatile than interest rates, parties normally rely on such periodic mark-to-market provisions in equity swaps to control counterparty exposure and credit risk over the term of a multiyear swap contract. Assignment of a party’s rights (but not obligations), or vice versa, is not treated as a termination for these purposes. A non-periodic payment on an off-market equity swap that represents a premium or discount greater than 10% of the present value of the ﬁxed payment stream on a comparable at-market swap may instead be recharacterized as a loan embedded in the swap (with the consequence that corresponding interest income and expense would be imputed to the swap counterparties). 1993-2 C.B. 215, 216. The Service also indicated in the preamble that it expects to address the treatment of such contingent payments, as well as the treatment of offmarket and prepaid ﬁnancial instruments, including in-the-money options, in future regulations. Those regulations have not yet been issued. For a comprehensive discussion of contingent swap payments and possible methods of taxing them, see New York State Bar Association’s Report on Notional Principal Contract Character and Timing Issues (May 22, 1998) (reprinted in Tax Analyst’s Highlights & Documents, June 2, 1998, at 2687). See Rev. Rul. 2002-30, 2002-21 I.R.B. 971 (non-periodic payment equal to the sum of (i) a 6% return on $92 million plus (ii) the change in the value of the S&P 500 multiplied

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by $8 million were treated as two separate payments, with the former taxed under economic accrual method). Cf. reg. sec. 1.1001-3(e)(4) (change in obligor of recourse debt obligation generally gives rise to realization). Although the 1992 ISDA Master Agreement form contemplates that swaps generally may not be assigned, parties to swaps can and do agree to the assignment of swaps containing this provision. Parties entering into swaps obviously are free to (and sometimes do) modify this provision to permit assignment subject to the reasonable approval of the counterparty. Dealers may assign their positions in notional principal contracts to other dealers without triggering a realization event to the non-assigning counterparty, provided that the contracts permit such assignment, reg. sec. 1.1001-4. The Service clearly views periodic payments made pursuant to an interest rate or currency swap as ordinary in character. See Field Service Advice TL-N-6336-93 (August 3, 1993) (concluding that interest rate swap periodic payments are ordinary and deductible as business expense under sec. 162, and not as interest under sec. 163, because there is no loan of money) and TL-N-4094-93 (March 22, 1993) (same). A ﬁeld service advice is an internal memorandum of the Service that provides non-binding advice with respect to either legal or factual issues. As such, a ﬁeld service advice has no legal precedential value, but does provide insight into the Service’s views on particular issues. See also Private Letter Ruling 9824026, discussed in note 69 below. The Code section and regulations remedy (retroactively) most of the problems created by Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988). Section 1221(b)(2)(A) and reg. sec. 1.1221-2(b). In Private Letter Ruling 9824026, however, the Service did permit hedging treatment under reg. sec. 1.1221-2 for interest rate swaps that hedged a bank’s holdings of taxexempt municipal bonds. The facts of the ruling involved two banks, each of which purchased a ﬁxed rate, tax-exempt municipal bond at par. Under sec. 582(c)(1), the bonds were treated as ordinary assets in the hands of the banks. Each of the banks also entered into ﬁxed-for-ﬂoating interest rate swaps with unrelated counterparties that effectively converted their ﬁxed rate bonds into ﬂoating rate assets, which in turn better matched their ﬂoating rate liabilities. The ruling explicitly acknowledged that the banks were engaged in ‘gap’ hedging, whereby they attempted to mitigate interest rate and duration mismatches between their assets and liabilities. The hedging character regulations, of course, are famously ambiguous as to how their concept of ‘risk reduction’ should be applied to gap hedges. In the preamble to the hedging character regulations, the Service stated: ‘The status of so-called ‘gap’ hedging is not separately addressed in [the regulation]’, Treasury Decision 8555, 1994-2 C.B. 180, 182. Regulation sec. 1.1221-2(c)(1)(ii)(B) acknowledges gap hedging insofar as ﬁxed-to-ﬂoating hedges of liabilities are concerned. In this case, however, the Service treated the banks’ use of the interest rate swaps in connection with their municipal bonds as hedging their assets. The Service relied upon the fact that the municipal bonds were treated as ordinary assets in the hands of the banks, under sec. 582(c), in order to permit hedging treatment for the swaps. Other institutions that also engage in gap hedging but hold their bonds as capital assets, such as insurance companies, will not, of course, ﬁnd any comfort in this analysis. ‘Under the proposed regulations, a [gap] hedge of those assets does not qualify as a hedging transaction if the assets are capital’, Treasury Decision 8555, 1994-2 C.B. 180, 182. Finally, the ruling held that the periodic payments under the interest rate swaps were ordinary income or expense. (The Service has yet to express its view on the character of periodic payments under an equity swap.) It is not clear whether the Service intended this statement to mean only that periodic payments on interest rate swaps do not give rise to capital gain or loss, or whether the Service has in fact adopted a position that 173

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such payments deﬁnitively are ordinary income/expense, rather than ordinary gain/loss. The distinction between whether a net outﬂow under an interest rate swap constitutes a ‘loss’ or an ‘expense’ may be relevant if the swap in question forms part of a straddle, because the straddle rules defer losses but not expenses (although interest and certain ‘carrying charges’ for a straddle position must be capitalized under sec. 263(g)). Private Letter Ruling 9824026, see note 69, above; Technical Advice Memorandum 9730007, discussed in the text below; Field Service Advice TL-N-6336-93 (August 3, 1993) and TL-N-4094-93 (March 22, 1993); see note 66, above; Field Service Advice 001634 (July 6, 1995). The text ignores the question of whether net payments constitute ‘loss’ or ‘expense.’ See note 69, above. See Section VII.B, below. Field Service Advice 001634 (July 6, 1995) appears to take the position that no payment made pursuant to the terms of a contract may meet the sec. 1234A requirement of cancelling or terminating an obligation under that contract. The incorrectness of this position should be clear when one considers the very different results that obtain depending upon whether a taxpayer holds a swap (or cash-settled option or other cashsettled derivative) to maturity (apparently giving rise to ordinary gain or loss under this view) or instead chooses to sell the contract to a third party slightly prior to maturity (giving rise to capital gain or loss). A Field Service Advice, however, is not a binding document, has no precedential value and does not necessary reﬂect the well-thought-out institutional position of the Service. See Rev. Rul. 88-31, 1988-1 C.B. 302, 304. Technical advice memoranda are issued by the National Office of the Service to its agents to provide advice in connection with resolving legal issues arising in respect of a particular taxpayer, and is binding only on the taxpayer whose case is addressed thereby. As such, technical advice memoranda may not be cited as legal precedent, but they do provide insight into the Service’s position on particular issues. The Service concluded, in Field Service Advice TL-N-4094-93 (March 22, 1993), that a termination payment in respect of an interest rate swap was capital in character, based on case law principles (rather than sec. 1234A); see note 66, above. That ﬁeld service advice was ﬁrst released to the public in 1998. Regulation sec. 1.446-3. The Service further noted that ‘dividends, interest … income from notional principal contracts … [and] other substantially similar income from ordinary and routine investments’ are excluded in computing unrelated business taxable income under reg. sec. 1.512(b)-1(a)(1). The Service claimed that this regulation would be unnecessary if income from periodic payments were gain from the sale or exchange of property. There are, however, swaps (for example interest rate swaps) which provide for no sale or exchange, and to which, therefore, the application of reg. sec. 1.512(b)-1(a)(1) would serve a legitimate purpose. The preamble to the unrelated business taxable income regulations also states that ‘the regulations do not affect the treatment of any gain or loss from the extinguishment, assignment, or other disposition of any swap position’ (emphasis added), Treasury Decision 8423, 1992-2 C.B. 108. For the divergent views on character issues in respect of swaps, see New York State Bar Association’s Report on Notional Principal Contract Character and Timing Issues (May 22, 1998) (reprinted in Tax Analyst’s Highlights & Documents, June 2, 1998, at 2687). As discussed in note 65 above, a non-assigning party may also recognize capital gain (or loss) when the swap to which it is a party is assigned, even though the nonassigning party receives or makes no actual payment as a result of the assignment. Regulation sec. 1.1001-4, however, generally provides non-recognition treatment to the non-assigning party when a notional principal contract is assigned by a dealer to another dealer.

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79 One argument to the contrary is that a payment made to relieve oneself of an obligation generally is treated as an ordinary loss, rather than a loss incurred from a sale or exchange. Analogous authority concerns the issue of payments made by a property owner to induce a potential purchaser to assume an unfavourable lease or liability associated with the property. In those cases, which generally address tax consequences to the purchaser, not the seller, courts have held the net payments to be a reduction in the purchase price paid and therefore in the purchaser’s tax basis for the property. See, for example, Oxford Paper Co. v. Commissioner, 194 F.2d 190 (2d Cir. 1952). Unlike those cases, the assignor of a loss swap position receives no net proceeds that could be subject to reduction. Moreover, according to currently accepted wisdom, a swap party is thought to have no tax basis in its swap position. The concept of recognizing a capital loss, which generally is deﬁned as the excess of the seller’s tax basis in property over the amount received on resale, thus is difficult to apply in respect of assigning a loss swap position. 80 1992-1 C.B. 1196, 1197. These ‘transparency’ regulations, which were adopted in ﬁnal form in 1997, are described in the discussion of stock loans at the end of this chapter. 81 See Section III.C. 82 For a more comprehensive discussion of the policy issues in respect of imposing US withholding tax on derivative dividend payments, see New York State Bar Association’s Report on the Imposition of U.S. Withholding Tax on Substitute and Derivative Dividend Payments Received by Foreign Persons (June 5, 1998) (reprinted in Tax Analyst’s Highlights & Documents, June 5, 1998, at 2869). 83 Although the grammatically correct term would be ‘mandatorily exchangeable’, Wall Street (and New York in general) has always preferred brevity to formal correctness. 84 The discussion is largely excerpted from Kleinbard ED and Nijenhuis EW, ‘Everything I Know About New Financial Products I Learned from DECS,’ in Tax Strategies For Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations and Restructurings (Practicing Law Institute, New York, 2002), which contains a more comprehensive discussion of the tax issues surrounding these instruments. 85 The history and economics of mandatory exchangeable instruments are described at length in The Issuer’s Guide to DECS (Salomon Brothers Inc., July 1995). 86 These alternatives are described in more detail in The Issuer’s Guide to DECS. 87 Mandatory exchangeable instruments have been issued as preferred stock in those instances in which the common stock to be delivered to the holders at maturity was the issuer’s own stock. See MascoTech, Inc. $1.20 Convertible Preferred Stock (Dividend Enhanced Convertible Stock–DECS) (June 30, 1993). Such mandatory exchangeable instruments almost certainly would be characterized as preferred stock for US federal income tax purposes even if denominated as debt, and in that case the current coupon payments in respect of those mandatory exchangeable instruments would be characterized as dividends – which are non-deductible to the issuer and may be eligible for a dividends-received deduction in the case of corporate holders of mandatory exchangeable instruments. Issuers wishing to issue mandatory exchangeable instruments on their own stock and receive an interest deduction in respect of the coupon payments (at the expense of the dividends-received deduction allowable to corporate holders) may issue a debt obligation paired together with a forward contract on their stock in an investment unit. These structures are described in Section V.B.2 below. 88 See Section VII.B for a more detailed discussion of the CPDI rules. 89 Under reg. sec. 1.1275-4(b)(9)(vi), the issuer would be required to treat that deduction as a loss subject to the straddle rules. Since, as discussed in Section VII.A below, the straddle rules technically defer the deduction of loss to the extent of unrecognized gain on offsetting positions, an issuer that delivers less than all of the stock underlying the mandatory exchangeable instruments may be required to defer the deduction of loss 175

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equal to the unrecognized gain at year end of the stock not sold. Although the payment would constitute interest expense under the CPDI rules, this loss disallowance rule would apply instead of the sec. 263(g) interest capitalization rules. See note 118 below. T. D. 8674, 1996-28 I.R.B. 7, 9 (preamble to the CPDI regulations). In addition, each subsection of the CPDI regulations containing an example includes the following disclaimer: ‘No inference is intended, however, as to whether the debt instrument is a debt instrument for federal income tax purposes.’ In addition, the CPDI regulations are issued under sec. 1275(d), which provides regulatory authority to modify the rules of ‘this subpart’, that is, secs 1271-1275, which again applies only to ‘debt instruments’. Given the scope of the Treasury’s statutory authority under sec. 1275(d), regulations governing contingent payments that are not made on debt instruments must be issued under a different section of the Code, such as sec. 446. This issue has been addressed by the Service in the case of a cash-settlement-only option, which obviously more closely resembles debt than an instrument requiring the delivery of property like the mandatory exchangeable instruments. See Rev. Rul. 88-31, 1981-1 C.B. 302 (‘right’ characterized as cash-settlement put option rather than equity); Private Letter Ruling 9235003 (similar ‘right’ does not constitute a CPDI and is not subject to secs 1271-1275, or sec. 483). See Duval Sulphur & Potash Company v. Phinney, 1956-2 U.S.T.C. ¶ 9969 (W.D. Tex. 1956). But see FSA 200131015 (May 2, 2001), in which the Service, concluding that a mandatory exchangeable instrument as a whole does not constitute debt for US federal income tax purposes, states without further analysis (and without considering there could be an interest component to the larger transaction) that the coupon payments on the instrument are not deductible interest. Other than describing the payments as ‘carrying charges’, the FSA offers no further guidance as to how the payments may be characterized. Cf. Unitex Industries, Inc., 30 T.C. 468 (1958), aff’d 267 F.2d 40 (5th Cir. 1939) (no debtor–creditor relationship arose, and no interest expense deduction was permitted for payments on subscription contracts to buy participating preferred stock, where payments were labelled ‘dividends’ on shares to be delivered under the contracts). Lucas v. North Texas Lumber Company, 281 U.S. 11 (1930). In North Texas Lumber, the taxpayer entered into an option contract in 1916 to sell timber lands. The purchaser notiﬁed the taxpayer in the same year of its intent to exercise the option, whereupon the seller ceased operations and withdrew all employees from the lands in question. Because the taxpayer did not transfer title or possession until the purchaser paid for the property in 1917, the Supreme Court concluded that the purchaser’s notice gave rise to a sales contract that remained executory at the end of the 1916 taxable year. The taxpayer therefore did not recognize gain until the sale was completed in 1917. See also Gulf Oil Corporation v. Commissioner, 914 F.2d 396, 408-409 (3d Cir. 1990) (income attributable to discount on future purchases of oil not includible because no oil had been purchased); Brown Lumber Co. v. Commissioner, 35 F.2d 880 (D.C. Cir. 1929) (lumber sale still executory where title did not pass and no payment made); S.C. Johnson & Son, Inc., 63 T.C. 778, 786 (1975) (no income to donor on donating appreciated forward contracts, because he had no right to gain until delivery under the contract); Samuel C. Chapin, 12 T.C. 235 (1949) (no sale took place where seller retained possession of land and other steps not taken), aff’d, 180 F.2d 140 (8th Cir. 1950); Charles W. Dahlinger, 20 B.T.A. 176, 184 (1930), aff’d, 51 F.2d 662 (3d Cir.), cert. denied, 284 U.S. 673 (1931)(‘[A] sale is complete when title passes.’); Rev. Rul. 79-294, 1979-2 C.B. 305 (commodity futures contract is an executory contract); Rev. Rul. 75-152, 1975-1 C.B. 144 (purchase of commodity futures contract is purchase of a right to acquire the commodity, not purchase of the commodity itself); General Counsel Memorandum

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12570, XIII-1 C.B. 114 (1934) (no sale of stock where stock delivered and transaction cleared in following year). But see Snider v. Commissioner, 453 F.2d 188 (5th Cir. 1972) (sale consummated when contract signed, lease terms agreed to, and loss from sale reasonably determinable rather than when bill of sale delivered and sale price paid) and Abe Pickus, T.C. Memo. 1963-342 (sale took place prior to passage of title or payment because seller could get speciﬁc performance). The precedential value of these cases is questionable, as they appear to conﬂict with North Texas Lumber. In addition, as a matter of income recognition for tax purposes, an upfront payment under an executory contract may not be includible in income upon receipt if it is made as a security deposit. Commissioner v. Indianapolis Power and Light Company, 493 U.S. 203 (1990). In Indianapolis Power, the Supreme Court ruled that deposits to secure utility service from the taxpayer did not constitute income unless ‘the taxpayer has some guarantee that he will be allowed to keep the money’, Id. at 210. Under this rule, if, at the time the payment is made, the payer is entitled to a refund as long as the payer complies with its contractual obligations (even if the payer has the right to offset its payment obligation with the deposit), then the taxpayer has no guarantee that it will be allowed to keep the money and the payment is not included in calculating the taxpayer’s income. See Doyle v. Commissioner, 110 F.2d 157 (2d Cir.) (approximately one-third down payment; not taxable as income because parties intended sale to be closed in later year), cert. denied, 311 U.S. 658 (1940); Bourne v. Commissioner 62 F.2d 648 (4th Cir. 1933) (20% down payment); Modesto Dry Yard, Inc., 14 T.C. 374 (1950) (partial prepayment on futures contract); Rev. Rul. 81-167, 1981-1 C.B. 45 (7% down payment); Rev. Rul. 73-369, 1973-2 C.B. 155 (12% down payment); Rev. Ru. 69-93, 1969-1 C.B. 139 (nominal down payment); General Counsel Memorandum 35957 (Dec. 20, 1976) (10% down payment); cf. Applegate v. Commissioner, 980 F2d 1125 (7th Cir. 1992) (parties assumed property disposed of at time of delivery of grain under ‘price later’ contracts under which small payment made at time of delivery but remainder of purchase price ﬁxed and paid at later date). Cf. reg. sec. 1.451-5 (providing rules for determining when prepayments received with respect to contracts to sell goods held for sale in the ordinary course of business must be included in income). The absence of any relevant North Texas Lumber cases in which a buyer prepays in full prior to delivery is not fortuitous. The North Texas Lumber cases focus on the transfer of property from seller to buyer rather than on the transfer of funds from buyer to seller. Those cases seek to determine when the seller’s performance is so substantial (measured by actual or constructive receipt of the property by the buyer) that the parties have achieved the transfer of property that was the purpose of the contract of sale. In the absence of that transfer, no sale has taken place, and the contract therefore remains executory. See, for example, Commissioner v. Segall, 114 F.2d 706 (6th Cir. 1940), cert. denied, 313 U.S. 562 (1941). See, for example, Rev. Rul. 69-93, 1969-1 C.B. 139 (ruling that a sale of real estate occurred at the time the deed passed or the buyer took possession rather than when the deposit was paid on the purchase contract). The right of an owner of property to dispose of a security is a critical element in a sales transaction. See, for example, Provost v. United States, 269 U.S. 456 (1926) (holding that a stock lender disposed of the stock lent out because the borrower had the right to sell such borrowed stock); Rev. Rul. 82-144, 1982-2 C.B. 34 (ruling that a purchaser of municipal bonds and put options thereon giving the purchaser the right to sell the bonds back to the original seller, thereby transferring risk of loss on the bonds back to the original seller, was the owner of the bonds, because the purchaser could dispose of the bonds to unrelated third parties). 177

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103 104 105 106

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Cf. Richardson v. Shaw, 209 U.S. 365 (1908) (holding that customer continued to own margined securities because, although customer’s securities dealer had the right to repledge such securities (and in fact did so), the dealer did not have the right to convey both legal title and the economic risks of the securities to a third party). For a comprehensive review of the relevant authorities, see generally Kleinbard ED, ‘Risky and Riskless Positions in Securities,’ 71 Taxes 783 (December 1993) (concluding that the right to dispose of fungible securities is the principal factor that determines tax ownership of the securities). See also Miller D, ‘Taxpayers’ Ability to Avoid Tax Ownership: Current Law and Future Prospects,’ 51 Tax Law, 279, 290–7, 329–32 (1998) (proposing a standard for tax ownership of property that looks to title and control of property in the ﬁrst instance, and to economic beneﬁts and burdens when title is severed from control). See reg. sec. 1.1012-1(c) (providing several different forms of identiﬁcation procedures for sale of stock where taxpayer holds multiple lots of stock acquired for different prices, and also providing that FIFO rule applies when speciﬁc shares sold cannot be identiﬁed). The ‘open transaction’ treatment of short sales prior to the enactment of sec. 1259 was based on the rationale in the discussion above. In such transactions, an investor that owned publicly traded securities could enter into a short-against-the-box transaction (for example a transaction in which the investor borrowed securities and sold them ‘short’ while continuing to hold identical securities), whereby it immunized itself from exposure to market ﬂuctuations in the value of those securities but continued as the tax owner of the securities during the open period of the short sale transaction. No gain or loss was taken into account in income until the delivery of securities to the securities lender to close the short sale, because the fungibility of securities meant that the source (and hence the tax basis) of the securities used to close the transaction could not be known for certain until those securities were actually delivered. See, for example, Solicitor’s Opinion 1179, 1 C.B. 60 (1919) (ruling that a short sale transaction is not completed at the time of the short sale because of the uncertainty as to gain or loss to be realized). That rule is now incorporated in reg. sec. 1.1233-1(a) (‘a short sale is not deemed to be consummated until delivery of property to close the short sale’). The fact that, at the issuance of a mandatory exchangeable instrument, the issuer might intend to deliver underlying stock to settle the instrument is not dispositive. Under tax law principles, the fact that the issuer has the right to deliver cash or other shares of underlying stock to settle the agreement is the relevant consideration. See Richardson v. Commissioner, 121 F.2d 1 (2d Cir.), cert. denied, 314 U.S. 684 (1941) (holding that taxpayer’s unfulﬁlled intention to use a block of shares to close a short position did not close such short position, because those shares were actually delivered pursuant to another sale); cf. James Cunningham, 29 B.T.A. 717 (1934) (holding that intent of taxpayer to execute and maintain a short-against-the-box position was not relevant when in fact his transactions did not reﬂect such intentions). See, for example, Handelman v. Commissioner, 509 F.2d 1067, 1070 (2d Cir. 1975) (concluding that agreement to sell stock placed in escrow remained executory, and citing retention by taxpayer of all voting rights of the stock as evidence of lack of sale). House Report at 189, 192; S. Rep. No. 33, 105th Cong. 1st Sess. 122, 125-26 (1997) (the Senate Report) (emphasis added). House Report at 193; Senate Report at 126 (emphasis added). House Conference Report, H.R. Rep. No. 220, 105th Cong., 1st Sess., 514 (1997). See, for example, Schizer D, ‘Hedging Under Section 1259,’ 80 Tax Notes 345, 350 (July 20, 1998) (‘[A] constructive sale would not arise from … holding stock and shorting socalled ‘mandatory exchangeable debt’.) Both the House and Senate reports provide an example of a collar with a strike price spread narrower than that featured in mandatory exchangeable instruments – a $95 put

