The rise in the volume and variety of financial instruments has begun to raise a number of questions and concerns in the area of international taxation. Of course, financial instruments are not new. We are all familiar with contracts such as stocks, bonds and options. However, the past 10-15 years has seen a tremendous development in the variety of financial instruments available in the market (either publicly traded, privately placed or individually negotiated). These newer instruments serve a wide variety of purposes including: (1) "resolving" a regulatory constraint, (2) more precisely tailoring a product to either a specific consumer or issues base, (3) enabling "instruments" that could be synthetically created by buying several different contracts- to be easily available (at a slight mark-up) to a broader investor base through the medium of single, new traded instruments, (4) risk diversification (5) "manipulation" of tax or accounting rules, either domestic or cross border.
In some sense none of these new financial instruments are really new. They are "new" in the sense that the particular set of contract terms of risks and benefits has never been previously available in a single instrument. Usually, however, the same net effect (at least economically) can be achieved by entering into several different more trading contracts. Stated differently, when looking at these new instruments you can understand them by deconstructing the new financial instrument into several common instruments that together have the same effect. The especially challenging fact, however, is that a given new financial instrument can typically be deconstructed in a variety of ways. Thus, new financial instrument "F" is the equivalent economically to someone holding the traditional instruments A+B+C, but is also comparable to holding A+C+D, and to holding B+D+C. This fact poses serious problems in trying to determine the appropriate taxation of "F." Depending on what "F" is, the income it generates and the activity it represents may receive very disparate tax treatment. In the domestic and international area much of taxation turns on classifying the activity and income (think of source, safe harbors, withholding, rules for substantive taxation of foreign persons, treaty provisions). If we could readily break the new instrument "F" into the well-known contracts that together replicate it, we might get some assistance in the tax treatment. However, there is usually no single set of contracts into with "F" can be "divided," so even that possible assistance is quite chimeric.
This paper will attempt to answer the following questions of, (1) how serious a problem are new financial instruments in the international tax setting; (2) why are they a problem, and (3) can a generalized approach to integrating financial instruments into international tax rules be developed?
What Interest Is Owned?
In the past 10-15 years there has been a tremendous development in the variety of financial instruments available in the market. The advent of these instruments poses many serious problems in trying to determine how to tax them appropriately, especially in an international setting. When the various issues below are aggregated, it is clear that taxing new financial instruments poses a serious international tax problem.
In addition to simple stocks and bonds, the market now offers much more complex instruments such as puts, calls, forwards, futures and swaps. The instruments have been aggregated and recombined to create new instruments. What is actually owned becomes more difficult to determine. Also, the ‘interest’ owned by the investor is not the actual security, therefore, the taxation of these interests poses new problems for lawmakers. For example, the purchase of a put option is the purchase of a right to sell, not the ownership of any actual security. The following problems arise is determining taxation of the put option. For example: valuation of the put is difficult, timing (whether there is ‘income’ that should be taxed before the true realization event [exercise of the option]) and where to source the income from the option.
Classification Of The Instrument.
These instruments can be pieced together to create various combinations; the income of each can yield disparate tax treatment. In particular, classifying the activity and the income pose serious issues for tax policymakers. For instance: Is the income foreign or domestic? Is it capital gain or ordinary income? Is the taxpayer foreign or domestic? Should taxation be placed on the instrument as a whole? or Should there be different tax treatment for the various elements of the instrument.
Financial instruments are technically complex. Therefore, in order to propose an effective tax scheme, one must be an expert in the workings of the instruments themselves. The expertise required to understand the instruments, makes tax policymaking and enforcement an even more daunting task. Specialists in the field must be employed to explore the industry, develop policy and enforce that policy. The resources required to achieve this goal may not be worth the revenue that it would generate.
Uses Of The Instrument For Tax Advantageous Purposes.
Investors have learned to structure transactions in order to take advantage of fluctuations in currency and interest rates. They have been able to avoid government regulations and taxation by creating ‘economically equivalent’ instruments. Some commentators, however, have noted that the new financial instruments are very different from taking ownership of the actual security. Many of these instruments (e.g. swaps) are mere ‘sidebets’, and should receive different tax treatment than owning stocks and bonds. The risks taken by an investor differs in three ways: credit, structural and legal. In reality, the interest is a contract right, which differs from property ownership of a security. For example, notional principal contracts have been developed to allow hedging or speculation with respect to commodity prices, interest rates and currency exchange rates. Tax avoidance also raises an issue of whether the behavior of the investor presents a threat to IRS revenue that exceeds the threat that impeding the behavior would present to the marketplace.
Tax Law Uncertainty Can Suppress Financial Innovation.
There is concern that changes in the tax treatment of financial instruments (in particular, implementation of the withholding tax) will hurt the market for financial instruments. Investors could be deterred from investing in a market where the tax treatment is uncertain. It is questionable whether the possible economic detriment of implementing new tax laws would outweigh the revenues and anti-abuse benefits of implementation. [Additional research would be necessary to answer this question.] Some commentators have actually gone so far as to suggest that rule changes should apply retroactively to securities that derive significant value from their tax characteristics. For example, issuers and investors can be required to apply the new rule to tax years prior to the change. A rule change also can be given partial retroactive effect by requiring taxpayers who issued or purchased the security prior to the change to apply the new rule from the date of the change or a date in the future. For example, in Notice 97-21, the Treasury took this position on the effective date of the rules announced on "step-down preferred stock." Notice 97-21, 1997-11 I.R.B. 9. Another way to give a rule change partial retroactive effect is to apply it to securities issued prior to the change if the security changes hands.
Is There Authority To Tax?
The U.S. cannot tax income that is not effectively connected to a U.S. trade or business or subject to §1441 or §1442 withholding tax. Many ‘new financial transactions’ do not involve net inbound investment to the U.S. where the investor is a foreign party. There are no current payments. Therefore, does not seem to be statutory authority to tax the income despite the fact that the underlying securities may have been a U.S. based interest.
Historically, the U.S. only taxes income upon realization. The fact that the taxpayer does not have the ‘ability to pay’ the tax until he realizes the income is one core premise of taxation upon realization. The other options posed by commentators create fictions in a transaction in order to tax income that has not necessarily been realized. This violates a basic tenet of our tax system. The system that is currently developing is becoming a maze of convoluted rules and regulations that are difficult even for a tax expert to navigate and determine the appropriate tax treatment. Therefore, a generalized approach that focuses on the basic rule of realization with anti-abuse provisions only in extraordinary circumstances is a potential alternative. [Extraordinary circumstances would be defined as ‘only where the loss of revenue to the IRS is extreme.’] This proposal would decrease the costs and burdens on the IRS and would likely simplify the tax treatment of financial instruments giving some certainty to the taxpayers.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.