UNITED NATIONS

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1 UNITED NATIONS Secretariat Distr. LIMITED ST/SG/AC.8/2001/L.6 24 May 2001 ORIGINAL: ENGLISH AD HOC GROUP OF EXPERTS ON INTERNATIONAL COOPERATION IN TAX MATTERS Tenth Meeting Geneva, September 2001 International Tax Aspects of New Financial Instruments 1 1 This document was prepared by Mr. Victor Thuronyi, Senior Counsel (Taxation), International Monetary Fund. This paper summarizes lectures delivered at the Second Interregional Training Workshop on International Taxation, held in Beijing, China in April Slides used in these lectures are attached. Views expressed are those of the author and do not necessarily reflect those of the United Nations.

2 Introduction The purpose of this set of lectures is to acquaint the participants with the types of new financial instruments that are in existence and to discuss the tax problems that they pose, with particular emphasis on cross-border transactions. The emphasis on cross-border transactions is appropriate given that this workshop is being organized by the Ad Hoc Group of Experts on International Cooperation in Tax Matters. One of the focus areas of this group is development and application of the UN Model tax treaty, and new financial instruments pose challenges in this respect. In addition, in many of the countries represented here, new financial instruments may play a relatively greater role in international transactions than in domestic transactions. Financial markets in many of the countries represented here are generally not as highly developed as in OECD member countries, and correspondingly new financial instruments are not as frequently used as in the OECD. Indeed, even in the OECD group of countries, the use of new financial instruments is much more widespread in some countries than in others. In addition, new financial instruments should pose relatively less of a problem domestically for most of the countries represented here than in OECD countries, for the following two reasons. First, one of the reasons that new financial instruments pose a problem in OECD countries is because some of these countries make distinctions in taxation according to the character of income, in particular, taxing capital gains at more favorable rates compared with other income. In the case of corporate income tax, however, most of the countries represented here do not make

3 - 2 - a distinction between capital gains and other income, taxing all the income of a corporation as business income. If this is not the case, I would heartily recommend that consideration be given to reforming your tax laws so as not to draw such a distinction (other than perhaps limitations on deductions for capital losses). To the extent therefore that there is no distinction between capital gains and ordinary income, new financial instruments pose less of a problem, because there is no need for special rules to determine the character of income. A second reason why new financial instruments may pose less of a problem domestically is that the rules for taxation of business enterprises typically are based on accounting rules. These rules tend to be more flexible and may provide a basis for dealing on a sensible basis with new financial instruments in such a way that there is not a significant threat to erosion of the tax base from use of such instruments. By contrast, in countries which formulate their tax rules independent of accounting rules, it is necessary to provide detailed rules for the taxation of financial instruments so that taxpayers cannot use them to avoid taxation. In conclusion, my assessment is that, at least in the near future, new financial instruments should be relatively easy to deal with in the domestic context in most of the countries represented here. There are many more issues that will pose more of a strain on a tax system than new financial instruments. By contrast, the international context may be more problematic. First, accounting norms will not help in this area, because rules for withholding must be based on norms specified in the tax laws. Second, the area of withholding is one where legal form makes a difference. Withholding applies only to specified types of payments. For example, some countries impose withholding tax on dividends, but not on interest or capital gains. Or they may impose withholding tax on

4 - 3 - interest and dividends, but not on other contractual payments. Because the payments under new financial instruments can take forms that are different from the forms of payment traditionally subject to withholding tax, difficulties in terms of the legislative definitions of payments subject to withholding tax can arise. Third, withholding presents a tax policy concern, because the amount of payments under some financial instruments may not be closely correlated with the amount of income actually earned. This is particularly the case for swap payments. There is a risk, therefore, that if a withholding obligation is imposed, taxpayers simply will not enter into the type of transaction subject to withholding, because the withholding would be out of proportion to the amount of income involved. This risks denying to domestic companies the risk-shifting benefits that new financial instruments can provide. Finally, in the international context tax treaties present an important constraint on countries freedom of action. Treaties present two main problems in this context for developing countries. First, the effect of existing treaties is generally to preclude taxation in many cases. Second, the application of tax treaties may present difficult legal issues of contruction because new financial instruments do not fit neatly into the categories contemplated by treaties. Definitions I would like to begin the technical discussion by considering the definitional issue for new financial instruments. I do this for two reasons. First, it is necessary for those who are going to be dealing with new financial instruments to understand at least some of their more common