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109 110 111 112

113 114

115

116

option strike price and a $110 call option strike price. In view of the fact that such a collar would have very different risk-shifting effects depending on whether its term was, for example, one year or 25 years, the legislative history does not express a view as to the application of the constructive sale rules to such a collar. Presumably, however, this very silence means that at least some such collars do not give rise to constructive sales. Similarly, a mandatory exchangeable instrument with a term of three–ﬁve years should generally be in line economically with terms of most market-standard collars existing when sec. 1259 was enacted in 1997. At least one Treasury official has unofficially expressed the view that a 20% spread between strike prices on a collar (which includes the current stock price) should not constitute a constructive sale under regulations to be issued. See Allen D, ‘IRS Looking for 20 Percent Safe Harbor for Collars Under Constructive Sale Rules’, Daily Tax Report G-2 (July 1, 1998) (government is considering safe harbour for collars with maximum term of three–ﬁve years and 20% spread that includes the current price of the stock); ‘Correction,’ Daily Tax Report G-4 (July 2, 1998). See also Schizer, note 106, above (‘Yet if there are also meaningful economic differences between the long and short [positions] – as is typically the case for mandatory exchangeables and the underlying stock – a short [position] should not be abusive’). See comment letter regarding potential sec. 1259 safe harbour guidelines from the Securities Industry Association to the Service and the Treasury Department (November 10, 1998) (reprinted in Tax Analyst’s Highlights & Documents, December 14, 1998, at 2609). For a more detailed discussion of sec. 163(l), see Section VII.A. General Explanation of Tax Legislation Enacted in 1997, at 193 (Jt. Comm. Prt. 1997). Section 1092(a)(1); reg. sec. 1.1092(b)-1T. Section 1092(b)(1); reg. sec. 1.1092(b)-2T. The regulation also provides rules on the holding period of gain or loss realized on the hedge that effectively can result in the conversion of long-term capital gain on the stock into short-term capital gain. Section 263(g). Section 1092(c)(1) (deﬁning the term ‘straddle’), (c)(2) (deﬁning the term ‘offsetting’), (d)(1) (deﬁning the term ‘personal property’), (d)(2) (deﬁning the term ‘position’). For more detailed discussions of the straddle rules as applied in practice, see Kleinbard ED and Nijenhuis EW, ‘Short Sales and Short Sale Principles in Contemporary Applications,’ 53 New York University’s Annual Institutes on Federal Taxation, ch. 17, sec. 17.03 (1995); Canellos P and Paul D, ‘Limitations on Loss Recognition,’ Taxation of Financial Instruments, ch. 6, secs 6.04 and 6.05 (Avi-Yonah R, Newman D and Ring D eds 1999). Regulation sec. 1.1092(d)-2; proposed reg. sec. 1.1092(d)-2. These regulations, released in the spring of 1995, implement the mind-numbingly complex rules of sec. 1092(d)(3)(B)(i)(II). Section 1092(d)(3) generally provides that stock can be treated as part of a straddle only if it is hedged by an option on that stock or (under the regulations cited above) by certain other hedges of a kind that would deny a corporate taxpayer the dividends-received deduction for dividends received on that stock, as described in Treasury reg. sec. 1.246-5. Such hedges include, for example, total return equity swaps on the same stock. The text assumes that the underlying stock in question was acquired by the seller after the effective date of the 1984 amendment of the straddle rules extending those rules to equity straddles. For discussion of this issue, see earlier versions of this article published in earlier versions of these volumes. In addition, see FSA 200131015 (May 2, 2001), in which the Service considers the application of sec. 263(g) to a transaction presumably predating the effective date of the proposed regulations and concludes that the coupon payments in respect of a mandatory exchangeable instrument: (i) do not constitute deductible interest, because the instrument as a whole does not constitute debt, and (ii) do constitute ‘carrying charges’ with respect to the underlying stock, because the instrument was ‘incurred to continue the [issuer’s] investment’ in the underlying stock. 179

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117 Lest there be any doubt as to whether mandatory exchangeable instruments qualify as ‘ﬁnancial instruments that are part of a straddle’, proposed Treasury reg. sec. 1.263(g)3(d)(3) speciﬁcally deﬁnes the term to include a ‘ﬁnancial instrument that is sold or marketed as part of an arrangement that involves a taxpayer’s position in personal property that is part of a straddle and that is purported to result in … economic realization of all or part of the appreciation in an asset without simultaneous recognition of taxable income’. 118 Compare, for example, the application of the proposed sec. 263(g) and 1092 regulations to CPDIs where one or more payments on the debt instrument is linked to the value of stock. The proposed regulations provide rules intended to make clear that CPDIs generally can constitute a position in personal property, proposed reg. sec. 1.263(g)2(a)(1); proposed reg. sec. 1.1092(d)-1(d). Example 5 of proposed reg. sec. 1.263(g)4(c) applies these rules to a debt instrument with payout features similar in some respects to those of a mandatory exchangeable instrument. In the example G purchases 100,000 shares of XYZ stock and issues a CPDI with a 2% coupon, a six-year term, and a principal amount equal to the purchase price of the XYZ stock. At maturity, the instrument pays the principal plus three-quarters of the appreciation of the XYZ stock over 120% of the purchase price. The analysis states that the debt instrument and the XYZ stock constitute a straddle and that the ‘interest payments’ therefore must be capitalized. The reference to ‘interest payments’ in this context appears to be a reference solely to the 2% coupon payments – and not to the ﬁnal contingent interest payment – as the example uses the term ‘interest’ to refer solely to the coupon payments and nothing in the proposed regulations indicates an intent to override reg. sec. 1.1275-4(b)(9)(vi) (requiring issuer to treat contingent payment as loss subject to sec. 1092 if debt instrument is part of a straddle and the contingency would be part of the straddle if entered into as a separate position). 119 Proposed Treasury reg. secs 1.263(g)-5 and 1.1092(d)-1(e). 120 Revenue. Rul. 83-98, 1983-2 C.B. 40; this treatment may not, however, be problematic to non-US issuers, who do not need interest deductions in the US. 121 Section 163(l) generally is effective for instruments issued after June 8, 1997. Section 163(l) has not yet been addressed in any regulations or other interpretations issued by the Internal Revenue Service. 122 Section 163(l)(3)(C). The legislative history to sec. 163(l) makes clear that the provision could apply ‘in the case of certain issuances of a forward contract in connection with the issuance of debt’, H.R. Rep. No. 220, Ways and Means Committee Report on the Revenue Reconciliation Bill of 1997, 105th Cong., 1st Sess. 458 (1997). 123 Section 163(l)(3). 124 Cf. reg. sec. 1.1275-5(f) (a reset bond for which the reset does not give rise to a taxable event under reg. sec. 1.1001-3 is treated as maturing and being reissued as a result of such reset ‘solely for purposes of calculating the accrual of original issue discount’) (emphasis supplied). 125 The transaction was structured by Merrill, Lynch & Co. 126 Regulation secs 1.1272-1(e) and -2(j). This rule applies regardless of whether the option is cash settled or physically settled, and whether the underlying stock is stock of the issuer of the bond or a related party (such as the issuer’s parent or subsidiary). This treatment is in contrast to the treatment of bond-warrant units, discussed in Section VIII.A below, where the purchase price is allocated between the bond and warrant components based on the relative values of each. 127 Section 171(b) (ﬂush language); reg secs. 1.171-1(e)(1)(iii), -1(f) (Example 2). 128 Revenue Rul. 72-265, 1972-1 C.B. 222. This non-taxable treatment applies only where the stock issued upon exercise of the embedded option is stock of the debt issuer. Where a bond is exchanged for stock of a related party, such as the issuer’s parent, the 180

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129 130 131 132

133

134 135

136

137

138

139

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exchange of the bond for the stock will be treated as a taxable event, Rev. Rul. 69135,1969-1 CB 198. Revenue Rul. 85-119, 1985-2 C.B. 60. Notice 94-47, 1994-1 C.B. 357. General Explanation of Tax Legislation Enacted in 1997, at 193 (Jt. Comm. Prt. 1997). The legislative history to sec. 163(l) provides as an example of an arrangement, to which that provision is intended to apply, ‘certain issuances of a forward contract in connection with the issuance of debt’, General Explanation of Tax Legislation Enacted in 1997, at 193 (Jt. Comm. Prt. 1997). For a more detailed discussion of the mechanics of the CPDI regulations, see Kleinbard ED, Nijenhuis EW and Vemireddy R, ‘Final Tax Regulations Governing Contingent Payment Debt Obligations,’ 72 Tax Notes 499 (July 26, 1996); Kleinbard ED, Nijenhuis EW and McRae W, ‘Contingent Interest Convertible Bonds and the Economic Accrual Regime,’ 95 Tax Notes 1949 (June 24, 2002). Regulation sec. 1.1275-4(a)(4). Such a portion of the return (at least outside the CPDI rules) is not de minimis if it is greater than 25 basis points of the bond’s face amount multiplied by the number of full years the bond is outstanding, sec. 1273(a)(3). As discussed below, a bond will not be taxed as a CPDI under economic accrual principles if the contingent payments on the bond are either ‘remote’ or ‘incidental’. The term ‘variable rate debt instruments’ includes bonds paying interest at a standard ﬂoating rate (for example LIBOR plus a spread) and certain other bonds with variable rates accruing at least annually. Interest in respect of such bonds generally accrues over a given accrual period at the then-current rate for the bond. For rules governing the treatment of variable rate debt instruments, see regs sec. 1.1275-5. ‘For bonds with embedded options, the cash ﬂow is difficult to estimate. The required yield used to discount the cash ﬂow is determined by the yield offered on comparable securities.’ Fabozzi F, ‘Bond Pricing and Return Measures,’ Ch. 4 in The Handbook of Fixed Income Securities, p. 76 (Irwin Professional; 5th edn, Chicago, 1997). See also Shuldiner R, ‘A General Approach to the Taxation of Financial Instruments,’ 71 Tax Law Review 243, 284-87 (1992); Warren AC, ‘Financial Contract Innovation and Income Tax Policy,’ 107 Harvard Law Review 460, 478-79 (1993); Scarborough R, ‘Different Rules for Different Players and Products: The Patchwork Taxation of Derivatives,’ 72 Taxes 1031, 1032 (1994). If the CPDI has contingent payments that are not based on market information or if the CPDI is marketed to tax-indifferent investors, then there is a presumption that the CPDI’s yield is equal to a rate for US Treasury obligations with similar maturities. See reg. sec. 1.1275-4(b)(4)(i)(B). See reg. sec. 1.1275-2(h). Although it is not entirely clear how the ‘remote’ and ‘incidental’ standard interacts with the 25-basis-point standard generally applicable for determining whether payments are de minimis (see note 135), the author believes that, as a matter of regulatory consistency, a contingent payment should be viewed as non-remote and nonincidental if there is a reasonable scenario under which the payment would have an effect on the bond’s yield similar to that of a payment of greater than 25 basis points over the bond’s term. In general, the determination of whether an instrument constitutes indebtedness for tax purposes requires recourse to 70 years of not altogether consistent case law. See Plumb W, ‘The Federal Tax Signiﬁcance of Corporate Debt: A Critical Analysis and a Proposal,’ 26 Tax Law Review 369 (1971) (exhaustive discussion of debt-equity issue). Where the equity-linked features of a bond are so signiﬁcant as to make debt-like features insigniﬁcant by comparison, there is a chance that the bond will be characterized as an equity instrument for tax purposes. See Rev. Rul. 83-98, 1983-2 C.B. 40 181

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141

142 143

144

145 146 147 148 149 150 151 152 153

154

(holding that adjustable rate convertible notes constitute equity where the instrument was structured to make conversion all but certain and provide for a current yield referenced by dividends. A ‘related party’ for this purpose is deﬁned by reference to the broad related party deﬁnitions of secs 267(b) and 707(b)(1). Section 267(b) in general treats a chain of corporations linked by greater than 50% ownership of each member of the group as ‘related’ for this purpose. Revenue Rul. 2002-31, 2002-22 I.R.B. 1023. The determination of whether a given set of contingent payments is in fact remote or incidental is a highly fact speciﬁc and usually complicated question that will vary from issuer to issuer. See Rev. Rul. 2002-31, 2002-22 I.R.B. 1023, Notice 2002-36, 2002-22 I.R.B. 1029. For detailed discussions of the policy issues raised by contingent convertible bonds, see Kleinbard ED, Nijenhuis EW and McRae W, ‘Contingent Interest Convertible Bonds and the Economic Accrual Regime,’ 95 Tax Notes 1949 (June 24, 2002); Trier D and Farr L, ‘Rev. Rul. 2002-31 and Taxation of Contingent Convertibles,’ appearing in two parts in 95 Tax Notes 1963 (June 24, 2002), and 96 Tax Notes 105 (July 1, 2002); Hariton D, ‘Conventional and Contingent Convertibles: Double or Nothing,: 96 Tax Notes 123 (July 1, 2002). See Notice 2002-36, 2002-22 I.R.B. 1029. Revenue Rul. 2002-31, 2002-22, I.R.B. 1023. Section 1272(c)(2)(B). Section 1032 states that a corporation shall not recognize gain or loss in respect of dealings in its own stock. 453 F.2nd 300 (2nd Cir. 1971). Id. at 305 (emphasis in original). 57 T.C. 633 (1972). See also AMF Inc. v. United States, 476 F.2d 1351 (Ct. Fed. Cl. 1973) (same). Tom Barkley, ‘Berkshire Hathaway to Sell Bond Investors Must Keep Paying For’, New York Times, May 22, 2002, at C-17; Floyd Norris, Is Lending Money to Buffett a Privilege Worth Paying For? (May 22, 2002), available at http://www.nytimes.com; Reuters, Berkshire Sells 1st Negative Coupon Paper (May 22, 2002), available at http://www. nytimes.com. Speciﬁcally, the remarketing proceeds per bond will be targeted to equal 100.125% of par.

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CHAPTER 6

AUSTRALIAN TAXATION OF EQUITY, DEBT AND STRUCTURED PRODUCTS

OVERVIEW OF THE AUSTRALIAN TAX SYSTEM The Australian tax system relies on classical income taxation, supplemented by a recently introduced goods and services tax. In 1987, the income tax system was overlaid with a capital gains tax, which essentially applies to proﬁtgenerating transactions which prior to its introduction were not captured by the income tax system.1 The core concept of income taxation based on net accretions to wealth are contained in two provisions in the Income Tax Assessment Act 1997: 6-5 Income according to ordinary concepts (ordinary income) (1) Your assessable income includes income according to ordinary concepts, which is called ordinary income. (2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year. (3) If you are not an Australian resident, your assessable income includes: (a) the ordinary income you derived directly or indirectly from all Australian sources during the income year; and (b) other ordinary income that a provision includes in your assessable income for the income year on some basis other than having an Australian source. 183

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(4) In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. 8-1 General deductions (1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or (c) it is incurred in relation to gaining or producing your exempt income; or (d) a provision of this Act prevents you from deducting it.

Some additional confusion arises for taxpayers and participants in the Australian tax system as a result of the existence of two tax acts; the 1997 legislation referred to above was introduced as part of the now defunct ‘Tax Law Improvement Program’, but remnants of the previous 1936 Income Tax Assessment Act still operate in key areas. For example, dividend income is included in the assessable income of taxpayers pursuant to s. 44 of the 1936 Act: 44 (1) The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) shall, subject to this section and to section 128D: (a) if he is a resident – include dividends paid to him by the company out of proﬁts derived by it from any source; and (b) if he is a non-resident – include dividends paid to him by the company to the extent to which they are paid out of proﬁts derived by it from sources in Australia.

As the following discussion will illustrate, the key taxation issues that arise for Australian investors in structured products, which involve underlying shares with frankable dividends, essentially involve questions about the deductibility of interest on moneys borrowed to assist in the purchase of or as part of the product, and the character of the income which ﬂows from the product, for example is it a frankable dividend or an assessable interest payment? Since Australia operates an income tax system overlaid by a capital gains tax regime, it is normally the case that gains on the disposal of structured products are either assessable as ordinary income or a capital gain. There are 184

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signiﬁcant beneﬁts for investors who are taxed under the capital gains tax rules (for example they are assessable at discount rates compared to the rates applicable to ordinary income taxpayers), and since typical Australian individual investors and superannuation funds are classed as capital gains taxpayers, the availability of this concessional capital gains tax treatment is not normally controversial. The analysis which follows focuses on those key tax issues which structured product issuers, investors and advisers will ﬁnd of relevance, and does not purport to provide an exhaustive analysis of general issues of investment, derivatives or business income taxation, nor does it provide an exhaustive discussion of the rules relating to the timing or characterization of income or capital gains taxation. First, the basic tax rules for debt, equity and structured products are considered; this is followed by an analysis of the taxation of geared equity products, focusing on Instalments. The chapter closes with a discussion of key antiavoidance provisions which operate in the area of structured products.

BASIC TAX RULES FOR DEBT, EQUITY AND STRUCTURED PRODUCTS As we saw in Chapters 1–3, over the last decade or so Australian companies have used capital management techniques and new securities issues to increase financial gearing within the firm, but without changing the accounting composition of the balance sheet.2 The usual technique replaces variable cost equity capital (ordinary shares) with ﬁxed cost equity capital (hybrids). At the start of this period, the usual vehicle was the issuance of converting preference shares with notionally ﬁxed dividends, with capital protection for the investor provided through the conversion mechanism. Although these securities were normally issued in the early 1990s under cover of rulings from the ATO conﬁrming their tax treatment as equity, tax uncertainties in relation to the products grew over time, leading to a legal challenge in the Federal Court case of Radilo Enterprises v Federal Commissioner of Taxation (1997) 97 ATC 4151. Although this case was resolved in favour of the taxpayer, the result was narrow in its application and did not provide any durable test for the taxation of hybrids. Following that case, convertible preference shares were popular for a time but changes to their accounting treatment in the late 1990s triggered a wave of innovation as issuers and advisers sought to replicate their ﬁnancial results in a new form which would be more advantageous under accounting standards. This led to the rise of so-called ‘income securities’, which were structured as

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perpetual debt instruments but with proﬁt contingent coupons, argued to attract an equity accounting treatment. The need for reform of the debt/equity tax borderline in Australia was hastened by the issuance of those deductible equity hybrid instruments in the late 1990s. These instruments are listed on the ASX, were promoted by Salomon Smith Barney, Warburg Dillon Reed and Merrill Lynch and were issued both onshore and offshore by large corporates, banks and the insurance sector. They became known as ‘income securities’ following the successful issue of National Income Securities by the National Australia Bank on 29 June 1999. Income securities are perpetual ﬁnancial instruments with characteristics of both debt and equity: they stand close to the old debt/equity borderline. However, payments on most income securities are contingent on the proﬁtability of the issuer and are typically non-cumulative (meaning that if one periodic payment is missed it is not automatically made up later). Holders’ rights on winding up generally rank behind ordinary debt holders and ahead of ordinary shareholders. Around $8 billion worth of income securities were issued to residents and non-residents. Most income securities issued by Australian Prudential Regulatory Authority (APRA)-regulated institutions are classified by APRA as tier I capital (equity like) and by commercial accounting standards (AASB 1033 and AARF/AASB Statement of Accounting Concepts SAC 4) as equity. Standard & Poor’s assigns an equity credit rating to income securities. However, largely because of inadequacies in the then-existing legislation, confusion and substantial uncertainty arose as to the tax treatment that should apply to income securities. The only published ruling on an income security type arrangement was IT 2411, issued by the ATO on 18 June 1987. However, with the passage of time, IT 2411 was thought by the tax authorities to be addressing outdated RBA capital adequacy guidelines and no longer reflected judicial attitudes. Also, the ATO and the Treasury believed that IT 2411 was being relied upon by issuers in unintended situations: certain issuers believed that income securities should be accorded deductibility treatment (that is, treated as debt). As a consequence IT 2411 was withdrawn on 5 November 1999. In light of these developments and general uncertainties, and taking into account potential adverse implications for the tax base, a decision was taken by the Australian Government to legislate a new debt/equity borderline. The government also announced that this legislation would be brought forward ahead of other proposed tax reforms impacting on all ﬁnancial instruments. Two ATO Rulings were issued to clarify the appropriate tax treatment applying to income securities (see TR2000-D8 and TR2000-D9 dated 21 February 2001). The reforming legislation was released as draft legislation (entitled New Business Tax System: Thin Capitalisation and Other Measures 186

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Bill 2001) which, together with the Explanatory Memorandum for that Bill, was also released on 21 February 2001. When the exposure draft legislation was released on 21 February 2001, the government announced a transitional rule under which issuers of income securities and equivalent instruments issued prior to 21 February 2001 could elect to have the current law apply to returns paid before 1 July 2004. Following subsequent consultations and amendments, the ﬁnal version of the Debt/Equity Act was passed by the House of Representatives on 8 August 2001. By its terms, the Debt/Equity Act operated with effect from 1 July 2001. The basic approach of traditional Australian corporate taxation characterized ﬁnancial instruments based on their legal form. This approach was arbitrary and did not adequately deal with near-ﬁnancial equivalences which were clothed in a different legal form. The new rules expressed in the Debt/Equity Act combine a redefined legal form test with a sophisticated economic substance analysis, designed to achieve two basic outcomes: ■ more accurate taxation of financial instruments based on their ‘real’

economic character; ■ reduction of the practical consequences of retaining a tax system which

differentiates between debt and equity. Schedule 1 of the Debt/Equity Act introduced new subdivision 974 into the Australian Income Tax Assessment Act 1997 (ITAA 1997). Subdivision 974-B deals with debt interests, subdivision 974-C deals with equity interests and subdivision 974-D deals with hybrids which are constructed as converting or convertible instruments. Section 974-20 of the Debt/Equity Act deﬁnes the new concept of debt interest, and provides that an interest in a company is a debt interest if, at the time of its issue, there is an arrangement under which the company has an ‘effectively non-contingent obligation’ to pay an amount/s to the holder of the interest at least equal to its issue price (see s. 974-20 (1) (c) and (d)). The meaning and application of the concept of an ‘effective non-contingent obligation’ is crucial to an understanding of the new rules. The ‘debt test’ lies as the central plank in the 2001 debt/equity legislation, and hence represents the single determinative factor at the heart of the design of the new rules. The debt test is carefully interfaced with the rest of the existing domestic business tax system. The traditional approach relied on broad concepts of dividend and shareholder to identify equity interests. The old approach did not have a central deﬁnition of debt, preferring instead to imply the existence of debt where a ﬁnancial instrument provided a return from a company but did not satisfy the tax law concept of equity. At the same 187

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time, the ‘old’ legislation has been adjusted with an extended deﬁnition of ‘equity’ based on economic substance: broadly speaking, interests which raise ﬁnance and provide returns contingent on the economic performance of a company constitute equity, subject to the operation of the debt test. The new debt test has also separately been incorporated into the new Thin Capitalisation legislation (which bears on foreign capital ﬂows) and will also be used in identifying distributions that may be frankable and which may be subject to dividend withholding tax. As a consequence, there is now much greater uniformity and consistency in the application of the debt/equity distinction throughout the relevant parts of the tax laws. Subdivision 974-C contains the new test for the tax law concept of equity. Section 974-75 outlines the basic rules for identiﬁcation of an equity interest, with the effect that, for tax purposes, ‘equity holders’ in a company are those that are: ■ shareholders; ■ holders of interests providing returns contingent on economic performance,

or at the discretion of the company; and ■ holders of interests that may or will convert into those contingent interests

(or shares). Section 974-5 (4) provides a tie-breaker for interests that satisfy both the equity and debt concept, and states that in this case the interest will be treated for tax purposes as a debt interest. That is, the concept of debt interest is a central provision and overrides that of equity interest. Sections 974-20 and 75 provide basic rules about the tax characterization of the legal form of a ﬁnancial instrument. One of the design advances of the new approach results from the inclusion of detailed economic substance rules to assist in the characterization. Section 974-35 provides rules for the valuation of interests, and is used to work out whether a transaction involves a debt interest (or by implication, an equity interest). The core legal form rule in s. 974-20 (1) (d) looks to whether, in relation to the ﬁnancial instrument: it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3))

The core economic substance test is in two parts. The ﬁrst part is in s. 974-20 (1) (c) which asks whether the ﬁnancial instrument sets up an ‘effectively noncontingent obligation’ to provide a return with an economic value, which is 188

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then characterized according to the legal form of the instrument in subs. 97420 (1) (d). The second part of the economic substance approach measures the value provided by the ﬁnancial instrument using the formula set out in s. 97435. Taken together, secs 974-20 (1) (c) and 974-35 embed the new economic equivalence approach. Section 974-20 (1) (c) asks whether the ﬁnancial instrument involves an ‘effectively non-contingent obligation’ to provide a ﬁnancial beneﬁt. Section 974-135 deﬁnes an ‘effectively non-contingent’ obligation in the following terms: (1) there is an effectively non-contingent obligation to provide a beneﬁt if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action … (2) … (3) an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity), other than the ability or willingness of that entity or associate to meet the obligation; …

The ﬁrst limb of the economic substance approach considers whether there is a real ﬁnancial contingency which should be taken into account when evaluating an apparent obligation to deliver economic value which results from the legal form of the ﬁnancial instrument. If the ﬁnancial instrument purports to involve an effective non-contingent obligation to provide a return of value at least equal to the value originally invested, the scheme of the new rules then measures those values either in nominal terms (for ﬁnancial instruments with a term less than ten years) or in net present value terms (for instruments with a term greater than ten years). Section 974-35 (1) provides that the value of a beneﬁt is its value: (a) in nominal terms if the performance period … must end no later than 10 years after the interest arising from the scheme is issued; or (b) in present value terms if the performance period must or may end more than 10 years after the interest arising from the scheme is issued.

Section 974-35 (3) provides that the performance period is the period within which, under the terms on which the interest is issued, the effectively noncontingent obligations of the issuer and any connected entity have to be met. Section 974-35 (4) provides that an obligation is treated as having to be met within ten years after the interest is issued if: (a) the issuer; or (b) the connected entity of the issuer 189

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has an effectively non-contingent obligation to terminate the interest within that ten-year period, even if the terms on which the interest is issued formally allow the obligation to continue after the end of that ten-year period. In summary, the approach of the Act reﬂects a design view that there are two basic characteristics of ‘debt’. The returns must be non-contingent and they must at least equal the issue price. The single central organizing concept for distinguishing debt from equity, therefore, is the notion of the certainty of at least getting one’s outlay back. Thus, under the Australian legislation, debt is a ‘riskless’ instrument, in the sense that the holder can be assured that, short of bankruptcy of the issuer, he will not lose the initial outlay. With the returns on a debt instrument, therefore, there could be upside, but no scope (in the normal course of business) for downside. Under this approach, equity for tax purposes simply exists when the instrument has returns contingent on the economic performance of the issuer. On this basis, equity is always a risky instrument. That is to say, there is, in respect of the returns on an equity instrument, scope for both upside and downside. It is arguable in these terms, therefore, that the ‘riskless/risky’ dichotomy stands at the heart of the Australian debt/equity distinction. The debt or equity character of an instrument is determined and becomes operational at the time the instrument is ﬁrst issued. A single rule generally resolves this characterization for all ﬁnancing instruments. Once determined at the point of issuance, the ‘debt’ or ‘equity’ characterization is not subsequently amended or altered. For purposes of the present value calculation (applicable where instruments have a tenor of ten years or more), an ‘adjusted benchmark rate of return’ is used. The adjusted benchmark rate of return is 75% of the benchmark rate of return. The benchmark rate of return is deﬁned as the internal rate of return on an investment if the investment were ordinary debt of the issuer, compounded annually. Using only 75% of the benchmark rate ensures that a relatively small equity component of a debt/equity hybrid will not preclude the hybrid from satisfying the debt test. The ten-year distinction (mentioned above) gives adequate weight to simplicity and the minimization of compliance costs. Many taxpayers will be able to avoid undertaking a present value calculation. The new debt test is designed to assess the economic substance of an interest in terms of its impact on the issuer’s position. The single determinative factor upon which the Australian approach is based resolves the tax treatment for the great bulk of hybrid instruments. The obvious exception is in relation to hybrid equity instruments where there is capital protection. In this case, the issue of whether there is risk imposed on

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the investor is not normally capable of being answered as simply as in the case of ordinary equity instruments. The resolution of this issue has been achieved under the Australian approach by embedding a mini ‘facts and circumstances’ test in the enabling provisions which are the basis of the ‘single determinative factor’ approach. For example, in the case of converting/convertible instruments, the ordinary shares which an investor receives on conversion are excluded from the calculation of the value of the converting/convertible instrument, pursuant to s. 974-30 (1). Dividends are also excluded from the calculation of the value of the ﬁnancial instrument, since they are not ‘effectively non-contingent’. (A cumulative dividend feature will reverse this analysis.) While superﬁcially this approach may appear to be arbitrary, on closer reﬂection the approach reﬂects the ﬁnancial reality that shares arising on conversion of a ﬁnancial instrument impose ﬁnancial risk on the recipient investor: ■ shares which an investor receives on conversion must be sold to realize their

value and until sold this value is subject to risk of loss (as well as opportunity for gain); ■ even where the convertible/converting ﬁnancial instrument provides for a

preset value of shares to be issued on conversion (in the Australian experience most convertible preference shares are designed to provide shares on conversion at least equal to the original value invested), the usual arbitrage method of forward sale of those shares, to lock in a preset value for them, relies on the existence of a liquid market for those shares, which is a risk that investors in such convertibles must assume. In addition, the single determinative factor needs to be supported by a limited number of deﬁnitions and additional rules in order for the method to be applied universally. For instance, a deﬁnition of ‘cumulative’ is required so that the borderline is clear cut and transparent in the case of different instruments with alternative cumulative features. Thus, strictly speaking, while more than a single determinative factor may be taken into account in the case of a small number of speciﬁc instruments, the great bulk of determinations can be resolved by the application of the single factor. Several key points which are relevant to financial product innovation emerge from these rules: ■ convertible instruments with capital protection provided through the

conversion process (that is, involving an issue of shares) will be treated as equity under the new Australian tax rules. The value of shares delivered to 191

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satisfy repayment of ﬁnancial obligations is not included in the calculation of the value of a repayment beneﬁt (s. 974-30 (1)); ■ although superﬁcially this approach is logically unprincipled and incon-

sistent with the accounting rules, (for example accounting standard AASB 1033 considers a ﬁxed obligation to deliver shares at a future time as a ﬁnancial liability), the approach accords with the basic design of the new rules, which consider equity interests to involve some degree of ﬁnancial risk; ■ this approach can also be understood in the context of the tax policy goal

surrounding the Debt/Equity Act, which aims to reduce the opportunity for tax deductible equity or quasi-equity instruments to be created, and prefers instead to classify hybrid securities as equity for tax purposes (presumably the creation of so-called ‘deductible equity’ is considered to be at the expense of the revenue, where the security is held by a nonresident or low rate Australian taxpayer, although this consideration may in fact be questionable); ■ the ﬁnancial valuation of the repayment beneﬁt is calculated in nominal

value if the performance period is less than ten years and in present value terms if it is greater than ten years (s. 974-35 (1)); ■ even long-dated instruments will be considered as having a term less than

ten years if the issuer has an ‘effectively non-contingent’ (that is, ‘ﬁxed’) obligation to terminate the interest in less than ten years, or if the issuer has the right to terminate that interest prior to ten years (s. 974-35 (4)); ■ it would seem that a perpetual preference share with a dividend reset date

at (say) year 5, with a conversion option in favour of the holder if the dividend is reset at unattractive rates, would be characterized under the present value approach, since the dividend reset is contingent upon future economic conditions. Section 974-135 permits the making of regulations to give further meaning to these issues; ■ since both dividends and shares arising on conversion are excluded from

the present value calculation, typical convertible share products will fail the debt test and be taxed as equity; ■ if the present value calculation is performed, s. 974-50 uses an approach

which discounts the actual present value of relevant future cash ﬂows to 75% of that value. If the adjusted present value is less than 75% of the actual present value, the debt interest test is not satisﬁed, implying that the interest will be taxed as equity. This effectively imposes some minimum upside ‘optionality’ for equity convertible interests where they have a tenor greater than ten years; 192

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■ this convoluted approach is used to require that long-dated or converting

interests should impose some real contingency of return on investors in order to be treated as equity interests for tax. Examples 2.18 and 2.19 in the Explanatory Memorandum to the Debt/Equity Act illustrate that: ■ convertible notes with coupons paying more than 75% of the company’s

relevant debt rate, and with a term of more than ten years, would be treated as debt because they have a present value in excess of the value of the beneﬁt originally provided to the issuer (that is, face value); and ■ converting preference shares are treated as equity because ‘although the

value to be returned to the investor at least equals the investment amount, that value is returned in the form of equity interests (ordinary shares), which are disregarded’. The interface of these various concepts and rules provides some interesting outcomes in relation to hybrids which are convertible into ordinary shares, but where that conversion is effectively at the whim of the issuer. For example, in the case of many of the frankable hybrids which are now on issue in the Australian market (including the CBA PERLS and the DJ RPS considered in Chapter 3), the issuer effectively controls the conversion process and hence the mechanism by which cash settlement can arise: ■ the issuer can reset the dividend on the hybrid after a predetermined period; ■ usually the reset triggers an opportunity for the investor to choose to

convert the hybrid (although of course, even if the investor did not feel that the reset dividend was attractive, it could simply sell the hybrid – but presumably buyers would only be attracted at discounted prices); ■ in such cases the usual result is that the issuer can elect to repurchase the

hybrid for a cash price equal to the value of shares which would have been issued had conversion occurred. Issuers have been driven towards the structural features of uncertainty of conversion to ensure that these hybrids receive an equity accounting treatment, but nevertheless the opportunity to control the conversion or cash redemption of these instruments offers significant practical flexibility to issuers. In many ways, it is possible to characterize the new Australian approach as being the platform for a system of ‘franked debt’.3

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Given the savage misuse of accounting standards in some recent spectacular corporate collapses, a word on accounting is appropriate. The relevant accounting standard which governs the accounting treatment for an Australian issuer of hybrids is AASB 1033. The AASB 1033 deﬁnition of a ﬁnancial liability focuses on a contractual obligation to deliver cash or another ﬁnancial asset. This obligation applies both to the principal and dividend amount. The convertible preference shares considered here do not meet this deﬁnition because: ■ there is no contractual obligation to deliver cash. The only conversion oblig-

ation is to issue new shares. ■ there is no contractual obligation to deliver another ﬁnancial asset as shares

in the company do not meet the deﬁnition of a ﬁnancial asset. ■ there is no contractual obligation to pay dividends. Dividends are only

payable if declared by the directors and are non-cumulative. In substance, the issuer has obtained access to a permanent increase in its capital base (via the issue of the hybrid). The only option available to the investors is to hold the instrument as a perpetual preference share, or convert the instrument into ordinary shares, and this means that the investor can never be in a position to call for cash from the company. The dividends are noncumulative and only payable if declared by the directors. The company has no obligation to redeem for cash, although there is in many cases the real prospect that cash will be delivered. It is possible to argue that this stretches the bounds of the policy behind the relevant accounting standards. That is, it is surely appropriate to consider a convertible with no cash redemption mechanism as on the equity side of the equity/debt divide, but where an issuer contemplates that it intends to cash settle, and uses a structure which will give effect to this, the instrument may be better treated as a ﬁnancial liability. It is regrettable that the proposed amendments to accounting standards in this area (see for example proposed IAS 32, paras 22C and 22D) would treat an instrument which is convertible into the issuer’s shares as a liability even where the conversion is not mandatory. This mischaracterizes convertible equity as a liability, even where the conversion may never occur, and has the potential to radically stiﬂe the use of equity-based structured products. A correct reﬂex would be to treat non-mandatory convertible shares as equity unless there exists some circumstances which make it likely, in fact, that the instrument will convert or be redeemed for cash. Paragraph 4.2 of AASB 1033 applies to ﬁnancial instruments that mandatorily convert to equity instruments, and accordingly does not apply to 194

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convertible preference shares. These do not mandatorily convert because conversion only occurs if the investor requests conversion (and the issuer elects not to redeem). At inception, it is not possible to predict whether the investors will request conversion. In addition, classiﬁcation of a ﬁnancial instrument does not incorporate consideration of the probability of the various possible outcomes (para. 4.2.6). In summary, reset convertible preference shares have been designed so as not to ﬁt the deﬁnition of a liability as set out in these paragraphs: ■ there is no provision for mandatory redemption by the issuer. The holder

can only request issue of ordinary shares (para. 4.2.9) ■ there are no special terms and conditions that would indirectly establish a

contractual obligation (para. 4.2.10) ■ dividends are non-cumulative and only payable if declared by the directors.

It is to be hoped that a future review of accounting standards for structured products does not improperly impact on their creation and use.

Synthetics issued by interposed entities The Australian Debt/Equity Act adopts an interesting approach to ‘synthetic’ equity (in Division 164 and related provisions), such that if an equity interest issued by a company is not a share in legal form, it will be characterized as a ‘non-share equity interest’ (as long as it does not trigger the ‘debt interest’ provisions as a result of its economic proﬁle – see below). Subscription moneys raised by the issue of non-share equity interests are ‘credited’ to a notional ‘non-share equity capital account’. This approach accommodates synthetic equity interests which are issued by a company and extends to certain arrangements which are debt in legal form (for example convertible notes). Both shareholders and holders of non-share equity interests may be paid frankable dividends by a company. However, because of the government’s decision to suspend the introduction of the Entity Taxation Bill (which proposes to treat most entities as if they were companies, with distributions by them being frankable), synthetic equity issued by entities other than companies will be taxed differently to corporateissued synthetic equity. Examples of non-corporate issued synthetic equity include interests in trusts which give the beneﬁciary exposure to some or all of the price performance of shares held by that trust. Under Australian legislation, foreign branches of APRA-regulated Australian deposit-taking institutions (ADIs) are able to issue unfranked 195

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equity interests. This approach ensures that the relevant institutions have the ability to raise capital through foreign branches to fund offshore business activities on relatively cost effective terms. As a consequence, Australian banks have a platform to compete for funds in foreign jurisdictions (where competition in capital markets is most critical) on a more level playing ﬁeld, and on similar competitive terms with those foreign banks that are able to issue deductible tier I instruments in foreign markets. Similar opportunities are available for non-resident subsidiaries of Australian domiciled companies.