5 - 4 - forms. The financial jargon should not become an obstacle to the proper formulation of policy and proper administration of the tax laws. Second, it is useful to consider the problem of definition because there is a very real question as to the extent to which some of these financial instruments can be defined, or are appropriately defined in the tax laws. Some countries try to include definitions in the tax laws, but these definitions may be imprecise. Therefore, exploring the multifaceted variety of new financial instruments is useful as a way of identifying some of the problems that may arise in formulating definitions in a statute or regulations. Please refer to slides 2-5 for definitions of the following terms: derivative, option (American, European, Bermuda), OID, LIBOR, present value, put-call parity, and underlying. These definitions are taken from the glossary of an excellent recent text that I would recommend to anyone pursuing in-depth study in this area: Tim Edgar, The Income Tax Treatment of Financial Instruments: Theory and Practice (2000). Additional definitions of relevant terms can be found in the OECD, Taxation of New financial Instruments (1994). In addition, the general report by C. Plambeck, H.D. Rosenbloom and D. Ring, Cahiers de droit fiscal international (1995), contains a useful introductory discussion that explains the meanings of the relevant terms generally used in this area. See also the papers published in the reports of the seventh and eigth meetings of the Ad Hoc Group of Experts on International Cooperation in Tax Matters. Put-call parity and basic building blocks

6 - 5 - The concept of put-call parity merits some discussion, because it is one way of illustrating how any given financial instrument can be created by combining others. This has important implications for taxation. In particular, it suggests that the search for a unique economic substance underlying any given instrument will be futile, since any of the possible sets of equivalent combinations of instruments is an equally valid representation of the instrument in question. Put-call parity can be illustrated by an example, taken from p. 22 of Tim Edgars book cited above: +A +P = +B +C. +A long position in an asset +P purchase of a European put option on the asset (i.e. an option exercisable only upon expiration of its term) +B is a long position in a zero-coupon bond +C is the purchase of a European call option on the asset that is exercisable at the same time as the put. For example, an investor purchases an asset at 91 and acquires a put option on the asset exercisable in one year at 100. An equivalent portfolio consists of (1) the purchase of a zerocoupon bond for 91 and (2) the purchase of a call option on the asset at 100. To see the

7 - 6 - equivalence, imagine that the spot price declined to 75, so that an investor who purchased the asset and the put option would have a net worth of 100. An investor who purchased the zero coupon bond and the call option would also have a net worth of 100 (the call option would be worthless). On the other hand, if the spot price goes to 125, an investor who holds the asset and the put option would have a net worth of 125 (put option is worthless). An investor with the bond and the call option would exercise the option and also have a net worth of 125. The put-call parity is related to the basic building block concept of new financial instruments, under which all financial instruments can be thought of as being composed of the following: Credit-extension instruments Price-fixing instruments _ Price-insurance instruments. 2 Price-fixing instruments fix the price of an asset by obliging one party to purchase the asset at a specified price. A forward contract is an example. Swap contracts are equivalent to a series of forward or futures contracts on the subject of the swap. Price-insurance instruments (options) give the holder the right, but not the obligation to purchase or sell a specified asset at a specified price. 2 See Edgar, op cit., at 5.

8 - 7 - To explain the details of the equivalences would be time-consuming, but the basic point to be made here is that any given financial instrument is the equivalent of a combination of others. Use of new financial instruments for tax avoidance One of the concerns that new financial instruments pose is that they can be used by taxpayers often subsidiaries of multinational groups to avoid taxation in the countries where they operate. We will consider two examples of this. 3 The first is a hybrid instrument, which is treated as debt in the jurisdiction of the payor and as equity in the jurisdiction of the payee. A debt-equity hybrid is conceptually straightforward. Legally, it takes the form of a debt instrument. If the jurisdiction of the issuer allows an interest deduction, tax can be saved due to the value of the deduction. On the other hand, if the jurisdiction of the residence of the income recipient applies an economic substance approach and treats the instrument as equity, it may benefit from favorable treatment for equity, for example a participation exemption. 4 3 See OECD, Taxation of New Financial Instruments (1994), Appendix II. 4 In the case of the example in the above-cited OECD publication, the residence jurisdiction does not tax payments received because under the facts of the case the issuer has no profits and under the laws of the residence jurisdiction distributions not made out of profits are not considered to be taxable dividends.