TAXATION OF INSTALMENTS Instalments provide powerful and legitimate tax beneﬁts which need to be understood and considered as part of an effective investment strategy. The key tax issues involve the questions of how much interest is deductible (and the timing of that deduction), the capital gains tax (CGT) consequence of using Instalments, and the way in which franking credits attached to dividends ﬂowing from the underlying parcel can be used by investors.The acquisition by the security trustee will result in the acquisition by the cash applicant of a beneﬁcial interest in the underlying parcel. Legal title to the underlying parcel will be held by the security trustee. On the basis that the beneficiary is absolutely entitled as against the security trustee, for CGT purposes, the cash applicant will be considered to have acquired the underlying parcel. It will be recalled from Chapter 3 that Instalment warrants are packaged loans over shares which are listed and traded on the ASX. The investor makes (i) a down payment (the ‘ﬁrst Instalment’) plus (ii) a prepayment of interest, and in return receives (i) a loan from the Instalment issuer (which is repayable at the Instalment holder’s election, by paying the ‘second Instalment’) plus (ii) the evidence of the transaction, represented by the Instalment. The loan which may be repaid by paying the Second Instalment is limited in recourse to the underlying shares (the ‘underlying parcel’) and it is this feature that gives the product its ‘optionality’ (since the payment of the second Instalment is at the election of the investor). In legal terms, the Instalment is the combination of a loan and the beneﬁcial interest in the underlying parcel: normal Instalments are ‘fully covered’, that is, the underlying shares must be held by a security trustee pending repayment of the embedded loan and release of the security over the shares granted by the investor. As an alternative to the simple cash application described above, some Instalment issuers allow for ‘shareholder applications’ where a pre-existing shareholding is used as security for a loan which is advanced to the investor and which is repayable by that investor making a payment of the second Instalment. 196

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The purchase of an Instalment warrant involves the investor making the following payments during the life of the Instalment warrant: (a) an interest amount which is a prepayment of interest for the term of the loan embedded in the Instalment (the ‘interest period’); (b) in the case of a cash applicant, a ﬁrst payment (the ‘ﬁrst Instalment’); (c) a ﬁnal Instalment. Shareholder applications involve payment of an interest amount, but do not require a ﬁrst Instalment payment. Instead, the shareholder applicant will transfer legal title to its existing underlying parcel to the security trustee. That underlying parcel is then held subject to an equitable mortgage. Shareholder applicants will then receive in return a limited recourse loan and one Instalment warrant. Where the cash or shareholder applicant sells the Instalment prior to the ﬁnal Instalment, the ﬁrst loan (including any prepaid but unaccrued interest) is repaid and a new loan is advanced to the incoming investor. Accordingly, the transferor will have an outstanding loan obligation to the issuer in respect of the interest accrued from the period of the acquisition of the Instalment warrant until the date of transfer and will not be able to make the ﬁnal Instalment. The transferor will pass to the transferee the beneﬁcial interest in the underlying parcel. The new holder will hold the Instalment subject to the security interest of the issuer (but note that security interest is at the level of the investor and does not interfere with the investor’s rights as against the trustee). Each holder of an Instalment has the right (but not an obligation) to make the ﬁnal Instalment at or prior to the exercise date. Upon that payment being made, the holder will obtain legal title to the underlying parcel as a result of satisfying the loan from the issuer and discharging the equitable mortgage given to the issuer. If the holder does not make the ﬁnal Instalment, the issuer can enforce its security interest against the holder and sell the underlying parcel and use the proceeds to pay the ﬁnal Instalment. The amount of the ﬁnal Instalment payable is the same for all holders, irrespective of the amount borrowed by any particular holder. The acquisition by the security trustee will result in the acquisition by the cash applicant of a beneﬁcial interest in the underlying parcel. Legal title to the underlying parcel will be held by the security trustee. On the basis that the beneficiary is absolutely entitled as against the security trustee, for CGT purposes, the cash applicant will be considered to have acquired the underlying parcel. The cost base of the underlying parcel will be the amount paid by the cash applicant for the acquisition of the Instalment warrant, together with 197

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the capital component of the loan (that is, the ﬁrst Instalment) and certain incidental costs of acquisition. A shareholder applicant for an Instalment warrant will previously have acquired the underlying parcel to which the Instalment warrant relates. The cost base of the underlying parcel for CGT purposes is the capital amount paid by the shareholder applicant originally to acquire the underlying parcel. It will also include certain incidental costs related to the original acquisition of the underlying parcel. The interest amount incurred by the applicant is not included in the cost base of the underlying parcel (unless, in the case of a cash applicant, such interest is non-deductible). Likewise, no amount of the ﬁnal Instalment (if made by the applicant) should be included in the cost base of the underlying parcel, since that ﬁnal Instalment is the repayment of a loan. The CGT cost base of an on-market purchaser will consist of the on-market consideration paid by the purchaser to the holder, together with the capital component of the loan provided by the issuer to the purchaser and any incidental costs of acquisition. It also includes any amount the purchaser is required to repay in respect of the interest liabilities which the purchaser assumes from a previous holder of the Instalment warrant, that is, the amount of interest which accrued during the period that the Instalment warrant was held by the transferor and any previous transferor. A disposal of an Instalment warrant will be treated, for CGT purposes, as a disposal by the holder of its beneﬁcial interest in the underlying parcel. This may result in either a capital gain or a capital loss. A capital gain will arise if the net proceeds from the disposal of the beneﬁcial interest in the underlying parcel exceed its cost base. The net proceeds on disposal of the underlying parcel include the capital proceeds that the holder has received or is entitled to receive. The capital proceeds that the holder has received in respect of a disposal is deemed under s. 103-10 of the 1997 Act to include the discharge of all or part of the debt that is owed by the holder. The capital proceeds will therefore include the price received by the holder on disposal of the Instalment warrant and an amount equal to the capital component owing by the holder to the issuer and which is discharged upon the sale of the Instalment warrant. A holder who chooses to exercise an Instalment warrant will make a ﬁnal Instalment payment. That holder will then receive legal title to the underlying parcel held by the security trustee. The security interest of the issuer against the holder will be extinguished. The making of the final Instalment should not cause any tax liability for a holder. At that point, the holder’s legal and beneficial interests will merge and the holder will be legally entitled to the underlying parcel as against the

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security trustee and will be free from the security interest of the issuer. This should not create any tax liability since: (a) the mere extinguishment of a security interest does not constitute the acquisition or disposal of an asset for CGT purposes pursuant to s. 104-10 (7) of the 1997 Act; (b) the transfer of an asset on redemption of a security interest in the asset is treated by ss 104-10 (7) and 109-15 of the 1997 Act as not constituting an acquisition or disposal of the asset for CGT purposes; (c) section 104-10 (2) of the 1997 Tax Act provides there is no change in ownership (and hence no disposal) of a CGT asset if there is only a change in legal ownership of the asset. The ultimate ‘cancellation’ of the Instalment simply reﬂects the fact that the legal title to the underlying parcel is no longer held by the security trustee. There should be no change in the cost base of the holder in the underlying parcel as a result of making the ﬁnal Instalment. The disposal of an underlying parcel by the holder after making the ﬁnal Instalment may result in a capital gain or a capital loss. A capital gain will arise if the net proceeds from the disposal of the underlying parcel exceed its cost base (indexed if relevant). A capital loss will arise if the net proceeds from the disposal of the underlying parcel are less than its cost base (with no indexation). If a holder fails to pay the ﬁnal Instalment, the issuer can cause the sale of the underlying parcel. As a consequence, the security trustee may be required to sell the underlying parcel on behalf of the holder. The security trustee will typically then: (a) use the sales proceeds to satisfy the ﬁnal Instalment; and then (b) pay any balance (after costs and other applicable charges, if any) to the holder. The sale by the security trustee will constitute a disposal by the holder of the underlying parcel for tax purposes. This may result in a capital gain or a capital loss. Interest incurred by cash applicant Instalment warrant holders is in normal cases tax deductible to them. Interest incurred by shareholder applicant Instalment warrant holders should also be tax deductible to them in certain circumstances. Whether or not an item is interest is dependent on the character of the underlying transaction. Typically, in order for an item of expenditure to be

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classiﬁed as interest, the transaction to which it relates must display the following characteristics: ■ the transaction must involve a relationship of debtor and creditor; ■ the interest must be calculated by reference to a sum of money; ■ the interest must be payable for the use of money and must be in the nature

of compensation; and ■ the interest must accrue over time (see Radilo v FCT (1997) 97 ATC 4151).

Based on these criteria, the payments described as interest in the typical Instalment warrant offering circular typically constitute interest for tax purposes. Although the ATO has argued that the cost implied in an Instalment for the right to non-recourse ﬁnance is not deductible, this view has been rejected by the Full Federal Court, and this issue is discussed in more detail below. The deductibility of interest is governed by the general deduction provisions under Australian law. Under these provisions, the deductibility of interest is basically determined by reference to the use to which the money is put by the borrower. Section 8-1 (1) of the 1997 Tax Act provides that interest incurred on moneys borrowed will be deductible to the extent that they are used in producing assessable income or carrying on business for that purpose. Section 8-1 (2) of the 1997 Tax Act provides that interest will not be deductible to the extent that the borrowings are used for private or domestic purposes. The purpose for which the Instalment warrant is acquired by a cash applicant will differ for each applicant. Where the Instalment warrant is acquired for the purpose of deriving assessable income such as future dividends, or trust distributions, the interest will be deductible based on the principles outlined above. In the case of a shareholder applicant, the deductibility of the interest payments will depend on the use to which the loan funds received when the Instalment warrant is acquired are put, that is, the interest will only be deductible where the moneys paid to the applicant are used to produce assessable income or in carrying on business for that purpose. This will be a question of fact to be determined for each shareholder applicant. The interest amount paid by the cash and shareholder applicants will be a prepayment of interest. Each interest amount will be incurred when paid. If either the cash or the shareholder applicant disposes of the Instalment warrant prior to making the ﬁnal Instalment or the shareholder applicant ceases to use the loan funds for income-producing purposes, the amount of the deduc200

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tion available in respect of the prepaid interest will be reduced. In the case of a disposal of the Instalment warrant, the amount refunded to the transferor will be included in the assessable income of the transferor. Subject to the qualiﬁcations as to interest deductibility expressed above, an on-market purchaser of an Instalment warrant should also be entitled to an interest deduction for the interest payment on the loan which the purchaser receives from the issuer. This appears to be a conclusive consequence ﬂowing from those transaction documents which provide for a loan repayment and refreshment as part of the process of secondary market trading. The secondary market holder who disposes of the Instalment warrant in an on-market transaction will receive a refund of prepaid interest relating to the interest period remaining after disposal of the Instalment warrant. This refund should be treated in the same manner as outlined above for a cash applicant or shareholder applicant. The terms of the typical security trust deed provide that each cash dividend paid on an underlying parcel is to be distributed by the security trustee to the holder. Each trust distribution should be included in the holder’s tax return for the year of income in which the relevant dividend is paid by the payer of the dividend, which will generally be when received by the security trustee. If a dividend is wholly or partly franked, a holder who is an individual must also include in his/her taxable income for the relevant year the amount of any imputation credit attached to the dividend. The holder will then be entitled to claim a rebate of tax equal to the imputation credit amount included as assessable income. Any rebate may be used to reduce the tax payable by the holder on the dividend and, depending upon the holder’s marginal tax rate, on any other assessable income derived in that year. Coupled with the eligibility of Instalments for superannuation investors (conﬁrmed by APRA Superannuation Circular II.D.4 – see below), this makes Instalments a powerful, and legitimately tax effective, investment product. For individual and simple (for example SMSF) superannuation fund investors, the question of whether an interest expense is deductible looks at whether the asset which is purchased with borrowed money produces assessable income. Where the assets are shares paying dividends, interest deductibility is often a very simple issue. In cases where the dividends are less than the interest cost, this raises the related issue of how deductions are treated in ‘negative gearing’ situations. Where the Instalment is acquired for the purpose of deriving assessable income such as future dividends, the interest will ordinarily be deductible, even where the investment is negatively geared. In the case of a shareholder applicant (that is, where the investor already owns a share and obtains ﬁnance against it by ‘exchanging’ it for an Instalment), the deductibility of the interest payments will depend on the use to 201

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which the loan is put, that is, the interest will only be deductible where the loan is used to produce assessable income. For example, reinvesting the loan in other income-producing property will allow the interest to be deductible. Most Instalments which have a term longer than 12 months involve interest payments at the end of each year – to simplify accounting and management, most of these long-dated Instalments include a mechanism where the interest prepayment is paid for by the Instalment issuer. (This involves the issuer lending the interest to the Instalment investor and then crediting the Instalment investor’s interest payment account with that loan. No net cash ﬂows occur in these cases.) Each interest amount will be incurred when paid or credited on behalf of the investor. The tax deduction which ﬂows from the interest expense will be deductible in the tax year when it is incurred. If an investor disposes of an Instalment before maturity, or if they are a shareholder applicant and cease to use the loan funds for income-producing purposes, the amount of the deduction available in respect of the prepaid interest will be reduced, to reﬂect the actual period of the loan. An on-market purchaser of an Instalment should also be entitled to an interest deduction for the interest component of the purchase price which the investor pays for the Instalment. Most Instalment issuers provide information on their web sites to allow secondary market investors to calculate how much of their purchase price represents interest. There is some debate over the deductibility of ancillary borrowing fees for Instalments. The ATO takes the view that these are not deductible, but has not yet successfully been able to persuade a court to this view. The ATO considers that instead of being deductible, borrowing fees should be added to the cost base of the Instalment, which means that the tax beneﬁt is available to reduce CGT on sale of the Instalment. The alternative approach, which is more likely to be correct, is that the borrowing fee is deductible over the term of the loan. In the case of moderately geared Instalments, the borrowing fee is relatively small, so the actual difference between the two approaches is often insigniﬁcant.

Dividends and franking The terms of the typical Instalment provide that each cash dividend paid on an underlying parcel is to be distributed to the investor. Each dividend distribution should be included in the investor’s tax return for the year of income in which the relevant dividend is paid. If a dividend is wholly or partly franked, an investor who is an individual or complying superannuation fund (s. 272 1936 Tax Act) must also include in their taxable income for the relevant year the amount of any imputation credit 202

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attached to the dividend. The investor will then be entitled to claim a rebate of tax equal to the imputation credit amount included as assessable income. Any rebate may be used to reduce the tax payable by the investor on the dividend and, depending upon the investor’s marginal tax rate, on any other assessable income derived in that year.

Refundable franking credits Following the introduction of the new franking credit refund provisions, where an investor has a surplus of franking credits, a refund will be paid on lodging the investor’s tax return. This means that a superannuation fund can use interest deductions from Instalments to lower its tax bill, and any excess (unused) franking credits will be refundable in cash from the ATO.

Tax reform changes During the late 1990s the Australian Government commissioned a review of business taxation, chaired by John Ralph. The Ralph Review closely examined interest deductibility issues and has made three changes to the general rules described above. The ﬁrst change (the ‘non-commercial loss’ rule) is not relevant to typical superannuation and private investors, because the legislation contains a broad statement that Division 35 (which contains that rule) will not apply to the receipt of passive investment income from activities which do not constitute the carrying on of a business. Therefore, provided Instalment investors do not carry on a ‘business’ by virtue of their investment activity, dividends from shares or interest on ﬁnancial securities should constitute passive investment income and Division 35 should have no application. Typical retail or SMSF investors will not be conducting a business and hence the non-commercial loss rules will not apply to them. In recent product rulings issued by the ATO in relation to Instalments of speciﬁc issuers (for example PR 2002/90) the ATO takes the view that the second Ralph Review change (the so-called ‘tax shelter rule’) will not apply to Instalments. The tax shelter rule, if it applied, would spread interest deductions across the life of geared investments, where the level of gearing (and hence the amount of the interest expense) is high. The third important Ralph Review change applies to investors such as superannuation funds. Sections 82 KZMA, 82 KZMB, 82 KZMC and (after 21 September 2002) s. 82 KZMD set the amount and timing of deductions for expenditure for investors, such as superannuation funds who either: 203

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■ carry on a business; or ■ are taxpayers that are not an individual and which do not carry on a business.

For those taxpayers, the deduction for prepaid interest on the Instalment will be apportioned over the relevant interest payment period. ATO Product Ruling 2002/90 conﬁrms that the provisions of sec. 82 KZME will not apply to ordinary Instalments, because they are within the scope of the ﬁrst exception to that provision, which relates to geared investments in shares (which the Instalment is considered to be, since the Instalment holder owns the beneﬁcial interest in the share).

Can superannuation funds use Instalments? In Superannuation Circular II.D.4, the Australian Prudential Regulation Authority provides guidance on the restrictions that apply to borrowing of moneys by superannuation funds. Except in extremely limited circumstances, the legislation which governs most superannuation funds prohibits a fund from borrowing money in such a way that a liability to repay is created. The APRA Circular, however, allows the use of Instalments: where the remaining instalment(s) is not ‘compulsory’ … APRA considers the … [gearing] does not constitute a borrowing.

Since the gearing within Instalments is repayable at the option of the investor, APRA’s view is not merely based on a narrow view of the legislation, but is a reasonable attempt to interpret both the words and the intent of the law as envisaged by parliament. Clearly, permitting a superannuation fund to invest in an Instalment is very different from allowing it to gear where a liability to repay is created. The fact is that, through the use of Instalments, investing into the equity market effectively takes place for less risk than investing directly, because repayment of the loan is optional. Until recently, Instalments were only being offered over individual stocks, however Instalments over baskets of shares or exchange-traded funds have begun to appear and will become more common. As franking credits are now fully refundable, Instalments provide an extremely effective way for superannuation funds to generate higher returns. They can do this by using the dividends and, if necessary, the attached franking credits to pay the interest costs.

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Case study: tax beneﬁts from instalments Assume XYZ Superannuation Fund buys Instalments over shares, for an outlay of $1100 ($100 interest @10% pa and $1000 principal), and has other investment income of $200 pa. Assume the Instalments yield 7% fully franked. XYZ Superannuation Fund tax position at year end Dividend income: Franking gross up: Other income: Subtotal: Less: Interest deduction: Total:

70 30 200 300 (100) 200

Tax @ 15%: Franking rebate:

(30) 30

Net after tax:

200

ANTI-AVOIDANCE AND TAX DEDUCTIONS Australia has had a general anti-avoidance rule since 1981, when Part IV A of the 1936 Income Tax Assessment Act was introduced. The Australian tax system also labours under a range of speciﬁc anti-avoidance rules, some of which are explicitly apparent, and some of which are embedded in operative taxation rules. Here we address an important speciﬁc provision which also has effect as an anti-avoidance rule: the limitations on interest deductibility which are contained in s. 8-1.

Limitations on interest deductibility Section 8-1 of the 1997 Act operates as a central gateway to the availability of tax deductions for expenses incurred in relation to the earning of assessable income. It also provides for limitations on those deductions where they are incurred as capital expenditures, or for private or domestic purposes. The ATO has been pursuing aggressively a strategy of challenging the deductibility of expenditures incurred in relation to structured products which contain some element of capital protection, arguing that this is an expense of capital nature 205

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and hence it ought not be deductible. The leading contemporary example of this challenge is in relation to the deductibility of interest expenditures for money borrowed on a limited recourse basis. In the case of Commissioner of Taxation v Firth (2002) FCA 413, the ATO argued that the inherent premium in the interest charged for a geared equity investment product – at least as far as that interest related to the cost of the limited recourse nature of that loan – was not tax deductible. This case followed the release by the ATO of a statement which sought to disallow interest deductions for geared equity products with limited recourse ﬁnance, to the extent that interest was charged in excess of a ‘benchmark interest rate’ set by the ATO. This case was argued on the basis of the well-accepted apportionment principle which exists within s. 8-1, but the essentially radical nature of the challenge – which expressed a bifurcation approach – was rejected by the Full Federal Court of Australia (although the ATO has appealed the decision). The operation of the deduction provisions is explained succinctly in the judgement of Hill J in Firth: 6 The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a ‘perceived connection’ between the loss or outgoing and the assessable income or business: Federal Commissioner of Taxation v Hatchett (1971) 125 CLR 494 at 499. In other cases it has been said that the expenditure must be ‘incidental and relevant’ to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56, Federal Commissioner of Taxation v Smith (1981) 147 CLR 578 at 586. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v Federal Commissioner of Taxation (1958) 100 CLR 478 at 499. 7 If the loss or outgoing has some connection with the assessable income or the business which more directly gains or produces the assessable income but in addition some connection which is not that described in the section it will be necessary to apportion the loss or outgoing at that point. 8 The negative tests in subs (2) will exclude the loss or outgoing from deductibility where the whole or some part of the loss or outgoing falls within one or more of the four stated exclusions. If the loss or outgoing falls within any of the four stated exclusions but only in part, it will be necessary for there to be 206

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an apportionment in order to see how much of the loss or outgoing is excluded from deductibility.

In relation to geared investments in shares, the income against which the cost of ﬁnance is deducted is typically the dividends which ﬂow from those shares, since proﬁts – to the extent that they are taxed as a capital gain – are not included as assessable income as required by the deduction provisions. In rejecting the ATO claim, Hill J in Firth refused the proposition that some part of the interest paid by the taxpayer was actually not for the purpose of borrowing money, but was instead for the purpose of purchasing capital protection: 30 However, the real reason why the interest here was not on capital account rests on a simpler basis. It is that even if it can be said that some part of the interest did relate to securing freedom from personal suit, the real character of the payment was no different from the real character of the balance of the interest paid. It lay in the securing of funds to permit the acquisition by the taxpayer of income producing assets. It was, on revenue and not on capital account for the same reason as the balance of the interest paid by the taxpayer was.

The judgement is interesting because it indicates a judicial unwillingness to bifurcate a structured product into its component parts (or into derivatives which when combined will replicate the cash ﬂows from the product in question). This reasoning is clear from the judgement of Sackville and Finn JJ, who comprised the Full Federal Court bench in this case, along with Hill J: 76 In our view, the aggregate of the terms and conditions of each PEIL agreement, including the non-recourse provisions, constituted the basis on which the lender advanced funds to the taxpayer for the purpose of enabling him to acquire capital assets or working capital (depending on one’s view of his activities). The relatively high interest rate doubtless reﬂected the lender’s assessment of the risk that it was incurring in making an advance on all the terms and conditions of the agreement (as well as other commercial factors). There is, however, nothing in the agreement which suggests that any portion of the interest liability incurred by the taxpayer was attributable to a particular provision in the agreement. Nor is there anything in the agreement to suggest that the taxpayer’s purpose in incurring the interest liability was otherwise than to raise and maintain the borrowing. The provisions of each PEIL agreement, including those governing the taxpayer’s options concerning repayment and limiting the lender’s remedies, were integral elements of the loan itself. The non-recourse provisions, in particular, were not distinct from the loan or severable from it.

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One of the important value drivers of geared share investments or structured products is the ability to deduct the cost of interest on them. Although it is not at all clear that this tax beneﬁt is the primary motivation for many investors,4 it is certainly true that the scheme of the Australian income tax system is to allow taxpayers deductions for expenses incurred in the earning of assessable income, such as interest on ﬁnance for share purchases, and any change to this scenario will require legislative ﬁat. Given the intense scrutiny of deduction claims – including for geared share purchases – which the recent Australian government’s Review of Business Taxation engaged in, it is unlikely that any change to this concept will be recommended to government in the near term. Tax reform pressures will continue to remain an important policy driver in Australia, despite the lengthy reform process which was completed during the late 1990s and early 2000s. The recent collapse of business support for a radical change in the basis of calculation of income (the so-called ‘tax value method’) will not spell the end for big ticket tax reform. While both business and the ATO remain committed to seeing in the reforms already agreed to by government, the ATO in particular has a substantial backlog of claims and will proactively be seeking action on a number of sensitive fronts. This tax reform pressure will increasingly be ventilated through agencies such as the Board of Taxation, and the administrative review function of the Inspector General of Tax. Consider the following tax points where further action is anticipated: ■ the ATO continues to seek expansion of the categories of non-deductible

expenditure through persistent legal challenge and the use of non-reviewable ‘synthetic legislation’ such as media releases; ■ business is still questioning the limits on deduction of so-called ‘blackhole’

expenses such as mineral exploration costs and feasibility studies; ■ the Senate Mass Marketed Tax Scheme inquiry recommended the intro-

duction of an ‘at risk’ rule to limit tax deductions for investment expenses, as well as supporting calls for penalties for ‘promoters’ of tax schemes; ■ all stakeholders support an ongoing and drastic need for tax law simpli-

ﬁcation and the integration of old and new tax laws. The tax value method (TVM) was sold by its proponents as a way of simplifying and improving the certainty of tax laws. This ambition was overwhelmed by the radical approach adopted, which looked to identify assessable income by measuring a new concept, the ‘tax value’ of assets and liabilities created or transacted by taxpayers. 208

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While the TVM has some positives, it has negative themes which are likely to resurface in ATO attempts to redeﬁne core tax provisions. The key concern is a continuation of TVM-like attacks on the simple link between expenditure (normally deductible if linked to income) and taxable income. Current ATO activity seeks to give credence to what one recently retired ATO official has labelled a revisionist ‘idea’ about the tax system. This ‘idea’ is that the current deduction provisions in the Australian system were conceived in the middle of last century, are out of date and inappropriate in the context of a modern economy characterized by complex and innovative transactions. According to this new school of thought, deductions are simply tax subsidies for particular activities and are to be carefully limited to transactions of an orthodox type. The current High Court appeal in Firth’s case follows the Full Bench of the Federal Court’s rejection of this ATO argument, that interest is not deductible where ﬁnance involves limited or non-recourse aspects. This approach is behind the ATO drive for an ‘at risk’ rule, which seeks to replace the current test (which simply links deductions to income) and requires that a taxpayer assumes investment risk to claim a deduction. The only problem with this approach is that it cuts across the last 20 years of global ﬁnancial innovation, which seeks to reduce risk and increase income. For example, should a bank lose access to interest deductions for operating expenses simply because it sheds balance sheet assets in order to increase economic returns to shareholders? Similar concerns are raised by calls for tax scheme promoter penalties, which if applied to professional advisers operating in the normal course clearly infringe the right to counsel. Such calls were soundly rejected by the American Bar Association in the US context, and they raise an important Australian concern as well. A more careful approach to tax avoidance is called for here, as it was ultimately found in the US. Against this backdrop, the Board of Taxation will increasingly assume responsibility for mustering the competing forces of tax reform. Healthy debate and transparent dialogue are some of the best outcomes of the current round of tax reform. The new Inspector General of Tax will also need to assume responsibility for review of the extra-legislative tools being used with great effect by the ATO. ‘Synthetic legislation’ by media release has all the compulsive force of law but is unreviewable and, unless reviewed, essentially anti-democratic. A mechanism requiring media releases to be recast as reviewable ATO rulings will be one of the early key requirements for the establishment of the Inspector General.

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GENERAL ANTI-AVOIDANCE RULE: PART IV A The Australian tax system contains a general anti-avoidance rule – in Part IV A of the 1936 Act – which denies tax beneﬁts where a ‘dominant purpose’ of avoiding tax exists. Despite a deceptively simple formulation, Part IV A is uncertain in application in the case of transactions where mixed commercial and tax minimization motives or outcomes exist. Compared to the binary logic expressed in the formulation of tax avoidance proposed by Jeff Strnad – namely that tax arbitrage exists where a transaction involves no change in the economics of a party but is argued to produce a tax beneﬁt5 – the Australian rule triggers a denial of tax beneﬁts where the ‘dominant purpose’ of a transaction is to generate a tax beneﬁt, even in those circumstances where the taxpayer has experienced fundamental economic change as a result of the transaction. Part IV A denies certain tax beneﬁts where the taxpayer has entered a scheme with the dominant purpose of securing them. Section 177 A deﬁnes ‘scheme’ in broad terms: 177 A Interpretation (1) ‘scheme’ means: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action, or course of conduct, … (3) The reference in the deﬁnition of ‘scheme’ in sub-section (1) to a scheme, plan, proposal, action, course of action or course of conduct shall be read as including a reference to a unilateral scheme, plan, proposal, action, course of action or course of conduct, as the case may be. (4) A reference in this Part to the carrying out of a scheme by a person shall be read as including a reference to the carrying out of a scheme by a person together with another person or other persons. (5) A reference in this Part to a scheme or a part of a scheme being entered into or carried out by a person for a particular purpose shall be read as including a reference to the scheme or the part of the scheme being entered into or carried out by the person for 2 or more purposes of which that particular purpose is the dominant purpose.

Section 177 C deﬁnes a tax beneﬁt as: 177C Tax beneﬁts (1) Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax beneﬁt in connection with a scheme shall be read as a reference to: 210

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(a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; or (b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out …

Section 177 D contains a number of items which expand and clarify the scope of Part IV A: 177 D Schemes to which Part applies This Part applies to any scheme that has been or is entered into after 27 May 1981, and to any scheme that has been or is carried out or commenced to be carried out after that date (other than a scheme that was entered into on or before that date), whether the scheme has been or is entered into or carried out in Australia or outside Australia or partly in Australia and partly outside Australia, where: (a) a taxpayer (in this section referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax beneﬁt in connection with the scheme; and (b) having regard to: (i) the manner in which the scheme was entered into or carried out; (ii) the form and substance of the scheme; (iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out; (iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme; (v) any change in the ﬁnancial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme; (vi) any change in the ﬁnancial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; (vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and (viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi);

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it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax beneﬁt in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax beneﬁt in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).

Despite the wide scope and potential for uncertainty which Part IV A contains, Australian courts have recently provided some practical guidelines for the application of Part IV A. The leading case on the application of Part IV A to structured products is the Budplan case (Fiona Howland-Rose & Ors v Commissioner of Taxation (2002) FCA 246) which related to tax deductions for interest costs claimed by participants in structured agricultural schemes. In that case, Conti J considered a number of aspects of geared, tax effective investing, including the availability of interest deductions in respect of borrowed moneys, the application of Part IV A to the scheme, and the impact which the use of structured ﬁnance techniques will have on the incidence of Part IV A. The central factual ﬁnding of the case was ultimately conclusive in relation to these points. The judge held that the Budplan scheme was designed to provide ﬁnance for research and development, and that there was no certainty that any technology would be produced which was capable of generating assessable income. On the basis that the core deduction provisions require that deductible expenditure be linked to or have some nexus with assessable income, the judge found that the prerequisite conditions for deductibility did not exist: 96

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Contrary to the Applicants’ submissions, and despite what I would describe as the creative draftsmanship readily discernible in the Prospectus to which I have referred on several occasions, it is plain that what was objectively intended by subscribers for syndicate participations, upon the true interpretation of the Prospectus, including the pro forma Syndicate Deed forming part thereof, was that the initial activity of the members of the BPS was research and development activity to be undertaken over an initial period of two years or thereabouts, and further that there was a real risk that the same would be unsuccessful, with the consequence that any income producing activities to result therefrom would never in fact occur. I am therefore unable to accept as accurate the often repeated theme of the Applicants’ submissions that ‘commercialisation [began] at the outset’. Of course, to adopt the Applicants’ submission, there was a commitment to manufacturing and marketing as well as to research and expenditure, but those activities were not in substance or reality contemporaneous commitments. Without successful research and development in place, there would be no product contemplated by the Prospectus which would be available to be marketed.

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118 The principles which I have extracted lead to the inevitable conclusion, in my opinion, that the outlays of the Applicants referred in the preceding paragraph must fail to qualify within the ﬁrst limb of subs 51(1),6 since the same were wholly related to the cost of research and development, and are not capable of being identiﬁed with the derivation of any assessable income by any participant in the BPS, in the sense of assessable income derived as a result of those outlays, much less some disproportionate amount of income in the sense described in Fletcher.

A related point which was raised by the ATO questioned whether the indebtedness which was incurred by the taxpayers in Budplan was validly and effectively created by the process of drawing of bills of exchange, a simple example of a structured ﬁnance building block. The judge found that bills of exchange were effective in this case to create indebtedness: 125 The circumstances giving rise to this further issue raised by the Commissioner have been summarised in [43-46] above, the issue being whether the Applicants are disqualiﬁed from entitlement to deductibility pursuant to subs 51(1) in any event, for the reason that, according to the Commissioner, the Applicants never in fact subscribed their respective funds of $12,000.00 in respect of each of their ﬁrst two ﬁscal years of involvement, or multiples thereof in the case of Mr Harvey and Mr Davidson, for the gaining or producing of assessable income, because such ﬁnds were said not to have been fact paid to ATTORI and BARM respectively in the ﬁscal years for which deductibility was respectively claimed. All that was relevantly paid, so the Commissioner’s contention proceeded, was in the case of each Applicant part of the sum allegedly borrowed pursuant to the Loan Agreement made with PGF, together with 2 years interest calculated on the whole of that sum (see again the table of the Prospectus set out in [17] above) … 127 In Fletcher, the circumstances of the controversial payment of funds by scheme participants were more analogous to the present, in the sense that there was an exchange of commercial bills alone, that is to say, not accompanied by entries in the bank accounts of the payer participants and the payee promoters. The High Court said as follows (at 14) as to the signiﬁcance of such methodology of payment by the taxpayers in the circumstances there involved: The fact that the relevant ‘payments’ were purportedly made by ‘round robins’ of bills of exchange which were not supported by equivalent amounts of cash and which all ended up in the hands of the original drawees does not, once arguments of sham and ﬁscal nullity are rejected, necessarily preclude those ‘payments’ from being effective and legally binding. Depending upon the circumstances, they could constitute counterbalancing set-offs of credit and debit amounts. Prima facie, it would seem that they so operated in the 213

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circumstances of the present case. Whether they did is, however, a mixed question of law and fact. Those circumstances in Fletcher appear to have been similar to the circumstances of the ‘round robins’ which here took place. 130 The conclusion is therefore open rightly to be drawn that each grouping of the bills of exchange that were drawn and circulated, and the book entries made pursuant thereto by way of ‘counterbalancing set-offs of credit and debit amounts’ (to adopt the description in Fletcher extracted in [127] above), in the accounting records of PGF, BARM and ATTORI respectively, were duly authorised by the respective participants for the purpose of providing the means for, and effecting payment of, their respective contributions to scientiﬁc research expenditure and of their respective obligations to pay management fees, each as envisaged by the Prospectus … Accordingly I would reject the contention of the Commissioner that the Applicants did not effect payment according to law of the relevant sums respectively of $24,000 (or multiples thereof in the case of Messrs Harvey and Davidson) appertaining to the first two years of participation in the BPS (or for that matter together with interest thereon related to such period of time). The Commissioner’s contention as to the absence relevantly of ‘commercial value’, an expression used in a different revenue context in Moreau v Federal Commissioner of Taxation (1926) 39 CLR 65 at 70 (Isaacs J), an authority to which the Commissioner referred, should not be sustained.

Having determined that the expenditure incurred by the taxpayers was too remote from any future income to sustain the claim of deductibility, Conti J then analysed the alternative argument, relating to the potential application of Part IV A to the scheme. Essentially he found that the commercial arrangements in the scheme were unlikely to produce any proﬁt to the investors, even if income was ultimately derived by the scheme. This ﬁnding relied upon the judge’s conclusion that the pricing and return proﬁle of the scheme was diseconomic from the perspective of the investors, primarily because the scheme promoter was to be paid a fee of 25% of the gross proﬁt of the scheme: 132 The issue arises as to the application of Pt IVA adversely to the claims of the Applicants to deductibility for income tax purposes in respect of the research fees, management fees, interest and borrowing costs, if I am incorrect in my conclusion that deductibility should be denied to such outgoings, pursuant to subs 51(1) and subs 67(1) of the ITAA (as the case may be). Given the ‘test case’ character of the present proceedings, it is appropriate that I resolve that issue in any event. In Federal Commissioner of Taxation v Spotless Services Limited (1996) 186 CLR 404, the following passage in the joint judgment of Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ at 422 appears: 214

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Beaumont J, in his dissenting judgment, held that the form and substance of the EPBC proposal had been to take steps to ensure that the source of the interest was located in the Cook Islands. The dominant purpose of the taxpayers in doing this was to achieve a tax beneﬁt in Australia in the form of the exemption made under section 23(q) of the Act. Without that tax beneﬁt, the proposal would have made ‘no sense’. We agree with those conclusions. The above catchwords ‘no sense’ have received widespread recognition since their original formulation by Beaumont J of this Court in his dissenting judgment in a Full Federal Court in Federal Commissioner of Taxation v Spotless Services Limited (1995) 62 FCR 244 at 271. 133 Consequently it would not be to the point that any one or more of the Applicants testiﬁed as to a primary purpose of deriving assessable income from participation in the BPS. What is called for is an objective analysis of relevant facts, and the drawing of conclusions therefrom as to the existence of a dominant purpose of enabling a participant in the BPS, such as any one or more of the Applicants, to obtain a tax beneﬁt. An objective analysis must be chieﬂy based upon the contents of the Prospectus which have been comprehensively extracted in these Reasons for Judgment. Perforated syndicate participation application forms were contained in each printed copy of the Prospectus, and a pro forma of the Loan Agreement and of the Syndicate Agreement were embodied therein, preceded by explanations, summaries and illustrations of the operation of such Agreements, including the ﬁscal implications thereof. In the context of a disputed claim for tax deductibility, and in concluding that Pt IVA adversely applied to disallow the claim, Gyles J in Hart v Commissioner of Taxation [2001] FCA 1547, adopted the abovementioned theme in Spotless as to ‘making no sense’, along with the related notion of ‘commercial rationale’, in the following context: 48

49

It can hardly be seriously doubted that a purpose of both Austral and the ordinary borrower in entering into a transaction such as that in issue here would be to take advantage of the tax beneﬁts claimed and demonstrated by Austral, namely, the deductibility of all interest, including additional and further interest. This was a signiﬁcant advantage of the product … I am satisﬁed that there would be no commercial rationale for the arrangements in issue without the borrower being able to deduct all of the interest incurred for taxation purposes. It would make no sense otherwise. This is borne out by the manner in which the product was presented by Austral.

140 … the Applicants sought to answer the Commissioner’s case by reliance upon dictum of Emmett J in Metal Manufactures Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5229 (his Honour’s judgment was affirmed on appeal: Federal 215

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Commissioner of Taxation v Metal Manufactures Ltd (2001) 108 FCR 150), and in particular the following passages in what appears at 5275: 260 … a taxpayer may have a particular objective or requirement that is to be met or pursued by a particular transaction. The shape of such a transaction need not necessarily take one form. It is only to be expected that the adoption of one form over another may be inﬂuenced by revenue considerations ... Nor, in my opinion, does the fact that a taxpayer chooses one or two more alternative courses of action, being the one that produces a tax beneﬁt, determine the answer to that questions. Part IVA will be satisﬁed if it was the obtaining of the tax beneﬁt that directed the relevant persons in taking steps they otherwise would not have taken by entering into the scheme – Spotless Services Ltd at ATC 5210; CLR 423. 261 However, more is required than that a taxpayer has merely arranged its business or investments in a way that derives a tax beneﬁt. The scheme must be examined in the light of the eight matters set out in section 177D(b). Further that examination must give rise to the objective conclusion that some person entered into or carried out the scheme or part of the scheme for the sole or dominant purpose of enabling the taxpayer to obtain a tax beneﬁt in connection with the scheme. Such a conclusion will seldom, if ever, be drawn if no more appears than that a change of business or investment has produced a tax beneﬁt for a taxpayer – ... Nor should such a conclusion be drawn if no more appears than that a taxpayer adopted one or two or more alternative courses of action, being the alternative that produces a tax beneﬁt.

Applying the ‘no sense’ formulation in the context of the facts in the case, in particular the research and development focus of the scheme, the uncertainty of income, and the high cost/fee structure, the judge concluded that Part IV A would have applied to Budplan investors, if the deductions for interest expenses had not been disallowable on the basis of his earlier ﬁndings. In conclusion, the reasoning in Budplan illustrates that structured products which (unlike the transaction in Budplan) produce demonstrable or anticipated ﬁnancial beneﬁts and the reasonably legitimate prospect of assessable income should not be at risk of challenge under Part IV A, even where that income is speculative in quantum. Where the income is not likely to be generated for some time after the structured product has been purchased, or where the investment cost drastically outweighs the actual or likely income – such that the investment makes ‘no sense’ except as a tax beneﬁt device – Part IV A is more likely to apply. The difficult middle ground is where the after-tax cost of the product is signiﬁcantly less than the pre-tax cost, and the availability of the tax beneﬁt 216

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provides a considerable subsidy to the cost of the investment, but where it is objectively arguable that the transaction would still have been attractive without the tax beneﬁt (even if only marginally attractive, or where the attraction arises only upon a positive outcome for future speculative events, such as markets moving in a certain direction). The difficulty for taxpayers, advisers and structured product issuers is that Part IV A cannot rationally be applied to transactions which simply make more sense with tax beneﬁts than without.

FRANKING CREDIT TRADING RULES In the May 1997 budget, the Australian Treasurer introduced ﬁve measures designed to prevent so-called ‘trading’ in the franking credits attached to dividends on shares of Australian companies. There were two situations which caused the problems of tax revenue leakage which the rules address. First, a non-resident shareholder was able under previous law temporarily to transfer its share ownership to an Australian taxpayer, which received the dividend and franking credits, made compensatory payments to the non-resident, and then returned the stock. This situation was essentially the transfer of stock subject to the sale by the new ‘shareholder’ of an at-the-money call option/purchase of an at-the-money put option, with the non-resident as the counterparty. The second situation was economically equivalent to the ﬁrst but involved a different legal form: the stock was held from the outset by the Australian taxpayer, who wrote derivatives over its physical position to transfer the economic exposure to the non-resident. Both trades involved the attempted retention of the equity tax beneﬁts by an investor who holds a quasi-debt position, so the problem was also one which confronted the uncertainty of the differentiated debt/equity tax system. The core arbitrage of both transactions relied on the Australian tax law emphasis (under the laws as they existed at the time) on legal form as the determinant of tax result. The essence of both transactions involved the transfer of the franking credit from one shareholder (which did not value it) to another (which did).7 This is reﬂected in a contemporary statement made by the Australian Commissioner of Taxation, Michael Carmody, that: A lot of what we see is about transferring a tax beneﬁt from someone who can’t utilise it, to another person. So that’s why we have seen things like franking credits, transfer of tax losses, trading in losses. If you start to understand what is the more systemic issue, there is an issue about people who have a tax beneﬁt that they can’t take advantage of, then it is therefore of value to someone else, so it helps you focus.8

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The mechanism which both structures relied upon to achieve their result was the emphasis on legal form in Australian tax laws. This was reﬂected by the statement made in Treasurer’s Press Release 47 of 1997, that: The underlying principles of the imputation system as introduced in 1987, and as reﬂected in its affordability, include: ﬁrst, that tax paid at the company level is in broad terms imputed to shareholders proportionately to their shareholdings; and second, that the beneﬁts of imputation would be available only to the true economic owners of shares, and only to the extent that those taxpayers were able to use the franking credits themselves.9

The franking credit transfer resulted from the operation of the technical legal measures in Part III AA Income Tax Assessment Act 1936 (the Tax Act), for example ss. 160 AQT and 160 AQU which extend the imputation credit and rebate to ‘the shareholder’, deﬁned in s. 6(1) Tax Act as including ‘the member or stockholder’. This concept did not allow for a look through of a ‘temporary’ shareholding to an ultimate permanent shareholder in order to control the allocation of the equity tax beneﬁts, rather it simply recognized the entitlement of the shareholder on the company’s share register. The franking credit trading rules rely upon an economic substance approach to taxation of the combined stock and related positions in that stock, derivatives or other stock. The uncertainty of this economic substance approach is generated by the possibility of transactions approximating, but not involving, franking credit trading to display similar legal and economic substance to transactions which actually do involve a trade. For example, the simple long stock/short derivative example given above will transfer franking credits if the strike prices of the options are at-the-money with respect to the underlying share price. But if the options have strike prices which are out-of-the-money, the trade will decreasingly operate to transfer franking credits without economic risk; and in fact there will be a point along the derivative overlay continuum where the economic cost of the transaction will exceed the maximum corporate tax rate – at this point the trade may be explained by many factors, but simple franking credit trading will not be one of them. In practice, the bright line test which the rules use limits the degree of uncertainty and does not overly interfere with the majority of mainstream derivative trading or structuring strategies. The franking credit trading measures were ﬁrst announced in Treasurer’s Press Releases 46 and 47 issued on 13 May 1997, which described ﬁve scenarios: 1. Dividend streaming (PR 46); 2. Cancelling franking credits of wholly owned non-resident companies (PR 47); 218

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3. Preventing short-term franking credit trading – introduction of a holding period for shares (PR 47); 4. Preventing long-term transfer arrangements – related payments rule (PR 47); 5. General anti-avoidance rule – amendments to Part IV A (PR 47). The government, the ATO and the Treasury entered into close consultations with industry in relation to the scope and application of these announcements. Legislation effecting some of the announcements was released in November 1997 (Taxation Laws Amendment Bill No. 7/1997) and the government also released a clariﬁcation to the announcements in Treasurer’s Press Release 89. The release of TLAB 7 caused instant dismay for at least one large Australian company, since the share buyback announced by the Commonwealth Bank of Australia on 12 November 1997 was signiﬁcantly modiﬁed as a result of ATO pressure (including indications that it would seek to apply some of the budget measures to the franking component of the buyback). Whilst the CBA proposal may have been correctly thwarted by the perception that it was designed to provide tax beneﬁts, the uncertainty surrounding the application of the new rules to general dividend payments was unwelcome. Although the market was somewhat surprised by the broad scope of the measures as they were announced on budget night, the immediate concern was in relation to the third measure, which introduced a prohibition on the risk management of share portfolios during the announced new minimum holding period of 45 days for shares. The easiest way to understand the third measure is to analyse its two separate limbs: it requires that an investor hold new stock for at least 45 days around the (ﬁrst applicable) dividend date, and that during that 45 days the investor should be ‘at risk’ on the stock. Although the language of the third measure was largely borrowed from the US Internal Revenue Code s. 246 (c), which denies the intercorporate dividend deduction where shares are not held ‘at-risk’ for at least 45 days, the operation of the third measure as it was originally announced was believed to be unworkable. First, it was apparent that the analogy with the US was slight, since the US does not have an imputation system, and the US rule only applies to intercorporate dividends (that is, it does not apply to individual shareholders, trusts or partnerships). Second, the announced operation of the Australian version of the rule was that, during the prescribed ‘at risk’ period of 45 days, it would prevent diminution of the risk of loss on a share by more than 70% (since any higher risk diminution would lead to a denial of franking credits to the shareholder). Concerning this second limb, the perceived anomaly was that requiring all investors to expose themselves to at least 30% downside risk 219

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on shares is inconsistent with prudent investment practice, just as a prohibition on insuring a home against full risk of loss would be an irrational attitude towards wealth protection. The result of industry consultations was that Press Release 89 was issued on 8 August 1997. It contained a number of ‘carve outs’ which modiﬁed the scope of the 70% rule; of particular interest was the replacement of the blanket prohibition on reducing risk by more than 70% with a new concept, which permitted full risk reduction provided the shareholder retained at least 30% of the overall or ‘net equity exposure’ on the share. The measurement of the 30% net equity exposure was postulated by PR 89 to involve consideration of the ‘delta’ of the share and related derivative risk management positions, and was a welcome enhancement of the oversimpliﬁed concepts which were expressed in the original budget announcements.