9 - 8 - The second example is use of a forward contract to circumvent withholding on interest. Here, instead of borrowing in local currency (which is assumed to be a weak currency with a high interest rate), the borrower borrows in hard currency (with a correspondingly low interest rate) and enters into a forward contract to buy hard currency to repay the debt at maturity. Instead of paying a large amount of interest, most of the interest payment is in effect converted into a payment under a forward contract, which is not subject to withholding tax and presumably also is not subject to any applicable limitations on deductiblity of interest. Treaty issues Slides: cases of discount bonds, interest rate swap, obligatory convertible. These are 3 concrete examples designed to illustrate some treaty issues that come up with new financial instruments. discount bonds (slides 7-10) In this example, the issuer issues a bond with a principal amount of 1,000 and an issue price of 800. Interest is payable at 8% of the principal amount (80 per year), but the total rate of interest is higher because there is 200 of OID.

10 - 9 - Slide 8 shows the payment flows under this instrument: 80 of interest in years 1 through 4. Suppose that a withholding tax of 10% is imposed, then tax withheld is 8. In year 5, there is an interest payment of 80 also subject to withholding tax of 8. In addition, the bond is redeemed for Therefore, 200 of the redemption represents payment of the OID. Slide 9 shows a bond without OID with 10% interest. Here the withholding tax is 10 per year. The issue raised by this example is will the OID be subject to withholding tax as interest? If interest is subject to withholding as it accrues, para. 108 of the OECD report on New financial Instruments states: Article 11 of the Model Double Taxation convention considers only interest paid and to impose a withholding tax yearly on an accruing discount would not seem to be in accordance with the provisions of Article 11 because such discount is not paid until redemption. This therefore is a potential obstacle to withholding under tax treaties (I wish to express no view on the legal validity of this statement, however.) Article 11 of the model treaty would treat the OID as interest. The following quotations from the commentary on the OECD model may be helpful in this context: Commentary on article 11, para. 18. The term designates, in general, income from debt-claims

11 of every kindon the other hand, debt-claims which carry a right to participate in the debtors profits are nonetheless regarded as loans if the contract by its general character clearly evidences a loan at interest. Para. 19. Interest on participating bonds should not normally be considered as a dividend, and neither should interest on convertible bonds until such time as the bonds are actually converted into shares. However, the interest on such bonds should be considered as a dividend if the loan effectively shares the risks run by the bebtor companyin order to avoid any possibility of overlap between the categories of income dealt with in Article 10 and Article 11 respectively, it should be noted that the term interest as used in Article 11 does not include items of income which are dealt with under Article 10. Para. 20. Generally speaking, what constitutes interest yielded by a loan security, and may properly be taxed as such in the State of source, is all that the institution issuing the loan pays over and above the amount paid by the subscriber, that is to say, the interest accruing plus any premium paid at redemption or at issue.. Para. 21. the definition of interest in the first sentence of paragraph 3 is, in principle, exhaustive. It has seemed preferable not to include a subsidiary reference to domestic laws in the text Para The definition of interest in the first sentence of paragraph 3 does not normally

12 apply to payments made under certain kinds of nontraditional financial instruments where there is no underlying debt (for example, interest rate swaps). However, the definition will apply to the extent that a loan is considered to exist under a substance over form rule, an abuse of rights principle, or any similar doctrine. Derivatives: interest rate swap (slides 13-17): In this example, two companies, LIC and SIC, have borrowed, in one case on flexible interest rates and in the other at a 7% fixed rate. Under loan 1, the rate is LIBOR plus 1%. Assume that actual LIBOR for year 1 is 5% and for year 2 is 6.5%. The two companies enter into a swap, in effect to swap their obligations to pay interest. Under the arrangement, LIC makes a payment of 10 to SIC in year 1. In year 2, LIC receives payment of 5 from SIC. The issue is whether the payments under the swap are in the nature of interest. If so, they might be subject to withholding tax. If not, that is, if they are contractual payments, then the other income article (article 21) applies, under which the payment is taxable only in the state of residence, i.e. no withholding tax may be imposed. obligatory convertible (slides 18-20)

13 This is an example of an obligatory convertible bond, which must be converted in year 6. Suppose that in the country of issue an economic substance approach is taken, and that withholding is imposed under the dividends article. Suppose that in the country of the investors, the convertible is treated as debt. In this case, article 23A(2) requires a tax credit for the tax withheld by the source state. Paragraph 32.3 of the OECD commentary on articles 23A and 23B states: Where, due to differences in the domestic law between the State of source and the State of residence, the former applies, with respect to a particular item of income or capital, provisions of the convention that are different from those that the state of residence would have applied to the same item of income or capital the two Articles require that relief from double taxation be granted by the State of residence notwithstanding the conflict of qualification resulting from these differences in domestic law.