Franking credit streaming Legislation giving effect to the ﬁve measures has now been introduced. The ﬁrst measure is designed to prevent companies paying dividends to investors which effect a transfer of franking credits to them. The classic example of such a transaction is a structured share buyback where the consideration includes a franked dividend component, which is priced so as to be attractive to shareholders who can beneﬁt from franking credits (for example Australian residents) but not to non-residents. The legislation covering the ﬁrst measure is contained in s. 160 AQCBA of the 1936 Act. It is useful to consider the terms of the 1997 CBA buyback to illustrate the operation of s. 160 AQCBA. The original version of the buyback was announced on 12 November 1997, and it was subsequently modiﬁed as a result of ATO pressure on 20 November 1997. The original terms involved the CBA offering to purchase a proportion of its stock from shareholders for $2 (that is, returning par value) plus a fully franked dividend for the remainder. The structure allowed the CBA to offer shareholders through the buyback an amount roughly equal in cash terms to the prevailing market price of $17.10, and it was the pricing and structure which caused the ATO concern. The commercial reality is that shareholders typically demand a premium to market to sell stock into buybacks or bids, and the premium was in the CBA case designed to ﬂow from the tax beneﬁts (since the tax beneﬁts allowed the investors to ‘gross up’ the cash consideration to a level signiﬁcantly higher than market). The supposed tax beneﬁts were on two levels. First, s. 159 GZZZQ 1936 Tax Act provided that the consideration which a shareholder would be considered to have received for an off-market buyback (and hence the amount of any 220

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capital gain or loss which the shareholder will be required to account for) would be determined by excluding the value of any dividend received as part of the buyback price. Thus, CBA shareholders would have been able to claim large capital or income losses, based on the difference between their acquisition and disposal price (the latter being considered pursuant to that provision to be $2). Since all investors would have bought CBA stock at least at $5.80 (that is, the sale price of the ﬁrst tranche in 1991), and many would have bought at higher prices, the structure was liable to generate signiﬁcant opportunities for crystallizing capital or income losses. The second tax beneﬁt was the large dividend, which was wholly or partly tax-free to investors because of its franked component. The outcome negotiated by the ATO involved restructuring the offer so that $7 was charged to paid up capital and share premium, with the balance of around $7.65 being payable as a franked dividend. The CBA also had its franking account debited by a reported $25 million. The negotiated outcome thus reduced the tax beneﬁts considerably. Section 160 AQCBA (2) describes the operation of the provision in the broadest possible terms. It is stated to apply to the ‘streaming’ (not deﬁned) of the payment of dividends, or the streaming of the payment of dividends and the giving of other beneﬁts to its shareholders in such a way that: (a) franking beneﬁts are received by shareholders (advantaged shareholders) who would derive a greater beneﬁt from franking credits than other shareholders; and (b) other shareholders (disadvantaged shareholders) will receive lesser franking credit beneﬁts or will not receive any franking credit beneﬁts. In discussions with the ATO immediately following the budget it was conﬁrmed that the anti-streaming rules would not apply in an extended form, for example in relation to the payment of a franked dividend on a converting preference share, unless the arrangement by itself constituted a streaming arrangement. For example, the mere payment of a CPS dividend was not ordinarily thought to be offensive, but could be where the ordinary shareholders were not receiving any dividends. This approach may be observed in s. 160 AQCBA (3) which provides that the Commissioner may make a determination in relation to a streaming arrangement and either cause a franking debit to arise in respect of each dividend or other beneﬁt paid or given to a disadvantaged shareholder, or cancel franking credits in respect of dividends paid to an advantaged shareholder. The structure of the section gives a clue as to its intended operation. The prospect of making a determination and generating a franking debit, in respect 221

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of a dividend which is less than fully franked and which is paid to a disadvantaged shareholder, evidences the view that the provision is designed to apply to attempts at paying dividends or beneﬁts to shareholders which are differentially franked. This is clear from the opening paragraph of PR 46 which states that the scope of the measure is to attack: Dividend streaming arrangements [which] involve a company disproportionately directing franked dividends to shareholders who can beneﬁt most from franking credits. (emphasis added)

Accordingly, s. 160 AQCBA would, at least, appear to attack the selective franking of dividends or beneﬁts and, where a shareholder is ‘disadvantaged’ because it does not receive a franked dividend, the company may suffer a franking debit. This concept is fairly clear to apply where the disadvantaged shareholder does not receive a franked dividend, receiving instead an unfranked or partly franked dividend (as to which see s. 160 AQCBA paras (9) and (10)). The difficulty in the case of the CBA buyback is that the precise nature of that transaction which the ATO found offensive was not immediately apparent, since non-participating shareholders did not receive any beneﬁt at all. Section 160 AQCBA paras (1) and (15) provide a deﬁnition of ‘giving a beneﬁt to a shareholder’ as including: ■ the issue of bonus shares; ■ a return of capital; ■ debt forgiveness; ■ making of a payment of any kind.

However, the deﬁned term is not used in its precise form in the operative provisions (which use similar but not identical concepts such as ‘deriving greater beneﬁts from franking credits than other shareholders’ – see s.160 AQCBA (2) (a)), nor is it clear how a mere return of capital can be offensive. Perhaps the key is to notice that the CBA share register includes a signiﬁcant number of foreign shareholders, and that the buyback was not a compulsory acquisition of a pro-rata number of all shareholders stock. In this view, the commercial operation of the initial terms of the offer was such that a selective beneﬁt was offered to certain shareholders, that is, it was only those Australian taxpayers who would value the tax beneﬁts which generated the premium to market necessary to encourage taking up the buyback. Accordingly, it can be seen that the literal operation of s. 160 AQCBA (2) would be triggered by the 222

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initial CBA offer, since the pricing and structure would operate such that ‘franking credit beneﬁts are … received by shareholders (advantaged shareholders) who would … derive a greater beneﬁt from franking credits than other shareholders’ (s.160 AQCBA (2)). For completeness, it is interesting to note how the ATO remedies are circumscribed in this situation. Section 160 AQCBA (3) allows the Commissioner to make a determination that: (a) a franking debit of the company arises in respect of each dividend or other beneﬁt paid or given to a disadvantaged shareholder; (b) a determination that no franking credit beneﬁt is to arise in respect of any dividend paid to an advantaged shareholder. Since there was no differentially franked beneﬁt paid to different shareholders in the CBA case, because a non-accepting (that is, foreign) shareholder would not receive any beneﬁt at all, s. 160 AQCBA (3) (a) would not apply, so that under the new streaming rules the ATO was not able to create a franking debit to the CBA franking account. It could of course deny the franking credit to the accepting shareholders, and it was the uncertainty in this regard which apparently induced the CBA to the negotiating table.

45-day rule Division 1A of Part III AA of the 1936 Act enacts the ‘mechanical’ requirements of the third 1997 budget announcement, for shareholders wishing to retain franking credits on new share purchases, by prescribing a new minimum holding period (45 days around dividend date) and anti-risk reduction rules (the shareholder must retain a net equity exposure or ‘delta’ greater than 0.3 during that 45 days). The 45-day holding period rule applies to ordinary shares, while preference shares are required to be held at risk for 90 days (see s. 160 APHO paras (2), (3) (a) (ii) and (b) (ii)). If a shareholder satisﬁes those two criteria, they will be a ‘qualiﬁed person’ under the new rules: s. 160 APHO then provides that only ‘qualiﬁed persons’ can retain franking credits on share dividends which are covered by the new measures. Section 160 APHM in combination with s. 160 APHO requires that a new shareholder keeps a minimum delta of 0.3 during the holding period. Once a shareholder has qualiﬁed in relation to a particular share, the shareholder can then reduce the opportunities for risk and reward in respect of that share, without losing entitlement to future franking credits. 223

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Delta is a ﬁnancial concept, and is the measurement of the rate of change of an option’s price with respect to a unit change in the price of the underlying share. If a share changes in value by, say, $1.00, an option with a delta of 0.5 will change in value by $0.50. An example of how delta is to be used for the 45day rule is set out in s. 160 APHM (3). The delta concept is a precise ﬁnancial tool, and relates to derivatives and shares. However, the drafting of s. 160 APHJ paras (2)-(5) completely rewrites the meaning of delta, to include non-derivatives such as non-recourse loans, guarantees and indemnities: 160 APHJ meaning of position (2) A position, in relation to shares or an interest in shares, is anything that has a delta in relation to the shares or interest, and includes, without limiting the generality of the above: (a) a short sale, or a future sale, of: (i) the shares or interest; or (ii) property that is substantially similar to, or related to, the shares or interest; and (b) a purchase, or future purchase, of property that is substantially similar to, or related to, the shares or interest; and (c) an option to buy or sell the shares or interest; and (d) an option to buy or sell: (i) property that is substantially similar to, or related to, the shares or interest; or (ii) an interest in such property; and (e) an option in relation to the shares or interest that is embedded in other property; and (f) a non-recourse loan made to acquire the shares or interest; and (g) an indemnity or guarantee in respect of the shares or interest.

A number of the examples given do not accurately describe ‘things’ that ‘have a delta’ in relation to the underlying share. It is ﬁnancially incorrect that non-recourse loans, guarantees and indemnities move in value in line with changes in the values of the assets they relate to, and there is a considerable degree of uncertainty set up by this approach. It would be more appropriate for these instruments to be dealt with under the extension to Part IV A which was also introduced as part of these measures (see below). It is also useful to note that shares or interests in shares are treated by the 45day rule as having a base delta of 1: see s. 160 APHJ (4). The ‘delta’ concept measures the rate of change of an option position with respect to changes in the value of the underlying share. Since, in the case of both non-recourse loans and indemnity and guarantees, there is neither an 224

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option position nor something which changes in value in a temporal sense as the share price changes, it is illogical and inequitable to attempt the extension of the delta concept to non-recourse loans, guarantees and indemnities as proposed. This is not to say that in some cases the transactions mentioned in s. 160 APHJ (2) (f) and (g) might not be economically equivalent to options, but simply recognizes that in many cases they will not be so equivalent. For example, consider a company which grants negative pledges or restrictive covenants to external ﬁnanciers. In these cases, it is typical for such companies, if they wish to acquire shares in other companies for strategic or investment purposes, to do so on terms which include the following steps: ■ the purchase of those shares; ■ the purchase of at-the-money put options; ■ the borrowing of moneys (typically 100% of the purchase price of the shares); ■ on terms which restrict the lender’s recourse to those shares and put options.

In situations of this sort, the application of s. 160 APHJ (2) and (5) would operate to deem the taxpayer to have a net position of 0, despite the fact that the taxpayer would be fully exposed to the upside on the stock, the downside (at least, in respect of the expense incurred to purchase the put option) and would in ﬁnancial terms have a net equity exposure of 0.5. It would appear that such a result is unintended. In fact, such an approach is both inconsistent with, and unsupported by, the original Treasurer’s Press Release 47, where the following statement appears: Diminished Risk of Loss For the purpose of calculating how much of a holding period is to be disregarded because of a diminished risk of loss, if there is an arrangement under which the taxpayer or an associate (see above) can or will effectively dispose of the shares or interests (or substantially similar or related property, see below) the period during which the arrangement was in effect will be taken to be a period of diminished risk. Therefore, if shares or an interest in shares are acquired with such an arrangement in place which remains in effect, the measure will apply in relation to those shares or interest to deny the franking credits and intercorporate dividend rebate. Such an arrangement will exist if the taxpayer: ■ has an option to sell (see below), a contractual obligation to sell at a future date or makes a short sale of the shares (or substantially identical securities, deﬁned above); or ■ grants an option to buy the shares (or substantially identical securities) which diminishes the risk of loss (see below); or

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■

has diminished the risk of loss by holding one or more other positions with respect to the shares or substantially similar or related property (see below): a taxpayer will have diminished risk of loss for these purposes if changes in the market value of the shares and the positions are reasonably expected to vary inversely.

Since an option may be deﬁned as the right, but not the obligation, to sell or purchase shares at a particular price and time, for which an option premium has been paid, it is clear that non-recourse loans, guarantees and indemnities are not the sort of arrangements which are contemplated as risk reduction strategies by Press Release 47: rather than being options, each is simply a relationship which allows a lender to exercise its security rights over shares which are pledged as loan collateral. The approach taken in the 45-day rule has been discussed by Professor Alvin Warren of the Harvard Law School. In ‘Financial Contract Innovation and Income Tax Policy’10 Warren suggested ﬁve possible tax policy responses to equity derivative tax arbitrage, including ‘integration of related investment positions’ and ‘mark-to-market’ taxation. The integration approach is adopted in the 45-day rule, and the mark-to-market approach is expressed in the Taxation Of Financial Arrangements proposals which are now being prepared for implementation by ATO/Treasury. The inherent problem with the integration approach was noted by Warren himself: the potential generality of this approach is limited by the burden it places on the Internal Revenue Service to identify offsetting positions … actual transactions are more likely to involve equivalences that are not exact. A requirement that non-exact equivalences be integrated for tax purposes would create new and arbitrary distinctions that would be extremely difficult to enforce.11

The underlying design of the 45-day rule measures is an approach which operates on a ‘proxy’ basis: rather than exhaustively deﬁning and attacking franking credit trading as such, the measures cover a broad range of situations which often coincide with such trades, but also may not. The 45-day rule is a proxy measure, because it operates to deny franking on any trade which reduces short-term equity exposure below the prescribed level, even if the reduced exposure is simply a result of bona ﬁde risk management. The core of the problem with the 45-day rule is that it is forensically impossible objectively to identify ‘related’ stock and derivative positions, and the problem is compounded when it is acknowledged that the essence of tax arbitrage is a question of the subjective motive of the taxpayer/s. Tax avoidance is never accidental, but a subjective motive is rarely admitted to. 226

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An example of the irrationality in the 45-day rule is the broad identiﬁcation of ‘related’ stock/derivative trades, relying on a last in/ﬁrst out (LIFO) methodology (see s. 160 APHI (4)). The operation of s. 160 APHI (4) is explained in para. 1.25 of the Explanatory Memorandum to TLAB 7/97 as follows: ■ where a taxpayer holds shares (the relevant shares) or an interest in shares; ■ the taxpayer disposes of securities which are substantially identical to the

relevant shares during the qualiﬁcation period in relation to the relevant shares (explained below); and ■ during the qualiﬁcation period a franked or rebatable dividend or distribu-

tion is paid or payable on the securities; ■ the taxpayer receives a franking credit or a franking rebate, or if the

taxpayer is a company a rebate under section 46 or 46A; the taxpayer is deemed to have disposed of a number of the relevant shares which is equivalent to the value of the disposed securities. 1.26 For example, if on 1 July 1997 a taxpayer acquires 100 ordinary shares in a company and on 1 August disposes of 50 ordinary shares in the same company, irrespective of whether the shares disposed of are the shares acquired in July, the taxpayer will be taken to have disposed of 50 of the July shares. In effect therefore the 45 day rule operates on a ‘last-in, ﬁrst-out’ (LIFO) basis. (emphasis added)

The LIFO approach is inconsistent with normal investment management practice which operates on a ﬁrst in/ﬁrst out (FIFO) approach, such that later sales are matched against the ﬁrst acquisitions of that stock. The breadth of the LIFO approach is compounded by the integration of disposals by associates, the problem here being that s. 160 APHF will operate so that factually unrelated trades will be aggregated with each other for the purpose of the 45-day rule: see para. 1.27 of the Explanatory Memorandum to the introducing Bill: 1.27 New subsection 160APHF(1) deﬁnes a substantially identical security as being any property that is economically equivalent to the relevant shares or interests in shares and whose value is linked to the shares or interests. 1.28 Accordingly, in relation to shares (the relevant shares), substantially identical securities include but are not limited to: (a) other shares in the same company that are of the same class as the relevant shares; (b) other shares in the same company that are of a different class where there is no material difference between the classes or shares that are exchangeable for shares in the same class as the relevant shares; 227

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(c) shares in another company that predominantly hold shares in categories (a) and (b); or (d) shares in another company which are exchangeable for shares in categories (a) and (b). 1.29 In relation to an interest in the relevant shares, substantially identical securities include an interest in a trust or partnership that predominantly holds the shares in categories (a) and (b). 1.30 Therefore, for example, in relation to an ordinary share, a substantially identical security would be a converting preference share with a delta of +0.9 in relation to the ordinary share.

Because the approach taken by the 45-day rule is to ‘super’ integrate a broad range of stock and stock/derivative positions, market participants need carefully to structure positions and products to avoid unnecessary wastage of franking credits. The two key issues are: 1. deﬁning which stock and options are related (for example the LIFO problem); 2. identifying what are substantially identical securities. Despite the adverse possibilities suggested by the choice of an overly broad objective approach to resolve what is essentially a subjective question, there is the prospect for a reasonably rational reconstruction, so long as we can identify the appropriate control mechanism. Since the budget announcements are clearly predicated on the need to prevent trading in franking credits, we can assume that the scope of the measures is to be restricted to precisely that task.12 The ATO acknowledged that the budget measures were modelled on sec. 246(c) of the US IRC. But it was explicit in the process of reﬁnement of the Australian measures that a targeted outcome – operating to prevent franking credit trading, but not to thwart legitimate risk management activity – was sought by government. This is veriﬁable from the public statements made by the government, the ATO and the Treasury, as well as from a careful observation of the progress of the development of the new rules. The initial formulation of the 45-day rule was stated in PR 47 as being concerned to require that an investor maintain a prescribed level of risk in relation to its shareholding during the 45day period: Generally, if changes in value of a share are offset by changes in value of a derivative by an amount greater than 70%, there would be a materially diminished risk of loss.13

Unlike US IRC sec. 246(c) which has a limited application to the intercorporate dividend deduction, the dismay which followed the release of the budget 228

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measures as initially formulated was driven by Australian investors’ concern about a rule which arbitrarily prevented risk management beyond 70% downside risk. Press Release 47 was cognizant of this difficulty, since it acknowledged that: The Australian Taxation Office will hold early consultations with interested parties on the implementation of this aspect of the measures.14

Consultations were held in the weeks following the budget annnouncements, and culminated in the revised formulation of the 45-day rule which was announced in PR 89 on 8 August 1997, where it was acknowledged that: constructive and substantive submissions have assisted in tailoring the risk diminution aspect of the 45 day rule to exclude arrangements that do not have the objective effect of a franking credit trade and identifying entities that can be ‘carved out’ of the standard operation of the 45 day rule while still protecting the revenue.15

It is precisely these ‘constructive and substantive submissions’ that form the basis of the economic substance approach which is capable of guiding the interpretation of these rules. Press Release 89 contains the following critical statement: The 45 day rule has been reﬁned to take into account the cost of obtaining protection against downside risk. The effect of this will be to limit the risk diminution aspect of the rule to arrangements where a high level of both upside and downside equity risk is removed. Where the net equity risk is such that the net delta of the derivative(s) is less than 0.7, the arrangement will not attract the risk diminution aspect of the 45 day rule. The revised formulation provides a basis for distinguishing between legitimate commercial hedging and franking credit trading.16

The relevance of the economic equivalence approach is conﬁrmed by PR 89 which notes that the reformulation it expresses is also based on an acknowledgement that: The revised formulation takes into account the cost of obtaining the tax beneﬁts of franking and the section 46 intercorporate dividend rebate. This is done by using delta as a measure of net equity risk. The delta of a derivative is the ratio of the change in the price of the derivative to the change in the price of the underlying share. The delta test will operate on a net basis. This means that if the delta of a position comprising, for example, a share and derivative is less than 0.3, the arrangement will fall within the scope of the 45 day rule. The initial formulation of the material diminution of risk aspect of the 45 day rule only applied to the removal of downside risk. It did not take into account the cost of removing the downside protection [sic], 229

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which in many instances would inhibit entering into the arrangement for the purpose of franking credit trading.17

In the course of the consultations with industry which resulted in the reformulation announced in PR 89, a variety of submissions were provided which attempted to substantiate the cost of obtaining franking credits using stock and derivative overlays.18 The submission which was most persuasive relied on a series of real-time examples to show that it was diseconomic to procure franking credits if a net equity exposure of greater than or equal to 0.3 was retained during the 45-day at-risk period. These examples are reproduced below (note the example was constructed when corporate tax rates were 36%).

EXAMPLE 1: 45-DAY HOLDING PERIOD, NO PRESCRIBED DELTA $ Buy NAB shares @ $18.50

18.50

Buy $20.00 put option (delta 0.96)

1.94

Holding cost for 46 days (market interest rates)

0.14

Total cost

20.58

When the dividend is paid, the investor can sell (put) the share under the option contract for $20.00: Receive dividend

0.45

Sell shares

20.00

Total proceeds

20.45

Net cash loss per share

0.13

This trade discloses a cash loss of $0.13 per share, however the franking beneﬁt can be valued at $0.25 per share (that is, the s.160 AQU amount).

EXAMPLE 2: 45-DAY HOLDING PERIOD, PRESCRIBED DELTA < 0.7 Buy NAB shares @ $18.50 Buy $18.50 put option (delta 0.62)

0.66

Holding cost for 46 days

0.13

Total cost

230

18.50

19.26

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When the dividend is paid, the investor can sell (put) the share under the option contract for $18.50. Receive dividend

0.45

Sell shares

18.50

Total proceeds

18.95

Net cash loss per share

0.31

This trade discloses a cash loss per share of $0.31, which is well in excess of the cash equivalent value of the franking credits of $0.25 per share. The trade is diseconomic if it is motivated by franking credit trading. Actual transaction costs of stamp duty and brokerage aggravate the diseconomy.

The conclusions provided by this economic analysis of stock and derivative activity enabled the ATO/Treasury to verify that a prescribed maximum delta of 0.7 (in respect of a derivative overlay) would render franking credit trading diseconomic once a 45-day holding period rule is in place. This is an essential point, coupled with the recognition in the Treasurer’s Press Releases that the scope of the measures was to be conﬁned to preventing trading in franking credits, it is thus not only possible but also appropriate to rely on an economic analysis of transactions to assist in the application of the new measures. Some relief from the compliance burden of the 45-day rule is provided for institutional shareholders who can elect to qualify for retention of franking credits based on a benchmark level attributable to the level of franking credits which are paid on a notional diversified portfolio of shares (useful where the institution holds investments which track that portfolio) (see s. 160 APHN). Small individual shareholders are not required to comply with the 45-day rule where the amount of franking credits they receive does not exceed $5000 per annum.

Related payments rule The fourth measure announced in the 1997 budget is dealt with by ss. 160 APHN and 160 APHNA, which deal with so-called ‘related payments’. This is an area which is not signiﬁcant in practice, perhaps due to its core incoherence. If it applies to a transaction, the effect of the related payments rule 231

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disentitles a taxpayer from retaining any franking credits derived from that transaction (see s. 160 APHO). The breadth of the related payment rule is immediately apparent: 160 APHN (2) Effect of passing beneﬁt of dividend or distribution The taxpayer or associate is taken … to have made … a related payment in respect of the dividend or distribution if, under an arrangement, the taxpayer or an associate has done, or is under an obligation to do … anything having the effect of passing the beneﬁt of the dividend or distribution to one or more other person.

The rule potentially would treat an application of a dividend payment towards reduction of outstanding interest on loan funds used to purchase the relevant shares as a related payment. In practice, this type of outcome is not usually seen, unless the transaction contains some other offensive elements.

177 EA: the extended Part IV A The ﬁfth measure announced in the 1997 budget provides for an extension of the provisions of Part IV A to cover situations in which franking credit trading may arise. Section 177 EA is one of those provisions of the Tax Act which are so broad that any rational interpretation of them requires a purposive approach. That is, the language of s. 177 EA is deliberately wide, no doubt in order to achieve a powerful and effective weapon concerning franking credit transfers. But it is the attempted breadth of the new measure which will provide signiﬁcant impetus for its reading down, particularly by a court asked to apply it to what may be considered normal, or not unusual, commercial activity. It is disappointing that the parliamentary drafters have not learned the lesson which may be seen in the critical judicial approach to previous attempts at broad or omnibus anti-avoidance provisions, such as s. 46 D and ss. 160 APHA/APP (6). (Section 46 D was emasculated in Radilo,19 and ATO concerns about the likely judicial attitude concerning the attempted expansion of the concept of dividend stripping to franking credit trading, which has existed for many years in ss. 160 APHA/APP (6), has meant that the ATO has not yet litigated based on those provisions.) This perspective on the operation of s. 177 EA is fortiﬁed by the language of PR 47 which was the basis for its introduction. PR 47 is entitled ‘Measures to Prevent Trading in Franking Credits’, and concerning the scope of the foreshadowed new general anti-avoidance rule (s. 177 EA), the Press Release states that:

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The Government intends to introduce amendments to the ITAA to … provide for a general anti-avoidance rule against franking credit trading and streaming, to apply to arrangements where one of the purposes (other than an incidental purpose) is to obtain a tax advantage in relation to franking credits.

The implausible structure of the new provision can be seen by comparing two of its key operative sections. Section 177 EA (3) is the application section and provides that the section applies if: (a) there is a scheme for the disposition of shares or an interest in shares in a company; (b) a frankable dividend has been paid, or is payable or is expected to be payable …; (c) … (d) … a person (the relevant taxpayer) would receive, or could reasonably be expected to receive, franking credit beneﬁts …; (e) having regard to the relevant circumstances of the scheme, it would be concluded that the person … who entered into or carried out the scheme … did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain a franking credit beneﬁt.

The impossible breadth of the section is then exacerbated by s. 177 EA (18) which deﬁnes franking credit beneﬁt in terms which operate when the shareholder simply receives a franked dividend. This concern is generated by the recognition that the dominant purpose of many share investors is to receive franked dividend income.20 Accordingly, if taken literally, this would mean that all shareholders could be said to receive a franking beneﬁt within the scope of the now expanded Part IV A, simply by receiving an ordinary dividend. Given the severe consequences surrounding a breach of Part IV A, this is not an outcome which any rational adviser or judge would be expected to countenance. In recognition of the implausability of this construction of the new provision, the section itself contains some internal guidance as to how it is to be read down. Section 177 EA (4) states that: It is not to be concluded for the purposes of paragraph 3 (e) that a person entered into or carried out a scheme for a purpose mentioned in that paragraph merely because the person acquired shares, or an interest in shares, in the company.

So we are left with two competing propositions which establish the ﬁeld within which the correct operation of the new measure must lie. The ﬁrst, which is absurdly wide and therefore not rationally available, is that the literal effect of the section is that all and any shareholders receiving a franked divi233

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dend would be caught by the expanded Part IV A. The second is the conﬁrmation that the mere acquisition of a share will not trigger the measure. Although we can discern that the correct analysis of the measure is somewhere between these two extremes, the difficulty is in establishing exactly where the proper meaning lies. The key to unlocking the correct meaning is to recall that the scope of the budget night announcement concerning the amendments to Part IV A is conﬁned to ‘franking credit trading and streaming’. As a forensic aid to identifying trading and streaming, both the Press Release and the actual legislation list some criteria, and these are illustrated in s. 177 EA (19), (20) which relate to: (19) (a) the extent and duration of the risks of loss, and the opportunities for proﬁt or gain, from holding shares …; (b) whether the relevant taxpayer would … derive a greater benefit for franking credits than other persons who hold shares …; (c) … whether the company would have retained the franking credits …; (d) … (e) whether any consideration … was calculated by reference to the franking credit beneﬁts to be received by the relevant taxpayer; (f) whether a deduction is allowable or a capital loss is incurred in connection with the paying of the a dividend or the making of a distribution under the scheme; (g) … (h) the period for which the relevant taxpayer held shares, or had an interest in, the company; (i) any of the matters referred to in subparagraphs 177D (b) (i) to (viii). (20) The circumstances in which the relevant taxpayer would … derive a greater beneﬁt from franking credits than another person include: (a) the person is a non resident; (b) the amount of tax (if any) that, apart from Part III AA (ie the imputation Part), would be payable by the person is less than the amount of the rebate of tax to which the person would be entitled …; (c) the person is a company that is unable to pay a dividend to its shareholders …; (d) …

The meaning of s. 177 EA can be resolved by again looking at the 1997 CBA buyback. The unfortunate forensic issue in that case was that both the media and reports attributed to senior CBA management referred to the fact that the buyback had been designed to provide tax beneﬁts. This is similar to the position of the taxpayer in Spotless Services,21 where it had been clear that the trans234

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action was motivated by tax considerations (but in relation to which the taxpayer unsuccessfully argued that the tax beneﬁt was expressly sanctioned by s. 23 (q) Tax Act). Since it was commercially unattractive to foreign CBA shareholders to participate in the buyback because of the pricing and the structure, it was possible for the ATO to determine that s. 177 EA paras (3) (a), (b), (c), (d) and (e) were satisﬁed; and that s. 177 EA paras (14), (15), (18) and (19) were also applicable. In particular, the ATO would have been encouraged in its approach by the view that the purposive aspect in s. 177 EA (3) (e) was met, because of the forensic assistance from the CBA and the media (that is, this supported the view that a purpose, other than an incidental purpose, obtained). The commercial unattractiveness to foreign shareholders would have fortiﬁed this view. Also, the fact that the Australian shareholders would obtain a greater beneﬁt than foreigners would assist the application of s. 177 EA (19) (b), and the structure of the capital and income losses available to shareholders would assist the application of s. 177 EA (19) (f). It is interesting to note that the remedies available to the ATO on an application of the amended Part IV A are slightly broader in scope than under s. 160 AQCBA. In the case of s. 177 EA, the Commissioner can generate a franking debit to the company’s account, as well as deny the franking credit to the shareholder (s. 177 EA (5)). This is in contrast to the requirement under s. 160 AQCBA (3) that some beneﬁt be paid to a disadvantaged shareholder before a franking debit can be made. Thus it seems that the franking debit extracted by the ATO from the CBA (reported to be $25 million) would have been possible only upon an application of s. 177 EA, and not as a result of the application of s. 160 AQCBA. The spirit of the negotiated outcome between industry and the ATO/Treasury which culminated in PR 89, which allows comfort for ‘normal’ risk management strategies, will in all likelihood be seen to guide the resolution of disputes about the effect of s. 177 EA. It is to be hoped that the amended Part IV A will have no broader application to hedged equity transactions than that which is expected to prevail under the measures reflecting the rest of PR 47. This suggests that s. 177 EA does not provide the basis for a doctrine of ‘constructive’ franking credit trading, applying to undermine the status of a transaction to which the 45-day rule has applied without a negative tax consequence. The s. 177 EA amendments to Part IV A attack transactions where the ‘purpose (other than an incidental purpose) of the scheme is to obtain a franking credit beneﬁt’ (para. 1.1 Explanatory Memorandum (EM)). Section 177 EA is drafted so as to catch a wide range of normal trades: given the existence of the 45-day rule which addresses risk diminution, the Explanatory Memorandum to s. 177 EA contains the startling proposition that: 235

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1.80 The extent to which the person receiving a dividend is exposed to the risks and opportunities of owning shares or an interest in shares, or another person is so exposed, is a relevant factor. 1.81 For example, a taxpayer who buys a put option on shares (which provides the right but not the obligation to sell for a stipulated price on or before a speciﬁc date) will have diminished risk with respect to the shares because the taxpayer will have guaranteed the sale price of the shares and will be indifferent to falls in the market price of the shares …

But in the real world, how can it ever be the case that the mere purchase of a put option can be tax offensive, particularly when the 45-day rule permits the use of derivative overlays, provided the prescribed net equity exposure is retained? Because the application of s. 177 EA is designed to be determined by ﬁnding the objective purpose of the taxpayer (which will be difficult to determine in many cases, particularly where there are ‘mixed’ purposes), that section and its EM provide a checklist of factors to assist in the determination. The factors are: ■ Risk diminution; ■ Duration of share ownership; ■ Tax proﬁles of the parties; ■ Consideration paid by the parties; ■ Whether any tax deductions coincide with the share trade; ■ Whether the dividend is received in substitution for interest; ■ Whether the trade is at arm’s length, or is off-market.

The impossible difficulty in the checklist approach is that each of the points on the list also exist within perfectly normal and acceptable equity market trades. In recognition of this overlap, the government released a Supplementary Explanatory Memorandum in relation to s. 177 EA, which clariﬁed that it was not intended to apply where a franking credit beneﬁt arises ‘fortuitously or in subordinate conjunction’ with a transaction. Concerning risk, it is universally accepted that risk reduction by using put options is commercially appropriate. Without put options, an investor is left with the simple choice between selling a risky stock early (that is, in a pre-emptive strike, before the market price drops) or late (that is, at a loss, after the market has corrected). Both outcomes promote systemic market risk; the pre-emptive strike can be a precursor to a market rout, whilst the wait-and-see approach imposes real ﬁnancial risk on the investor.

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Concerning duration of ownership, how can such a tax rule not distort the investment decision? Much of the ‘range trading’ which has characterized the Australian stock market over the past two to three years involves superannuation investors buying and selling stocks rapidly as they trade around the investor’s assessment of ‘fair value’. Concerning the relevance of the tax proﬁle of the parties in question, it is vital to note that this aspect will impact directly (negatively) on all superannuation funds. Since these funds have a nominal tax rate of 15%, dividends franked at 30% offer surplus tax shelter to reduce the tax applicable to non-dividend receipts of the fund (for example bond income). The availability of the surplus tax shelter was a speciﬁc design feature of the tax reform in the mid-1980s which resulted in superannuation funds being taxed, and has always been recognized as a fundamental ingredient in the Australian imputation system. The focus on tax proﬁle would mean that a purchase of stock by a superannuation fund from either a resident individual or a non-resident taxpayer would start to raise the basis for concern as to the retention of franking credits on the stock. Concerning the relevance of the consideration paid for the stock, it is perfectly obvious to the most casual observer of the stock market that stocks increase in value as the dividend payment date approaches; and that the difference between the cum- and ex-dividend price is greater than the cash value of the dividend. The cash value of the dividend is accordingly being ‘grossed up’ to represent some, or all, of the value of the franking credits attached to it. How can we justify excluding an investment in stocks during the late cum-dividend phase, even if that investment is simply responding to a rational asset allocation decision? The ﬂip side of this point moves into the next of the criteria which the EM and legislation rely upon, that is, whether there are any deductions or losses available through the ‘scheme’. This point is aimed at policing the dividend stripping aspects of equity transactions, but it is clear that the claim for a tax deduction where there is a loss on sale is normally a proper incident of bona ﬁde equity transactions. Undue focus on the deduction is not appropriate in a tax system which taxes income, that is, the taxpayers’ net accretion to wealth. The point on the checklist with the most potential for collateral damage relates to the consideration of the character of the dividend and whether it is equivalent to interest. This is not an aspect of any of the structures which have been publicly identiﬁed by the ATO as involving franking credit trading, and in fact it can only be seen as yet another attempt at stymying the proper operation of the converting preference share market. This was never an intention of the budget measures as announced by the Treasurer. Finally, the list of other relevant factors does not particularly help the search for certainty of outcome; neither the arm’s length nor fair value aspects are

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capable of easily being ascertained where the parties are anonymous and where the price can be a reﬂection of the size of the parcel as much as other ‘value’-related factors. In recognition of the uncertainty which ﬂavours s. 177 EA, it is not surprising that recommendations for its abolition have been made by the government’s Review of Business Taxation.

Notes 1 For example, isolated transactions of individual taxpayers which produced proﬁts were often not taxed, because they were seen as being affairs of capital, not income. This produced characterization problems and regulatory uncertainty, as well as potential revenue leakage. 2 Portions of the following analysis are extracts from Rumble T and Wood R: ‘Enhancing Corporate Tax Integration: Australian Reforms to the Taxation of Debt, Equity and Innovative Financial Contracts’ (2002, np, paper on ﬁle at SavingsFactory). 3 See for example the analysis of a system of franked debt in Rumble T: ‘Franked Debt – A Capital Markets Savings Cure’ in Rumble T (ed.) Australian Business Tax Reform, Tax Laws and Policy (Sydney, Prospect Media, 1999) pp. 27–65. The concept of a system of franked debt elaborates on the notion of a bondholder credit of the sort described by Alvin Warren in his Reporter’s Study on Corporate Tax Integration. 4 For example, trading volumes in the ASX Instalment market did not decline dramatically after the announcement of anti-avoidance rules (for example s. 82 KZME) limiting tax deductions for interest expenses on some structured products. (At the time of introduction of s. 82 KZME there was uncertainty as to whether it applied to products like Instalments.) This lack of impact on Instalment trading is consistent with the view that the primary purpose for many investors in equity structured products is to obtain exposure to growth assets, such as the underlying shares, and to the dividend income which derives from them. 5 Recall the analysis of tax arbitrage in Chapter 1, which reﬂected on Strnad’s formulation: ‘Tax arbitrage arises in its purest form when a series of transactions results in no net cash ﬂow but provides tax advantages ... it is equivalent, in cash ﬂow terms, to doing nothing, and the usual result for a taxpayer who does not engage in any transactions is that there are no tax consequences’ (Strnad, ‘Taxing New Financial Products – A Conceptual Framework’ (1994) 46 Stanford Law Review 569 at 573). 6 Section 51(1) of the 1936 Act was the precursor to s. 8-1(1) of the 1997 Act. 7 Presumably much of the motivation for domestic tax exempts to transfer franking has disappeared with the introduction of refundable franking credits. 8 ‘Lawyers and Loopholes: Australia’s Tax Umpire Speaks Up’ in Sydney Morning Herald 5 January 1998, 13–14. 9 Treasurer’s Press Release 47, 1997, at p. 1. 10 (1993), 107 Harvard Law Review 460. 11 Warren AC (1993) ‘Financial Contact Innovation and Income Tax Policy – Commentary’ Harvard Law Review 107: 475–6 (emphases added). 12 The title of and preamble to the Treasurer’s Press Releases are determinative of the scope of the measures: PR 47 is entitled ‘Measures to prevent trading in franking credits’ and contains the following opening remarks: ‘The Government has decided to introduce measures to address trading in franking credits and misuse of the intercorporate dividend rebate under section 46 of the Income Tax Assessment Act 1936 (ITAA).’ 13 PR 47 at p.9. 238

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14 15 16 17 18

PR 47 at p.11. PR 89 at p.1. PR 89 at p.1 (emphases added). PR 89 at p.4. The word ‘protection’ should be the word ‘risk’. The cash equivalent value of franking credits to an individual taxpayer is a function of the value of the franking rebate available under s. 160 AQU. This is determined under s. 160 AQU (1) as being equal to the ‘gross up’ amount included in the taxpayer’s assessable income under s. 160 AQT. The ‘gross up’ is determined by multiplying the cash value of the dividend received by that taxpayer by the amount (30/70) (reﬂecting that tax has been paid by the company at the rate of 30%). 19 (1997) 97 ATC 4151. 20 This is veriﬁed by the government’s own investor research conducted prior to the IPO of shares in the government-owned enterprise, Telstra. In his keynote address to the Securities Institute of Australia concerning his involvement in the Telstra IPO, Terry Campbell of JB Were (one of the three lead managers appointed by the government to the IPO) stated that: ‘But the most important feature or the strongest feature in the market research was for 86% was [sic] the ability to pay fully franked dividends. In virtually every market research piece that I’ve seen on retail investors, dividend franking is more important than anything else. It’s more important than the absolute yield and it’s more important than the capital growth prospects’ (Campbell T: ‘Telstra Float – Luncheon Address’ (1997), np, paper on ﬁle at the Securities Institute of Australia, at p. 1). 21 FC of T v Spotless Services (1996) 96 ATC 5201.

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Australian Financial Review, ‘Record In Warrants Trade’, 24 October 1997, p. 81. Australia Financial Review, ‘Managers Post Woeful Figures’, 22 May 2002, p. 1. Financial Derivatives and Risk Management, ‘Editor’s Note’ (1996) 8: 3–4. Sydney Morning Herald, ‘Lawyers and Loopholes: Australia’s Tax Umpire Speaks Up’, 5 January 1998, pp. 13–14. ACOSS Tax Reform Pack, September 1997. Allen D: ‘IRS Looking for 20 Percent Safe Harbor for Collars Under Constructive Sale Rules’, Daily Tax Report G-2 (1 July 1998). Anderssen H: ‘The Revenue Cost and Social Beneﬁt of International Dividend Streaming’ (Working Paper 96/4, BIE, AGPS, Canberra, 1996). Australian Taxation Office/Department of Treasury: Taxation of Financial Arrangements Issues Paper (AGPS, Canberra, 1996). Baltins E: ‘Implications of Taxation of Financial Arrangements Issues Paper’ in Rumble T (ed.) Derivative Tax Reform (Prospect Publishing, Sydney, 1997). Barkley T: ‘Berkshire Hathaway to Sell Bond Investors Must Keep Paying For’, New York Times, C-17 (May 22, 2002). Bernstein P: Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, New York, 1996). Boreham T: ‘Dividend Scheme Angers Tax Office’, The Australian, 26 February 1997, p. 24. Brooks N: ‘The Responsibility of Judges in Interpreting Tax Legislation’ in Cooper GS (ed.) Tax Avoidance and the Rule of Law (IBFD/ATRF, 1997).

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247

INDEX

45-day rule, 219, 223–31 60/40 character rules, 134, 136, 171n

A accruals basis, 110–11, 137–8, 160–1 adjusted benchmark rate of return, 190 issue price, 146 agency costs, 14, 60–1 All Ordinaries Index (AOI), 11–12, 42 AMP reset preference share, 78–80 anti-avoidance rules, 16, 99, 205–17, 233 Part IV A of 1936 Act (Australia), 210–17 Section 177 EA, 232–8 apportionment principle, 206 appreciated ﬁnancial position, 150 arbitrage, 14–15, 40, 42, 121, 123, 210 see also straddle tax arbitrage asset allocation, active, 36–42, 50 chargeable, 112 -linked debt, 91–2, 112 assignment payment, 142 associated transactions, 102 at risk rule, 208, 209, 219 at-the-money option, 144, 218 248

Australia accounting standards, 186, 194–5 fund managers, 32, 36–41 socioeconomic conditions, 30–2, 33–4, 35 Australian Equities Sector Specialist, 37 Australian Prudential Regulation Authority, 186, 204 Australian Stock Exchange (ASX), 42, 43, 48, 186, 238n ASX 200, 37, 51, 52 Australian Tax Office (ATO), 72, 185, 200, 202, 203, 205–6, 208, 209, 219, 220, 232, 235 Rulings, 186–7, 203–4 Australian tax system, viii–ix, 7, 15–20, 23n, 24n, 183–239 anti-avoidance and tax deductions, 205–9 case law, 206–7, 212–17, 232 franking credit trading rules, 217–38 general anti-avoidance rule: Part III AA, 218–25 Part IV A, 210–17, 232–8 imputation and its ﬂaws, 16–18 Income Tax Assessment Act 1936, 184, 205, 210, 218, 220–1, 223

INDEX

Income Tax Assessment Act 1997, 183–4, 187, 198–9 legal form in tax law, 217–18 New Business Tax System (Debt/Equity) Act 2001, 7, 187–90, 192–3, 195 related payments rule, 231–2 Section 177 EA, 232–8 Taxation Laws Amendment Bill 1997, 219 taxation of Instalments, 47–50, 196–205 tax rules for debt, equity and structured products, 185–96 avoidance, 16, 17, 22, 114 see also tax avoidance

B backloading, 138 bank bill rates, 71; see also interest rates; capital adequacy, 115–19 Bank for International Settlements (BIS), 115 bare trust, 45 basket of stocks, 134, 204 Berkshire Hathaway Inc., 165–7 betting, 91 bifurcation, 22, 23, 27n, 84–5, 105–6, 107–8, 109, 138, 153, 155, 206, 207 bill of exchange, 213–14 ‘bird in the hand’, 61 ‘blackhole’ expenses, 208 blue-chip stock, 48 BNP Paribas, 50–1 Board of Taxation, 209 bond, 71, 72, 94, 101 bond-warrant units, 121, 155, 158, 163–5, 167 tax treatment, 164 borrow fee, 127–8, 129 Budplan case, 212–16 business proﬁts, 129 ‘buy–write’ trade, 15, 70

C call option, 14, 41, 64, 76, 116, 123–4, 136, 144, 168n, 170n warrant, 54

capital analysis, 64–70 cost of, 8, 68 gain/loss, 122, 184 markets, 19, 33 optimal, 62–70 protection, 8, 42, 47, 50, 71, 72, 76, 191–2 structure, 58–70 and tax, 60–1 theories of, 58–62 capital gains tax (CGT), 45, 49, 72, 114, 185, 196, 197, 198–9 Carmody, Michael, 217 Carnahan, Michael, 34 ‘carve outs’, 220, 229 cash extraction, 49–50 cash-settlement option, 140, 145 Chock Full O’Nuts Corp. v. United States, 164, 167 Citibank Investments Ltd, 88–9 ‘close-to-the-money’, 15 Coles Myer (CMLPA), 41, 75, 76–8 collars, 150, 151, 178n–179n Commissioner of Taxation v. Firth, 206–7 commodity future, 86 swap, 140–1 common stock, 169n Commonwealth Bank of Australia (CBA), 41, 43, 48–9, 57n, 70–8, 219, 220–3, 234–5 ‘company’ taxpayers, see under UK complete market, 23n Computershare (CPUPA), 75 conduit approach to company tax, 18, 19–20 connection, 115 constant-yield method, 160 constructive ownership transaction, 133 sale, 132, 171n contingent convertible bonds, 121, 162–3 debt, 21 non-periodic payments, 138, 139–40 rules for, 159–61, 162

249

INDEX

contingent payment debt instruments (CPDIs), 140, 143, 146, 147, 158, 159–61, 176n, 180n contract for differences, 90, 96–7, 100 short, 134, 135 conversion mechanism, 63, 64, 67, 71, 158 process, 191–2 convertible bonds, 155, 158–9, 167 and debt, 84, 91–2, 113–15 tax characteristics of, 158, 194 converting/convertible preference share (CPS), 6, 8, 14–15, 24n–25n, 41, 62–70, 71, 76, 185, 193, 194–5, 221, 237 deﬁned, 63–4, 194, 195 efficiency gains, 70 hypothetical examples, 64–70 issue strategies, 65–70 risk, 191 corporate tax, 15, 17 counterparty credit risk, 103, 137 coupon, 144–5, 146, 148, 152 reset feature, 143

D David Jones Ltd (DJ) RPS issue, 74–6, 192 deﬁned, 74 key risks, 76 and other RPS, 75 dealer, 127, 134–5, 136, 171n, 173n debt ﬁnance, 42, 190 instruments, 146–8 interest, 187, 192 test, 187–8, 190, 192 debt/equity mix, 18, 59, 60–1, 144, 155, 186, 188, 217 see also hybrid instruments deductible equity, 192 expenses, 112, 212 deduction provisions, 212 deep gain, 113, 114 in the money, 124, 168n deﬁned outcome, 44 delta concept, 65, 223–5, 229–31 250

demographics, 30–1, 33 derivative contracts, 96–9, 104–5 overlay, 40, 55n, 230 dilution, 62, 69 diminished risk of loss, 225–6 disaggregation, 12, 15, 22 discount, 111 value, 64 discounted rights issues, 8 disqualiﬁed debt instrument, 156 distribution, 113 dividend, 17, 71–2, 76, 98–9, 116, 202–3 -received deductions, 126, 127, 135 step-up, 116, 117 streaming, 220–3 tax-free, 221 dominant purpose, 210, 215 double tax, 15–17, 25n

E earnings per share, 8, 69 economic substance, 138, 147, 188–9, 218, 229 effective non-contingent obligation, 187, 188–9, 190 deﬁned, 189 efficiency analysis, 8–10, 34, 64–70 efficient capital market, 3, 9–10, 13–15, 19 embedded options, 145, 158, 160 equity holders, 188 index futures, 134, 135 interest, 188 options, 64, 135–6 equity swaps, 12, 13, 24n, 136–43 deﬁned, 136–7 non-US investors, 142–3; tax-exempt investors, 142 US investors, 137–42 exchangeable bonds, 158, 159–61 exchange-traded funds (ETFs), 51, 124 excluded indexed securities (EIS), 92, 114 exclusion from derivative regime, 101–9 of tax relief, 28

INDEX

exemption, 18 expectations model, 160–1

futures contracts, 13, 86, 96, 97, 134, 135–6, 171n

F

G

fails, 127 Fairfax (FXJPA), 75 Federal Commissioner of Taxation v. Spotless Services, 214–15, 216, 234–5 ﬁeld service advice, 173n, 174n FIFO (ﬁrst in/ﬁrst out), 227 ﬁnancial analysis, 21–3 arbitrage, 3–4, 6, 10–12, 13, 15, 43 asset, 133 derivatives, 4, 6, 10, 21 distress, 79 futures, 86 innovation, 4, 5, 8, 209 ‘spiral effect’, 15 Financial Services Authority (FSA), 115–17 Fiona Howland-Rose & Ors v. Commissioner of Taxation, see Budplan case ﬁrm, theory of, 10, 13 Fitzgerald, Vince, 34 ﬁxed capital cost, 61–2 cost equity capital, see hybrid instruments coupon, 144–5 ﬂex option, 124 ‘ﬂight to cash’, 48 foreign tax credits, 126 forward contracts, 131–4, 136, 143–57 catch-all provision, 132, 150, 151 deﬁned, 150 tax considerations, 154–5 franked debt, 193 franking credit, 7, 16, 72, 196, 203, 204, 217–38 beneﬁt rules, 233–6 refundable, 203 structuring, 228 trading measures (1997), 218–19 trading rules, 217–38 franking debit, 221–2 FTSE 100 Index, 107, 108–9, 134, 136 fund managers, see investment managers

gain recognition, 132 gap hedging, 173n gearing, 51–2, 53–4, 60–2, 212 global pattern taxation, 23 goods and services tax (GST), 33 government debt, 33 Griffin v. Citibank Investments, 89 ‘gross up’, 239n guaranteed equity bond, 93, 94 returns, 101–8

H Hansell, Saul, 28–9 hedge funds, 132–3 hedging, 53, 94, 123, 132, 139, 152, 229 holding period, 219, 223–31 HSBC v. Stubbs, 103–4 Hunt Foods and Industries case, 164–5 Hutchinson, Daniel L., 13 hybrid instruments, 5, 21–2, 61–2, 74, 76, 77, 78, 143–57, 190–1, 192

I imputation, 15–18, 19–20, 218, 219, 237 credit, 201, 202–3, 218 income enhancement, 42–3 securities, 71, 185–6 streaming, 157 tax regime, 183–4 indebtedness, 146–7, 158, 160, 181n, 213 index replication, 40–1, 51 passive, 36–41 ‘individual’ taxpayers, see under UK industrial concentration, 19 information asymmetry, 59 Inland Revenue, 89, 91, 104, 105, 113 in lieu payments, see substitute payments innovation beneﬁt, 13–14, 18, 21, 191–2

251

INDEX

Instalment warrants, 41, 42–55, 77, 196–205, 238n deﬁned, 43–6 and gearing, 53–4 investor strategies, 47–50 shareholder applications, 46, 49 simple Instalments, 52–3 ‘streetTRACKS’ ASX 200 Instalments, 50–2 and taxation, 185–94 verdict on, 54 insurance, 10, 14, 92–4, 96, 101, 102–9 integration, 19–20, 22, 23n, 25n, 226, 228 interest costs, 212–14 deﬁned, 200 limitations on, 205–9 tax–deductible, 113, 147, 148, 158 interest rate, 47 cap, 154 reset, 154, 156 internal rate of return, 160 Internal Revenue Code of 1986, 121, 123, 219 also see under US tax system Internal Revenue Service (the Service), 138, 139–40, 141, 142, 159, 162, 171n, 173n, 174n, 226 International Swaps and Derivatives Association (ISDA), 89 ‘interstitial securities’, 41 investment managers, 31–2, 37–41, 50–51, 52, 56n strategies, 47–50 unit, 153 issuance, 14–15, 143 issuers, corporate, 13, 41, 145, 193

J Japan, demographics, 56–7n Jersey Limited Partnership (JLP), 117–18

K Krugman, Paul, 56–7n

L LEAPS (long-term equity anticipation securities), 172n 252

lenders, 127–30 leverage, 47, 53, 60, 69, 70 LIBOR (London interbank offered rate), 100 LIFFE (London International Financial Futures Exchange), 87 LIFO (last in/ﬁrst out), 227, 228 limited liability, 157 linearity, tax, 23 liquidity, 13, 14 loan relationships, 104, 109 deﬁned, 109–10 taxation, 110–12 local pattern taxation, 23 Lucas v. North Texas Lumber Company, 148, 176n, 177n

M management to expense ratio (MER), 56n mandatory convertible instrument, 121, 143, 153–7, 158 deﬁned, 153–5 taxation, 155–7 mandatory exchangeable instrument, 120–1, 143, 144–53, 175n, 180n deﬁned, 144–5 taxation, 146–50 margin loans, 43, 45 mark-to-market basis, 104, 105, 111–12, 131, 134, 226 market completeness, 21–3 -completing instruments, 4, 15 economies, 30–1, 33–4 -maker, 134–5, 171n shock, 40, 48, 50, 55n timing, 49–50 value, 59 married put, 124 Mass Marketed Tax Scheme, 208 maturity of agreement, 149 Mercer, William M, 37, 56n Merton, Robert, 23n–24n, 29–30 mispricing, 11, 67 mixed straddles, 171n Modigliani–Miller thesis, 24n, 26n, 58–60 and tax implications, 60

INDEX

money supply, 35 mutual funds, 42, 145 narrow-based security index, 134 National Commission of Audit, 30–1, 34, 55n national savings, 34–5 negative coupon instruments, 166 gearing, 201 neutrality, tax, 19, 35 Nikkei 225 Index, 134 non-commercial loss, 203 non-cumulative payments, 186 nonequity options, 136 non-periodic payments, 137, 138, 172n non-share equity capital account, 195 interest, 195 normal call premium, 163 ‘no sense’ formulation, 215, 216 notional principal contract, 139, 140, 141, 142, 150, 172n, 174n

periodic payments, 137, 139–42 PERLS (perpetual exchangeable resettable listed securities), 70–8, 192 deﬁned, 71, 73 distinctive features, 72–3 tax efficiency, 72 personal property, 121, 123, 126, 148, 152 plain vanilla debt, 126, 131 private savings, 19, 31, 34, 55n, 56n portfolio theory, 24n, 31–6, 41 position, 123, 224 Posner, Richard, 32 preference shares, 116–17 preferred stock, 145 present value test, 192 Provident Financial Group, Inc. (PFGI), 157 Income PRIDES, 157 public savings, 33 put options, 40, 54, 62, 72, 76, 125, 136, 144, 154, 236 ‘put/call parity’, 54

O

Q

offsetting positions, 152 open transaction, 178n option, 96, 97, 108, 135–6, 225–6 -based instruments, 158–67 optionality, 14, 46, 65, 192, 196 ordinary income, 183–4 interest income, 161 shares, 115, 185 original issue discount, 111 out-of-the-money option, 144, 218 outperformance, 47, 52, 72 overgearing, 60 over-the-counter (OTC) trading, 12, 13, 124 overweight position, 11

qualiﬁed boards or exchanges, 171n covered call, 123, 124 options, 86 person, 223

N

P packaged loan, see Instalment warrants passive investment income, 203 pass-thru entity, 133, 171n payments, 140 performance period, 38, 189–90

R Radilo Enterprises v. Federal Commissioner of Taxation, 185, 200, 232 Ralph, John, 203 Ralph Review, 203–4 range trading, 237 rational analysis, 6, 7, 10, 17, 22, 31, 42 real estate investment trust (REIT), 157 recapitalization, 158, 162 recombination, 12, 15, 22 reference price, 63 regulation, 6, 7, 9, 21 related payments rule, 231–2 relevant discounted security (RDS), 91–2, 114 253

INDEX

remarketing, 154, 155, 156–7, 166–7 ‘remote’ and ‘incidental’, 161, 162, 181n, 182n rental payment, 128 reserve capital instruments (RCIs), 119 reset convertible preference shares (RPS), 70, 74–8, 193 retail market, 41 price index (RPI), 111 retention of earnings, 19, 26n retirement, 30–1, 56n risk disaggregation, 10 management, 42 proﬁle, 6 reallocation, 12, 13 reduction, 5–6, 14, 42, 173n, 236 /return calculus, 40–1, 42, 51 taking, 3 transfer, 3, 4, 5, 8, 10–11, 14, 21–3, 70 variety of, 10 riskless/risky, 190 Russell, George, 56n

S S&P 500 Index, 134, 136 St George Bank (SGBPB), 75 sale constructive, 132, 171n current, 146, 148–51 short, 125, 127, 150, 170n ‘satellite’ products, 51 savings, 9, 10, 28–31, 34–5 Savingsfactory.com, 48 scheme, 210, 211–12, 237 securities futures, 134–5 loan, 127 ‘self-help integration’, 17, 25n–26n share buyback, 219, 220–3, 234–5 capital, 115 shareholder advantaged, 221, 222, 223 applications, 196–7, 198, 200 disadvantaged, 221, 222, 223 permanent, 218 254

rights, 145, 150 temporary, 217, 218 value, 5, 62–9 short -against-the-box, 125, 132, 178n contract, 134, 135 sales, 125, 127, 150, 170n signiﬁcant variation, 150 ‘simple’ portfolio theory, 24n social good, 12, 13 spanning sets, 23 SQUARZ, 158, 165–7 ‘stapled securities’, 78–9 State Street Global Advisers, 52 State Street Global Investors, survey, 36–40, 52 stock loan, 127–30, 169n straddle rules, 121–4, 125, 148, 151–2, 168n, 174n, 175n strategies, investment, 47–50 ‘streetTRACKS’ASX 200 Instalments, 50–2 Strnad, J, 22, 210, 238n structured bond-warrant units, 165–7 products, vii, 5, 6, 7, 8–9, 13, 28–31, 59, 208, 216–17 structuring techniques, 9–10, 212–14 STWIPA Instalment, 51, 52 substitute payments, 127, 128, 129 superannuation funds, 203–4, 237 swaps, 133, 141, 173n; see also equity swaps switch strategies, 15 synthetic legislation, 208, 209 products, 5, 6, 7, 1, 27n, 28–31, 35, 40–1, 43, 195–6 see also Instalment warrants

T tax ‘aggression’, 71 arbitrage, 7, 21, 22, 210, 226 asymmetry, 103–4 avoidance, 7, 226 beneﬁt, 210–11, 216, 220–1, 235 corporate integration, 18–20 rates, 9 return methods, 111

INDEX

shelter, 203, 237 systems, vii, 7, 9, 10, 18, 19, 23 see also under Australia, UK, US treaties, 17, 128–30, 170n taxpayer ‘purpose’, 236 tax value method (TVM), 208–9 Taylor, Frederick Winslow, 9 Technical Advice Memorandum (TAM) 9730007, 141–2, 174n Telstra, 43, 239n termination, 140 payment, 137, 138, 141 Thin Capitalisation, 186, 188 Thurow, Lester, 30, 31 tier I capital, 74, 115 instruments, 70–8, 186, 196 tier II, 117 TNT Ltd, 14, 24n, 41, 79 total return swaps, 98–100 transaction costs, 13, 15 transparency rule, 129–30 Treasurer Press Release 46 of 1997, 222 47 of 1997, 218, 225–6, 228–9, 232–3, 235 89 of 1997, 220, 229, 230, 235

U UITF (Urgent Issues Task Force), 119 UK tax system, 15, 83–120 basic principles, 83–4: bifurcation, 84–5, 93, 105–6, 107–8, 109 individuals, 85–94: asset-linked debt, 91–2 betting transactions, 91 case law, 87, 89 commodity or ﬁnancial futures, 86 contracts for differences, 90 convertible debt, 91–2 ﬁnancial trading, 86–7 legislation, 84, 85–6, 89, 90, 91, 92, 93, 119 options as employees, 89–90 qualifying options, 86 transactions in derivatives, 87–9 companies, 94–119: bank capital adequacy, 115–19 case law, 103

corporation tax, 15 derivative contracts, 95–7 exclusions from derivative regime, 101–9 legislation, 95–7, 99, 102, 109–10, 112, 113–15, 119 loan relationships, 109–12 total return swaps, 98–100 undergearing, 61 underlying parcel, 196, 197–9, 201 underperformance, 31–2, 36, 39, 41, 47, 52 unrelated business, 135, 172n US tax system, 15, 17, 21, 27n, 120–82 case law, 147–8, 155, 164 common law principles, 138, 148–50 legislation/regulation, 121, 122–3, 124, 125, 126, 127, 130, 131, and see section references non-US investors/stock lenders, 128–9, 131, 135 Notice 97–66, 130 personal property, 121, 123, 126, 131–2 position, 123 Revenue Ruling 85–119, 158 risk reduction rules, 121–6 section 163(1) (interest deductions of debt obligations), 151, 155–7, 159, 163 section 243 (dividends-received deduction), 126 section 246 (dividends-received deduction), 126, 219, 228–9 section 249 (deduction for premiums to redeem convertible debt), 163 section 263(g) (capitalization rules), 152, 168n, 179n section 512 (business taxable income), 142, 170n, 171n section 901 (foreign tax credits), 126 section 1058 (securities loans), 127–8 section 1091 (wash sales), 124–5 section 1092 (personal property), 122–4, 152–3, 168n, 179n section 1233 (short sales), 125 255

INDEX

section 1234A (payments), 140–1 section 1256 (US equity index futures), 125, 134–5, 136 section 1259 (use of derivatives for synthetic sale of assets), 131–2, 148, 149, 150–1 section 1260 (use of derivatives for synthetic purchase of assets), 132–3, 171n section 1.263(g) (coupon payments), 152, 180n section 1.446-3 (timing of income in swaps), 137–8, 142 section 1.863-7 (source of notional principal contract income), 142 stock loans, 127–30 US investors/stock lenders, 127–8 withholding tax policy, 129–30, 142–3, 146–7 US Treasury Department, 134–5, 153–4, 166

V valuation, of CPS, 63–4 value added, 39 protection, 67

256

Vann, Richard, 17 variable cost equity capital, see ordinary shares rate debt instrument, 160, 161, 181n

W warrants, 41, 55n, 163–4 Warren, Alvin, 12, 17, 18, 20, 226 wash sales, 124–5 weighting, 36 Westpac Banking Corporation, 25n, 41, 66, 79

Y yield comparable, 146 enhancement, 5–6, 8, 47–9 value, 64, 70

Z zero-coupon bond (ZCB), 106, 107, 109 US Treasury obligations, 153–4, 166